Summary of HARLEYSVILLE NATIONAL CORP

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

The following is management's discussion and analysis of the significant changes in the results of operations, capital resources and liquidity presented in its accompanying consolidated financial statements for Harleysville National Corporation (the Corporation), and its wholly owned subsidiaries-Harleysville National Bank (the Bank), HNC Financial Company and HNC Reinsurance Company. The Corporation's consolidated financial condition and results of operations consist almost entirely of the Bank's financial condition and results of operations. Current performance does not guarantee, and may not be indicative of, similar performance in the future. The information in Management's Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the Corporation's consolidated financial statements and the accompanying footnotes under Item 8 and the Forward-Looking Statements on page 3 of this report on Form 10-K.

Critical Accounting Estimates

The accounting and reporting policies of the Corporation and its subsidiaries conform to accounting principles generally accepted in the United States and general practices with the financial services industry. The Corporation's significant accounting policies are described in Note 1 of the consolidated financial statements and are essential in understanding Management's Discussion and Analysis of Results of Operations and Financial Condition. In applying accounting policies and preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amount of assets and liabilities as of the dates of the balance sheets and revenues and expenditures for the periods presented. Therefore, actual results could differ significantly from those estimates. Judgments and assumptions required by management, which have, or could have a material impact on the Corporation's financial condition or results of operations are considered critical accounting estimates. The following is a summary of the policies the Corporation recognizes as involving critical accounting estimates: Allowance for Loan Loss, Goodwill and Other Intangible Asset Impairment, Stock-Based Compensation, Unrealized Gains and Losses on Securities Available for Sale, and Deferred Taxes.

Allowance for Loan Losses: The Corporation maintains an allowance for loan losses at a level management believes is sufficient to absorb estimated probable credit losses. Management's determination of the adequacy of the allowance is based on periodic evaluations of the loan portfolio and other relevant factors. However, this evaluation is inherently subjective as it requires significant estimates by management. Consideration is given to a variety of factors in establishing these estimates including historical losses, current and anticipated economic conditions, diversification of the loan portfolio, delinquency statistics, results of internal loan reviews, borrowers' perceived financial and management strengths, the adequacy of underlying collateral, the dependence on collateral, or the strength of the present value of future cash flows and other relevant factors. These factors may be susceptible to significant change. To the extent actual outcomes differ from management estimates, additional provisions for loan losses may be required which may adversely affect the Corporation's results of operations in the future.

Goodwill and Other Intangible Asset Impairment: Goodwill and other intangible assets are reviewed for potential impairment on an annual basis, or more often if events or circumstances indicate that there may be impairment, in accordance with SFAS No. 142, "Goodwill and Other Intangible Assets and SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." Goodwill is tested for impairment at the reporting unit level and an impairment loss is recorded to the extent that the carrying amount of goodwill exceeds its implied fair value. The Corporation employs general industry practices in evaluating the fair value of its goodwill and other intangible assets. The Corporation calculates the fair value, with the assistance of a third party specialist, using a combination of the following valuation methods: dividend discount analysis under the income approach, which calculates the present value of all excess cash flows plus the present value of a terminal value and market multiples (pricing ratios) under the market approach. Management performed its annual review of goodwill and other identifiable intangibles at June 30, 2008 and determined there was no impairment of goodwill or other identifiable intangibles. No assurance can be given that future impairment tests will not result in a charge to earnings.

Stock-based Compensation: The Corporation recognizes compensation expense for stock options in accordance with SFAS 123 (revised 2004), "Share-Based Payment" (SFAS 123(R)) adopted at January 1, 2006 under the modified prospective application method of transition. The expense of the option is generally measured at fair value at the grant date with compensation expense recognized over the service period, which is usually the vesting period. For grants subject to a service condition, the Corporation utilizes the Black-Scholes option-pricing model (as used under SFAS 123) to estimate the fair value of each option on the date of grant. The Black-Scholes model takes into consideration the exercise price and expected life of the options, the current price of the underlying stock and its expected volatility, the expected dividends on the stock and the current risk-free interest rate for the expected life of the option. For grants subject to a market condition, the Corporation utilizes a Monte Carlo simulation to estimate the fair value and determine the derived service period. Compensation is recognized over the derived service period with any unrecognized compensation cost immediately recognized when the market condition is met. The Corporation's estimate of the fair value of a stock option is based on expectations derived from historical experience and may not necessarily equate to its market value when fully vested. In accordance with SFAS 123(R), the Corporation estimates the number of options for which the requisite service is expected to be rendered.

Unrealized Gains and Losses on Securities Available for Sale: The Corporation receives estimated fair values of debt securities from independent valuation services and brokers. In developing these fair values, the valuation services and brokers use estimates of cash flows based on historical performance of similar instruments in similar rate environments. Debt securities available for sale are mostly comprised of mortgage-backed securities as well as tax-exempt municipal bonds and U.S. government agency securities. The Corporation uses various indicators in determining whether a security is other-than-temporarily impaired, including for equity securities, if the market value is below its cost for an extended period of time with low expectation of recovery or for debt securities, when it is probable that the contractual interest and principal will not be collected. The debt securities are monitored for changes in credit ratings. Adverse changes in credit ratings would affect the estimated cash flows of the underlying collateral or issuer. The Bank recognized an other-than-temporary impairment charge of $1.9 million during the fourth quarter of 2008 as a result of deterioration in the individual credits of a collateralized debt obligation investment in a pool of trust preferred securities. The unrealized losses associated with the securities portfolio, that management has the ability and intent to hold, are not considered to be other-than temporary as of December 31, 2008 because the unrealized losses are primarily related to changes in interest rates and current market conditions, however, we do not see any negative effect on the expected cash flows of the underlying collateral or issuer. The unrealized losses are affecting all portfolio sectors with collateralized mortgage obligation securities and preferred securities having the largest reductions.

Deferred Taxes: The Corporation recognizes deferred tax assets and liabilities for the future effects of temporary differences, net operating loss carryforwards, and tax credits. Deferred tax assets are subject to management's judgment based upon available evidence that future realizations are likely. If management determines that the Corporation may not be able to realize some or all of the net deferred tax asset in the future, a charge to income tax expense may be required to reduce the value of the net deferred tax asset to the expected realizable value.

The Corporation has not substantively changed its application of the foregoing policies, and there have been no material changes in assumptions or estimation techniques used as compared to prior periods.

Financial Overview

For the year ended December 31, 2008, the Corporation's diluted earnings per share were $0.78 compared to $0.90 for 2007. Net income in 2008 was $25.1 million compared to $26.6 million in 2007. The year-to-date financial results include the impact on operations from the acquisition of the Willow Financial Corporation effective December 5, 2008 and the related issuance of 11,515,366 shares of the Corporation common stock. In addition, the Corporation's 2008 year-to-date results include a full year of income and expense resulting from the acquisition of East Penn Financial and its subsidiary, East Penn Bank, effective November 16, 2007. The following is an overview of the key financial highlights for 2008:

Consolidated total assets were $5.5 billion at December 31, 2008, an increase of 40.7% or $1.6 billion over $3.9 billion in total assets reported at December 31, 2007. Effective December 5, 2008, the Corporation completed its acquisition of Willow Financial. At the acquisition date, Willow Financial had approximately $1.6 billion in assets, $1.1 billion in gross loans and $946.7 million in deposits.

The return on average shareholders' equity was 7.45% in 2008 compared to 8.91% in 2007. The return on average assets was 0.63% in 2008 compared to 0.79% in 2007. The decrease in these ratios during 2008 was primarily the result of increases in average assets and average equity coupled with lower net income.

Loans increased $1.2 billion and deposits increased $953.4 million. Adjusted for the Willow Financial acquisition, organic loan growth was approximately $125.7 million or 5.1% and deposit growth was approximately $6.7 million or 0.2%.

Net interest income on a tax-equivalent basis increased $23.2 million, or 26.2%, for the year ending December 31, 2008, over the prior year. The net interest margin for 2008 increased to 3.04% compared to 2.82% for 2007. The net interest margin increased as a 56 basis point decrease in the yield on average earning assets of $3.7 billion was offset by a 98 basis point decrease in the cost of interest bearing liabilities of $3.2 billion.

Nonperforming assets increased $56.6 million to $78.5 million at December 31, 2008 from $22.0 million at December 31, 2007. Nonperforming assets as a percentage of total assets increased to 1.43% at December 31, 2008 from 0.56% at December 31, 2007. The provision for loan losses increased $5.0 million mostly as a result of decreased quality of the loan portfolio which caused an increase in the amount of the required reserve. Net charge-offs decreased $1.8 million for 2008 compared to 2007 principally due to prior year charge-offs for real estate construction loans for one borrower combined with an increase in recoveries both related to commercial and industrial loans and real estate loans.

Noninterest income increased $2.9 million or 6.6% during 2008. Increases in service charges of $3.8 million and gains on investment securities of $1.5 million were partially offset by a fourth quarter 2008 other than temporary impairment of available for sale securities of $1.9 million and a 2007 one-time gain of a sale-leaseback of bank properties transaction of $2.8 million. Other income increased $2.0 million during 2008 driven by increases in ATM and point of sale fee income of $835,000, fees on derivative instruments of $627,000 and a $405,000 death benefit earned on bank owned life insurance.

Noninterest expense increased $23.3 million or 28.6% in 2008 as compared to 2007. This increase is due primarily to increases of $7.3 million in salaries and benefits, $3.1 million in occupancy, $3.0 million in merger charges, $3.0 million in intangibles expense, $1.8 million in FDIC insurance and increases in consulting and legal fees. The increases in salaries and occupancy are mainly the result of a full year of expenses for East Penn Financial which was acquired in November 2007 as well as one month of expenses for Willow Financial. Intangibles expense in 2008 includes $1.4 million in valuation adjustments of mortgage servicing rights with the remaining increase relating to the acquisitions noted above. FDIC insurance expense increased as the Corporation had applied a one-time assessment credit in 2007 which offset most of the expense for the year.

Acquisitions/Dispositions

Effective after the market close on December 5, 2008, the Corporation completed its acquisition of Willow Financial. Under the terms of the merger agreement, dated as of May 20, 2008, Willow Financial was acquired by the Corporation and Willow Financial's wholly-owned subsidiary, Willow Financial Bank, a $1.6 billion savings bank with 29 branch offices in Southeastern Pennsylvania, was merged with and into the Bank. The merger of the Corporation and Willow Financial resulted in a combined company with approximately $5.5 billion in assets and delivers a significant market share in Chester County, one of the fastest-growing counties in Pennsylvania, increases the Corporation's market presence in Bucks and Montgomery counties, and establishes a new market presence in Philadelphia County. The combined company establishes a stronger presence in eastern Pennsylvania, including becoming the third largest financial institution headquartered in suburban Philadelphia. Willow Financial has complementary lines of business, a solid reputation with customers in growing markets, and a branch network that augments the Bank's traditional footprint. In conjunction with this transaction, the Corporation also acquired BeneServ, Inc., a respected provider of employee benefits services and Carnegie Wealth Advisors, LLC (Carnegie). Carnegie was subsequently sold in December 2008. The Willow Financial merger is expected to be accretive to the Corporation's earnings for the fiscal year of 2009.

The Corporation acquired 100% of the outstanding shares of Willow Financial. The transaction was accounted for in accordance with SFAS No. 141, "Business Combinations." Based on the terms of the merger agreement, Willow Financial shareholders received 0.73 shares of the Corporation's common stock for each share of Willow Financial common stock they held with cash paid in lieu of fractional shares. The purchase price was $13.79 per common share and was based upon the average of the closing prices for the Corporation's common stock on the agreement date and for two days before and two days after the agreement date and the agreement date. The Corporation issued 11,515,366 shares of common stock, incurred $2.4 million in acquisition costs which were capitalized and converted stock options with a fair value of $2.0 million for a total purchase price of $163.2 million at the closing on December 5, 2008. Willow Financial's results of operations are included in the Corporation's results from the date of acquisition, December 5, 2008.

Effective November 16, 2007, the Corporation completed its acquisition of East Penn Financial and its subsidiary, East Penn Bank. At the acquisition date, East Penn Financial had approximately $451.1 million in assets with nine banking offices located in Lehigh, Northampton and Berks Counties. The acquisition expanded the branch network of the Corporation in the Lehigh Valley and its opportunity to provide East Penn customers with a broader mix of products and services. As part of the merger agreement, East Penn Bank continues to operate under the East Penn name and logo, and has become a division of the Bank. Nine of the Bank's existing branches were transferred to the East Penn division including those in Lehigh, Carbon, Monroe, and Northampton Counties. The Corporation acquired 100% of the outstanding shares of East Penn Financial for a total purchase price of $91.3 million. The transaction was accounted for in accordance with SFAS No. 141, "Business Combinations." East Penn Financial shareholders received 2,432,771 shares of the Corporation's common stock and $49.9 million for all outstanding common shares. East Penn Financial option holders received $792,000 and options to acquire 25,480 shares of the Corporation's common stock in exchange for all outstanding options. East Penn Financial's results of operations are included in the Corporation's results from the date of acquisition, November 16, 2007.

On March 1, 2007, the Cornerstone Companies, a subsidiary of the Bank, completed a selected asset purchase of McPherson Enterprises and related entities (McPherson), registered investment advisors specializing in estate and succession planning and life insurance for high-net-worth construction and aggregate business owners and families throughout the United States. McPherson became a part of the Cornerstone Companies, a component of the Bank's Millennium Wealth Management division. The acquisition was part of the Corporation's plan to continue to build its fee-based services businesses. The consideration for the transaction was $1.5 million in cash.

Effective January 1, 2006, the Bank completed its acquisition of the Cornerstone Companies, registered investment advisors for high net worth, privately held business owners, wealthy families and institutional clients. Located in the Lehigh Valley, Pennsylvania, the firm serves clients throughout Pennsylvania and other mid-Atlantic states. The transaction was accounted for using the purchase method of accounting. The purchase price consisted of $15.0 million in cash paid at closing and a contingent payment of up to $7.0 million to be paid post-closing. The contingent payment is based upon the Cornerstone Companies meeting certain minimum operating results during a five-year earn-out period with a maximum payout of $7.0 million over this period. For 2006 through 2008, the minimum operating results were met resulting in earn-out payments totaling $3.6 million which was recorded as additional goodwill. At December 31, 2008, the remaining maximum payout is $3.4 million through 2010. The Cornerstone Companies results of operations are included in the Corporation's results from the effective date of the acquisition, January 1, 2006.

On December 27, 2007, the Bank settled and closed an agreement to sell fifteen properties to affiliates of American Realty Capital, LLC ("ARC") in a sale-leaseback transaction. The properties are located throughout Berks, Bucks, Lehigh, Montgomery, Northampton, and Carbon counties. Under the leases, the Bank continues to utilize the properties in the normal course of business. Lease payments on each property are institution-quality, triple net leases with an initial annual aggregate base rent of $3.0 million with annual rent escalations equal to the lower of CPI-U (Consumer Price Index for all Urban Consumers) or 2.0 percent commencing in the second year of the lease term. As tenant, the Bank is fully responsible for all costs associated with the operation, repair and maintenance of the properties during the lease terms and is recorded as occupancy expense. The agreement provides that each lease will have a term of 15 years, commencing on the closing date for the Agreement. The agreement also contains options to renew for periods aggregating up to 45 years. Under certain circumstances these renewal options are subject to revocation by the lessor. The Bank received net proceeds of $38.2 million and recorded a gain on sale from the transaction of $2.3 million (pre-tax) representing a portion of the total gain of $18.9 million. The remaining gain was deferred and is being amortized through a reduction of occupancy expense over the 15-year term of the leases an annual amount of $1.1 million. The Corporation also completed a separate sale-leaseback of office in October 2007 receiving net proceeds of $1.5 million with a recognized pre-tax gain of $473,000. The deferred gain of $552,000 is being amortized over the 10-year term of the lease. This strategic initiative was undertaken to help the Corporation translate a large non-earning asset into an earning asset in the form of loans, to help bolster earnings and increase liquidity.

For a five-year summary of financial information, see Item 6, "Selected Financial Data," which is incorporated herein by reference.

For quarterly information for 2008 and 2007, see Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations-Fourth Quarter 2008 Results," and Table 17, "Selected Quarterly Financial Data," which are incorporated herein by reference.

Investment Securities

SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities" requires that debt and equity securities classified as available for sale be reported at fair value, with unrealized gains and losses excluded from earnings and reported in other comprehensive income. The net effect of unrealized gains or losses, caused by marking an available for sale portfolio to market, causes fluctuations in the level of shareholders' equity and equity-related financial ratios as market interest rates cause the fair value of fixed-rate securities to fluctuate.

Investment securities and other investments increased 25.3% to $1.2 billion at December 31, 2008 from $982.9 million at December 31, 2007. The investment securities available for sale increased $231.6 million and the investment securities held to maturity decreased $6.9 million. The majority of the increase in available for sale securities is due to the securities acquired from Willow Financial of $238.3 million on December 5, 2008. The securities acquired from Willow Financial include $165.7 million in securities available for sale and $72.6 million in securities held to maturity. Upon acquisition, the Corporation recorded the securities held to maturity purchased from Willow as available for sale. During 2008, $208.5 million of securities available for sale were sold which generated a pre-tax gain of $2.6 million. The securities sold consisted primarily of bullet and callable agency, tax-exempt municipal and mortgage-backed securities. The increase in available for sale securities at December 31, 2007 compared to December 31, 2006 of $72.6 million was mainly due to the securities acquired from East Penn Financial of $66.2 million at November 16, 2007. During 2007, securities available for sale totaling $186.2 million were sold which generated a pretax gain of $1.2 million.

The following table shows the carrying value of the Corporation's investment securities available for sale and held to maturity:

   Table 1-Investment Portfolio

                                                                          December 31,
(Dollars in thousands)                                          2008           2007          2006
Investment securities available for sale:
    Obligations of U.S. government agencies and corporations $    93,894     $  98,734     $ 119,956
    Obligations of states and political subdivisions             286,875       228,436       201,643
    Mortgage-backed securities                                   705,483       515,989       476,107
    Other securities                                              55,696        67,208        37,960
        Total investment securities available for sale       $ 1,141,948     $ 910,367     $ 835,666
Investment securities held to maturity:
    Obligations of U.S. government agencies and corporations $     3,880     $   3,868     $   3,856
    Obligations of states and political subdivisions              46,554        53,479        55,023
        Total investment securities held to maturity         $    50,434     $  57,347     $  58,879

The maturity analysis of investment securities including the weighted average yield for each category as of December 31, 2008 is as follows. Actual maturities may differ from contractual maturities because issuers and borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

   Table 2-Maturity and Tax-Equivalent Yield Analysis of Investment Securities

                                                                                December 31, 2008
                                                                  Due after             Due after
                                           Due in 1 year       1 year through        5 years through       Due after
                                              or less              5 years              10 years           10 years           Total
                                                                             (Dollars in thousands)
Investment securities available for sale:
Obligations of U.S. government agencies
    and corporations:
    Fair value                            $           -       $        58,094       $        21,135       $  14,665       $    93,894
    Weighted average yield                            - %                3.13 %                5.18 %          5.39 %            3.95 %
Obligations of states and political
    subdivisions:
    Fair value                                        -                 2,886                70,782         213,207           286,875
    Weighted average yield(1)                         - %                8.75 %                5.97 %          6.62 %            6.48 %
Mortgage-backed securities:
    Fair value                                        -                17,177                94,789         593,517           705,483
    Weighted average yield                            - %                4.62 %                4.82 %          5.37 %            5.28 %
Other debt securities:
    Fair value                                    1,507                10,599                 6,008          15,917            34,031
    Weighted average yield                         4.73 %                3.53 %                2.68 %          5.57 %            4.39 %
Equity securities:
    Fair value                                        -                     -                     -               -            21,665
    Weighted average yield                            - %                   - %                   - %             - %            3.77 %
Total investment securities available for
    sale:
    Fair value                            $       1,507       $        88,756       $       192,714       $ 837,306       $ 1,141,948
    Weighted average yield                         4.73 %                3.65 %                5.14 %          5.69 %            5.45 %
Investment securities held to maturity:
Obligations of U.S. government agencies
    and corporations:
    Amortized cost                        $           -       $             -       $         3,880       $       -       $     3,880
    Weighted average yield                            - %                   - %                5.41 %             - %            5.41 %
Obligations of states and political
    subdivisions:
    Amortized Cost                                    -                     -                13,308          33,246            46,554
    Weighted average yield(1)                         - %                   - %                6.18 %          6.68 %            6.54 %
Total investment securities held to
. . .