Management's discussion and analysis of the significant changes in the results of operations, capital resources and liquidity presented in the accompanying consolidated financial statements for Codorus Valley Bancorp, Inc. (Codorus Valley or the Corporation), a bank holding company, and its wholly owned subsidiary, PeoplesBank, A Codorus Valley Company (PeoplesBank), are provided below. Codorus Valley's consolidated financial condition and results of operations consist almost entirely of PeoplesBank's financial condition and results of operations. Current performance does not guarantee, and may not be indicative of, similar performance in the future. Forward-looking statements:
Management of the Corporation has made forward-looking statements in this Form 10-Q. These forward-looking statements are subject to risks and uncertainties. Forward-looking statements include information concerning possible or assumed future results of operations of the Corporation and its subsidiaries. When words such as "believes," "expects," "anticipates" or similar expressions occur in the Form 10-Q, management is making forward-looking statements.
Note that many factors, some of which are discussed elsewhere in this report and in the documents that are incorporated by reference, could affect the future financial results of the Corporation and its subsidiaries, both individually and collectively, and could cause those results to differ materially from those expressed in the forward-looking statements contained or incorporated by reference in this Form 10-Q. These factors include:
• operating, legal and regulatory risks;

• the possibility of a prolonged economic downturn;

• political and competitive forces affecting banking, securities, asset management and credit services businesses; and

• the risk that management's analysis of these risks and forces could be incorrect and/or that the strategies developed to address them could be unsuccessful.

The Corporation undertakes no obligation to publicly revise or update these forward-looking statements to reflect events or circumstances that arise after the date of this report. Readers should carefully review the risk factors described in other documents that Codorus Valley files periodically with the Securities and Exchange Commission.
Critical accounting estimates:
Disclosure of Codorus Valley's significant accounting policies is included in Note 1 to the consolidated financial statements of the 2008 Annual Report on Form 10-K for the period ended December 31, 2008. Some of these policies require management to make significant judgments, estimates and assumptions that have a material impact on the carrying value of certain assets and liabilities. Management makes significant estimates in determining the allowance for loan losses. Management considers a variety of factors in establishing this estimate such as current economic conditions, diversification of the loan portfolio, delinquency statistics, results of internal loan reviews, financial and managerial strengths of borrowers, adequacy of collateral, if collateral dependent, and present value of future cash flows and other relevant factors. Estimates related to the value of collateral also have a significant impact on whether or not management continues to accrue income on delinquent loans and on the amounts at which foreclosed real estate is recorded on the balance sheet. Additional information is contained in Management's Discussion and Analysis regarding critical accounting estimates, including the provision and allowance for loan losses, located on pages 27 and 34 of this Form 10-Q.

The Corporation records its available-for-sale securities portfolio at fair value. Fair values for these securities are determined based on methodologies in accordance with SFAS No. 157, and as clarified by several FASB staff positions. Fair values for debt securities are volatile and may be influenced by any number of factors, including market interest rates, prepayment speeds, discount rates, credit ratings and yield curves. Fair values for debt securities are based on quoted market prices, where available. If quoted market prices are not available, fair values are based on the quoted prices of similar instruments or an estimate of fair value by using a range of fair value estimates in the market place as a result of the illiquid market specific to the type of security. When the fair value of a debt security is below its amortized cost, and depending on the length of time the condition exists and the extent the fair value is below amortized cost, additional analysis is performed to determine whether an other-than-temporary impairment condition exits. Available-for-sale and held-to-maturity debt securities are analyzed quarterly for possible other-than-temporarily impairment. The analysis considers whether the Corporation has the intent to sell its debt securities prior to market recovery or maturity and whether it is more likely than not that the Corporation will be required to sell its debt securities prior to market recovery or maturity. Often, information available to conduct these assessments is limited and rapidly changing; making estimates of fair value subject to judgment. If actual information or conditions are different than estimated, the extent of the impairment of the debt security may be different than previously estimated, which could have a material effect on the Corporation's results of operations and financial condition.
Management discussed the development and selection of critical accounting estimates and related Management Discussion and Analysis disclosure with the Audit Committee. There were no material changes made to the critical accounting estimates during the periods presented within this report. Three months ended June 30, 2009,
compared to three months ended June 30, 2008
FINANCIAL HIGHLIGHTS
The Corporation earned net income available to common shareholders of $49,000 or $0.01 per share ($0.01 diluted) for the three-month period ended June 30, 2009, compared to $971,000 or $0.25 per share ($0.24 diluted), for the second quarter of 2008. The $922,000 or 95 percent decrease in net income available to common shareholders was attributable to increases in the provision for loan losses, noninterest expenses and preferred dividends, which offset increases in net interest income and noninterest income and a decrease in income taxes. The $729,000 or 80 percent increase in the provision for loan losses was due to a decline in loan quality as a result of the long-drawn economic recession, declining real estate values and increased unemployment. A significant increase in the loan portfolio balance during the current period also contributed to the increase in the provision. The $1,278,000 or 26 percent increase in noninterest expenses was due primarily to increases in personnel expense and Federal Deposit Insurance Corporation (FDIC) insurance premiums. The $482,000 or 18 percent increase in personnel expense resulted from staff additions associated with planned business growth, particularly expansion of the banking franchise in the prior year. The $550,000 or 573 percent increase in FDIC insurance premiums was the result of an industry-wide increase in assessment rates, an increase in the volume of deposits upon which the assessment is based, and a special assessment totaling $382,000 (or $252,000 after tax). Effective June 30, 2009, the FDIC imposed a special assessment on all commercial financial institutions, based on 5 basis points of total assets less Tier 1 capital. Net interest income for the three-month period ended June 30, 2009, was $5,692,000, an increase of $590,000 or 12 percent above the second quarter of 2008 due primarily to an increase in the average volume of earning assets, principally business loans and investment securities. The net interest margin was 3.09 percent for the second quarter of 2009, compared to 3.69 percent for the second quarter of 2008. Net interest margin is net interest income (tax equivalent basis) as a percentage of average earning assets. The $238,000 or 13 percent increase in noninterest income was due primarily to an increase in gains from a larger volume of sales of mortgages. The $501,000 decrease in income tax was the result of a decrease in pretax income and an increase in tax exempt income.

A more detailed analysis of the factors and trends affecting corporate earnings follows.
INCOME STATEMENT ANALYSIS
Net interest income
Net interest income for the three-month period ended June 30, 2009, was $5,692,000, an increase of $590,000 or 12 percent above the second quarter of 2008 due primarily to an increase in the average volume of earning assets. The net interest margin, on a tax equivalent basis, was 3.09 percent for the second quarter of 2009, compared to 3.69 percent for the second quarter of 2008. The decrease in the net interest margin reflects: the low level of market interest rates, which has depressed yields on variable (floating) rate loans, overnight investments and investment securities; an elevated level of nonperforming assets; and excess liquidity.
For the second quarter of 2009, total interest income increased $1,086,000 or 12 percent above 2008 due primarily to an increase in the average volume of earning assets. Earning assets averaged $777 million and yielded 5.30 percent (tax equivalent basis) for the current quarter, compared to $574 million and 6.34 percent, respectively, for the second quarter of 2008. The $203 million or 35 percent increase in average earning assets was primarily the result of strong growth in the business loan and investment securities portfolios. For the second quarter of 2009, total interest expense increased $496,000 or 13 percent above the second quarter of 2008 due to a larger volume of interest bearing liabilities. Total interest bearing liabilities averaged $706 million at an average rate of 2.43 percent for the current quarter, compared to $513 million and 2.96 percent, respectively, for the second quarter of 2008. The $193 million or 38 percent increase in average interest bearing liabilities was the result of strong growth in the average volume of time deposits and money market deposits. The increase in the average volume of long-term debt, which provided the financing for a leverage strategy described elsewhere in this report, also contributed to the increase in interest bearing liabilities. In April 2009, PeoplesBank paid off a $15 million/2% Federal Home Loan Bank of Pittsburgh advance prior to its August 2010 maturity to reduce excess liquidity and interest expense. The early payoff resulted in a $24,000 prepayment penalty that was recognized in the current period as a miscellaneous expense. More information about net interest income is provided in the year-to-date section of this report.
Provision for loan losses
For quarter ended June 30, 2009, the provision for loan losses was $1,639,000, compared to $910,000 for the second quarter of 2008. The $729,000 or 80 percent increase was due to a decline in loan quality as a result of the long-drawn economic recession, declining real estate values and increased unemployment. A significant increase in the loan portfolio balance during the current period also contributed to the increase in the provision.

Noninterest income
The following table presents the components of total noninterest income for the second quarter of 2009, compared to the second quarter of 2008. Total noninterest income increased $238,000 or 13 percent.

Table 1 - Noninterest income

                                           Three months ended                    Change
                                                June 30,                   Increase (Decrease)
(dollars in thousands)                    2009            2008             $                %

Trust and investment services fees     $      303       $     362      $      (59 )            (16 )%
Income from mutual fund, annuity
and insurance sales                           358             496            (138 )            (28 )
Service charges on deposit accounts           581             563              18                3
Income from bank owned life
insurance                                     155              68              87              128
Other income                                  154             124              30               24
Gain on sales of mortgages                    403             108             295              273
Gain on sales of securities                   128             123               5                4

Total noninterest income               $    2,082       $   1,844      $      238               13 %

The discussion that follows addresses changes in selected categories of noninterest income.
Trust and investment services fees-The decrease in income from trust operations was the result of depressed capital markets and the impact it had on our fees, which are generally calculated on the market price of assets under management. Income from mutual fund, annuity and insurance sales-The decrease in income from the sale of mutual funds, annuities and insurance products by Codorus Valley Financial Advisors, a subsidiary of PeoplesBank, was a result of depressed capital markets and the impact it had on the volume of sales and fees. A portion of our fees is calculated on market prices of assets under management. Service charges on deposit accounts-In spite of increases in deposit volumes and number of accounts during the current quarter, service charges increased only slightly as deposit clients exhibited conservative spending and money management behavior due to concerns about the economic recession and job security. Income from bank owned life insurance-The increase in income from bank owned life insurance (BOLI) was due to an additional investment of approximately $4 million in November 2008 and an increase in the crediting rates on existing policies that were transferred to new insurance providers.
Other income-The increase in other income was due in part to an increase in income from real estate settlement services provided by SYC Settlement Services, a subsidiary of PeoplesBank.
Gain on sales of mortgages-The increase in gains from the sale of mortgages was the result of an increase in the volume of sales. During the current quarter, the low level of market interest rates on mortgage products and the first time homebuyers tax credit program, influenced by the federal government to stimulate the economy, increased mortgage refinancing activity.
Gain on sales of securities-During the current quarter $128,000 in gains were realized from the sale of U.S. agency mortgage-backed bonds totaling $3.3 million from the available-for-sale securities portfolio to take advantage of the low interest rate environment. Comparable gains from the sale of securities were also realized in the second quarter of 2008.

Noninterest expense
The following table presents the components of total noninterest expense for the second quarter of 2009, compared to the second quarter of 2008. Total noninterest expense increased $1,278,000 or 26 percent.

Table 2 - Noninterest expense

                                        Three months ended                 Change
                                             June 30,               Increase (Decrease)
   (dollars in thousands)                2009          2008            $              %

   Personnel                          $    3,157      $ 2,675     $       482           18 %
   Occupancy of premises, net                448          397              51           13
   Furniture and equipment                   401          368              33            9
   Postage, stationery and supplies          139          126              13           10
   Professional and legal                     99          109             (10 )         (9 )
   Marketing and advertising                 115          210             (95 )        (45 )
   FDIC insurance                            646           96             550          573
   Debit card processing                     130          120              10            8
   Charitable donations                       31           45             (14 )        (31 )
   Telephone                                 146           36             110          306
   Other                                     807          659             148           22

   Total noninterest expense          $    6,119      $ 4,841     $     1,278           26 %

The discussion that follows addresses changes in selected categories of noninterest expense.
Personnel-The increase in personnel expense, comprised of wages/sales commissions, payroll taxes and employee benefits, resulted from staff additions associated with expansion of the banking franchise in the prior year. Occupancy of premises, net-The increase in occupancy expense, comprised of rent, depreciation, maintenance, insurance, real estate taxes and utilities, increased primarily as a result of expanding the banking franchise in the prior year. Furniture and equipment-The increase in furniture and equipment expense was primarily the result of an increase in depreciation expense from capital expenditures that supported expansion of the banking franchise and information technology initiatives.
Marketing and advertising-The decrease in marketing and advertising expenses was due primarily to the timing of expenditures and to a lesser degree reductions to the marketing budget.
FDIC insurance-The percent increase in Federal Deposit Insurance Corporation (FDIC) insurance premiums was the result of an industry-wide increase in assessment rates, an increase in the volume of deposits upon which the assessment is based, and a special assessment totaling $382,000. Effective June 30, 2009, the FDIC imposed a special assessment on all commercial financial institutions, based on 5 basis points of total assets less Tier 1 capital. The purpose of the special assessment was to help replenish the FDIC's Bank Insurance Fund, which is being depleted as a result of bank failures in other parts of the country.

Telephone-The increase in telephone expense reflected the one-time conversion to a new carrier during the third quarter of 2008, telecommunication enhancements and corporate growth.
Other-The increase in other expense, which is comprised of many underlying expenses, increased primarily as a result of a $101,000 increase in carrying costs associated with impaired assets. Current period carrying costs increased as a result of larger portfolios of nonperforming loans and real estate acquired in satisfaction of debt.
Income taxes
The provision for income tax for the second quarter of 2009 was a $277,000 credit, or tax benefit, compared to a $224,000 expense for the same period in 2008. The decrease in income tax was the result of a decrease in pretax income and an increase in tax-exempt income. For both periods the Corporation's statutory federal income tax rate was 34 percent. The Corporation's effective federal income tax rate was negative for the second quarter of 2009 and 18 percent for the second quarter of 2008. The effective tax rate differs from the statutory tax rate due to the impact of low-income housing credits and tax-exempt income including income from bank owned life insurance. The effective tax rate for 2009 decreased primarily as a result of the decrease in pretax income.
Six months ended June 30, 2009,
compared to six months ended June 30, 2008
FINANCIAL HIGHLIGHTS
The Corporation earned net income available to common shareholders of $789,000 or $0.20 per share ($0.20 diluted) for the six-month period ended June 30, 2009, compared to $2,494,000 or $0.63 per share ($0.63 diluted), for the same period of 2008. The $1,705,000 or 68 percent decrease in net income available to common shareholders was primarily the result of increases in the provision for loan losses, noninterest expenses and preferred dividends, which offset increases in net interest income and noninterest income and a decrease in income taxes. The $823,000 or 78 percent increase in the provision for loan losses was the result of additions to the allowance for impaired commercial real estate loans and significant growth in the loan portfolio balance. Allocations to the allowance were deemed necessary due to continued uncertainty in the economy, softness in the real estate market and an increase in the level of nonperforming loans.
The $2,289,000 or 24 percent increase in noninterest expense was due primarily to an increase in operating expenses associated with expansion of the banking franchise and an increase in Federal Deposit Insurance Corporation (FDIC) deposit insurance premiums. During 2008, the Corporation added three full service financial centers to its banking franchise bringing the total number of financial centers to 17, 15 located in Pennsylvania and 2 located in Maryland. Current period FDIC insurance premiums totaled $876,000, an increase of $724,000 or 476 percent above the six-month period ended June 30, 2008. Of the total insurance premiums, $382,000 (or $252,000 after tax) pertained to a special FDIC assessment effective June 30, 2009, which was imposed on all commercial financial institutions. The remaining increase in deposit insurance premiums was caused by an industry-wide increase in assessment rates by the FDIC and an increase in the volume of deposits upon which the assessment is based. A $242,000 non-recurring cost of restructuring employee benefit plans in the current period also contributed to the increase in noninterest expense. Restructuring the benefit plans resulted in a federal income tax benefit so that the overall transaction had an insignificant impact on net income.

Net interest income for the six-month period ended June 30, 2009, was $10,788,000, an increase of $245,000 or 2 percent above the same period in 2008 due to a larger volume of earning assets, principally business loans and investment securities. The net interest margin was 3.04 percent for the first six months of 2009, compared to 3.88 percent for the same period in 2008. Total noninterest income was $3,905,000 for the current six-month period, an increase of $322,000 or 10 percent above 2008, as adjusted to exclude securities gains. The increase in noninterest income was attributable to an increase in gains from the sale of mortgages. The provision for income tax for the current period was a $373,000 credit (benefit), compared to a $766,000 expense for the same period in 2008. The decrease in income tax was the result of a decrease in pretax income, an increase in tax-exempt income and the recognition of a non-recurring $242,000 tax benefit associated with restructuring employee benefit plans. Total assets were approximately $840 million on June 30, 2009, an increase of $203 million or 32 percent above June 30, 2008. Asset growth occurred primarily in the business loans and investment securities portfolios, which were funded primarily by an increase in deposits, principally money market and time deposits, and to a lesser degree, borrowing from the Federal Home Loan Bank of Pittsburgh.
Net income as a percentage of average shareholders' equity (ROE) was 3.64 percent for the first six months (annualized) of 2009, compared to 10.08 percent for the same period of 2008. Net income as a percentage of average total assets (ROA) was 0.31 percent for the first six months (annualized) of 2009, compared to 0.82 percent for the same period of 2008. The decrease in both ratios for 2009 reflected the decrease in earnings. The ROE ratio was further depressed as a result of a $16.5 million capital addition described in the Shareholders' Equity and Capital Adequacy section of this report. The efficiency ratio (noninterest expense as a percentage of net interest income plus noninterest income on a tax equivalent basis) was 78.8 percent for the first six months of 2009, compared to 67.5 percent for the same period of 2008. The increase in the efficiency ratio during the current period reflected the increase in operating expenses described above.
On June 30, 2009, the nonperforming assets ratio was 3.29 percent, compared to 1.84 percent for June 30, 2008. Net loan charge-offs for the current six month period totaled $428,000, compared to $492,000 for the same period in 2008. Information regarding nonperforming assets is provided in the Risk Management section of this report, including Table 5-Nonperforming Assets. Based on a recent evaluation of probable loan losses and the current loan portfolio, management believes that the allowance is adequate to support losses inherent in the loan portfolio on June 30, 2009. An analysis of the allowance is provided in Table 6-Analysis of Allowance for Loan Losses.
Throughout the current period, Codorus Valley maintained a capital level well above minimum regulatory quantitative requirements. Currently, there are three federal regulatory definitions of capital that take the form of minimum ratios. Note 7-Regulatory Matters, shows that the Corporation and PeoplesBank were well capitalized on June 30, 2009.
A more detailed analysis of the factors and trends affecting corporate earnings follows.
INCOME STATEMENT ANALYSIS
Net interest income
Net interest income for the six-month period ended June 30, 2009, was $10,788,000, an increase of $245,000 or 2 percent above the same period in 2008 due primarily to an increase in the average volume of earning assets. The net interest margin, on a tax equivalent basis, was 3.04 percent for the first six months of 2009, compared to 3.88 percent for the same period in 2008. The decrease in the net interest margin reflected: the low level of market interest rates, which has depressed yields on variable (floating) rate loans, overnight investments and investment securities; an elevated level of nonperforming assets; and excess liquidity.

Interest income for the first six months of 2009 totaled $19,252,000, an increase of $978,000 or 5 percent above 2008 due primarily to an increase in the average volume of earning assets. Earning assets averaged $749 million and yielded 5.32 percent (tax equivalent basis) for the current period, compared to $564 million and 6.63 percent, respectively, for the first six months of 2008. The $185 million or 33 percent increase in average earning assets was primarily the result of strong growth in the business loan and investment securities portfolios. The increase in business loans reflected additions to the business banking staff and changes in the competitive landscape that benefited the Corporation. The increase in investment securities, principally U.S. agency mortgage-backed bonds and tax-exempt municipal bonds, resulted from the leverage strategy, which is discussed in the Investment Securities section of this report. The leverage strategy is expected to make a positive contribution to net interest income; however, the 2 percent tax equivalent margin spread resulting from this strategy is expected to constrain the Corporation's net interest margin. . . .