UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D. C. 20549

FORM 10-Q

________________________________

(Mark One)

x	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934 for the quarterly period ended September 30, 2007

o	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THESECURITIES EXCHANGE ACT OF 1934

For the transition period from ____________ to ____________

Commission File No. 000-50426

(Exact Name of Registrant as Specified in its Charter)

Pennsylvania		38-3681905
(State or Other Jurisdiction of Incorporation or Organization)		(I.R.S. Employer Identification No.)

90 Highland Avenue, Bethlehem, PA		18017
(Address of Principal Executive Office)		(Zip Code)

Registrant’s Telephone Number, Including Area Code: 610-861-5000

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

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

Large accelerated filer

Accelerated filer

Non-accelerated filer

Indicate by check mark whether the registrant is a shell company as defined in Rule 12b-2 of the Exchange Act. YES o NO x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock as of the latest practicable date: As of October 31, 2007, 26,527,157 shares of the Registrant’s common stock were outstanding.

KNBT BANCORP, INC. AND SUBSIDIARIES

INDEX

				Page
PART I – FINANCIAL INFORMATION
	Item 1.	Financial Statements		1
			Consolidated Balance Sheets	1
			Consolidated Statements of Income	2
			Consolidated Statement of Changes in Shareholders’ Equity	3
			Consolidated Statements of Cash Flows	4
			Notes to Interim Consolidated Financial Statements	5
	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		17
	Item 3.	Quantitative and Qualitative Disclosures about Market Risk		32
	Item 4.	Controls and Procedures		32
PART II – OTHER INFORMATION
	Item 1.	Legal Proceedings		33
	Item 1A.	Risk Factors		33
	Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds		33
	Item 3.	Defaults Upon Senior Securities		33
	Item 4.	Submission of Matters to a Vote of Security Holders		33
	Item 5.	Other Information		34
	Item 6.	Exhibits		34
Signatures				35

PART I.

FINANCIAL INFORMATION

Item 1.

Financial Statements

KNBT BANCORP, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

	September 30,			December 31,
(dollars in thousands, except share data)	2007			2006
	(unaudited)
ASSETS
Cash and due from banks	$	61,770		$	53,202
Interest-bearing deposits with banks		1,302			2,171
Federal funds sold		-			4,800
Cash and cash equivalents		63,072			60,173
Investment securities available-for-sale		646,121			858,854
Investment securities held to maturity
(Fair value of $28,398 at September 30, 2007 and $33,048 at December 31, 2006)		28,710			33,532
FHLBank Pittsburgh stock		23,597			30,724
Mortgage loans held-for-sale		900			1,994
Loans		1,819,014			1,620,166
Allowance for loan losses		(18,118	)		(17,044	)
Net loans		1,800,896			1,603,122
Bank owned life insurance		80,984			78,361
Premises and equipment, net		46,834			48,228
Accrued interest receivable		10,788			10,293
Goodwill		109,865			105,854
Other intangible assets, net		26,607			29,387
Other assets		35,102			38,305
TOTAL ASSETS	$	2,873,476		$	2,898,827

LIABILITIES
Non-interest-bearing deposits	$	188,250		$	206,972
Interest-bearing deposits		1,734,350			1,700,575
Total deposits		1,922,600			1,907,547
Securities sold under agreements to repurchase		173,563			45,296
Federal funds purchased		14,800			-
Advances from the FHLBank of Pittsburgh		367,025			519,161
Subordinated debt		15,464			38,406
Accrued interest payable		12,913			11,924
Other liabilities		17,407			20,467
TOTAL LIABILITIES		2,523,772			2,542,801

SHAREHOLDERS' EQUITY
Preferred stock, par value $0.01 per share; authorized 20,000,000 shares, none issued		-			-
Common stock, par value $0.01 a share; authorized 100,000,000 shares, 33,970,146 and
33,963,910 shares issued at September 30, 2007 and December 31, 2006 , respectively		330			330
Additional paid-in capital		340,843			338,406
Retained earnings, substantially restricted		146,711			142,519
Treasury stock, at cost; 7,443,739 and 6,285,342 shares at
September 30, 2007 and December 31, 2006, respectively		(117,645	)		(101,247	)
Unallocated common stock held by Employee Stock Ownership Plan		(12,949	)		(13,556	)
Accumulated other comprehensive loss, net		(7,586	)		(10,426	)
TOTAL SHAREHOLDERS' EQUITY		349,704			356,026

TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY	$	2,873,476		$	2,898,827

The accompanying notes are an integral part of these financial statements.

KNBT BANCORP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

	Three Months Ended September 30,					Nine Months Ended September 30,
(dollars in thousands, except per share data)	2007			2006		2007			2006
	(unaudited)
INTEREST INCOME
Loans, including fees	$	29,213		$	25,256	$	83,318		$	71,348
Investment securities
Taxable		8,545			12,099		28,173			37,133
Tax-exempt		-			37		-			1,373
Other interest		77			377		1,079			848
Total interest income		37,835			37,769		112,570			110,702
INTEREST EXPENSE
Deposits		14,399			12,573		42,048			33,111
Securities sold under agreements to repurchase		1,672			462		3,116			1,491
Advances from FHLBank Pittsburgh		4,177			6,028		13,699			18,809
Subordinated debt		292			731		1,609			2,059
Total interest expense		20,540			19,794		60,472			55,470
NET INTEREST INCOME		17,295			17,975		52,098			55,232
Provision for loan losses		813			365		1,458			2,315
Net interest income after provision for loan losses		16,482			17,610		50,640			52,917
NON-INTEREST INCOME
Trust revenue		1,523			1,214		4,324			3,608
Brokerage services revenue		902			847		2,841			2,675
Benefit services revenue		1,397			1,374		4,583			4,303
Insurance services revenue		760			772		2,306			2,162
Deposit service charges		1,739			1,566		5,061			4,447
Lending fees		336			322		961			847
Check card/ATM card fees		980			890		2,811			2,535
Bank owned life insurance		889			835		2,622			2,390
Net gain (loss) on sale of investment securities		1			1,440		(1,622	)		3,175
Net gain on sale of residential mortgage loans		116			178		327			233
Net (loss) gain on sale of other assets		(22	)		2		(291	)		2
Net (loss) gain on sale of other real estate owned		(2	)		29		(14	)		26
Net gain on extinguishment of debt		-			-		-			1,179
Other non-interest operating income		751			704		2,239			2,120
Total non-interest income		9,370			10,173		26,148			29,702
NON-INTEREST EXPENSE
Compensation and employee benefits		11,296			11,265		33,771			33,086
Net occupancy and equipment expense		2,891			3,171		8,847			9,399
Professional fees		1,117			796		2,536			2,451
Advertising		261			205		889			1,079
Data processing		768			682		2,164			1,948
Telecommunication		328			297		1,022			1,004
Office supplies and postage		501			404		1,474			1,575
Amortization of mortgage servicing rights		92			94		264			281
Amortization of intangible assets		963			927		2,888			2,744
Other operating expenses		1,593			1,362		5,179			4,550
Total non-interest expense		19,810			19,203		59,034			58,117

Income before income taxes		6,042			8,580		17,754			24,502
Income tax expense		1,939			2,669		6,153			7,205
NET INCOME	$	4,103		$	5,911	$	11,601		$	17,297

PER SHARE DATA
Net income- basic	$	0.16		$	0.22	$	0.45		$	0.63
Net income- diluted	$	0.16		$	0.22	$	0.44		$	0.63
Cash dividends per common share	$	0.10		$	0.08	$	0.28		$	0.23

The accompanying notes are an integral part of these financial statements.

KNBT BANCORP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY

	Nine Months Ended September 30,
(dollars in thousands, except share data)	2007			2006
	(unaudited)
Common stock number of shares
Beginning balance		33,166,591			33,080,609
Allocated Employee Stock Ownership Plan shares		35,701			35,701
Shares issued upon exercise of stock options		6,236			22,147
Ending balance		33,208,528			33,138,457

Treasury stock number of shares
Beginning balance		(6,285,342	)		(3,861,000	)
Repurchase of common stock		(1,158,397	)		(2,413,842	)
Ending balance		(7,443,739	)		(6,274,842	)


Common stock value
Beginning balance	$	330		$	330
Shares issued upon exercise of stock options		-			-
Ending balance		330			330

Additional paid in capital
Beginning balance		338,406			342,144
Reclass of unearned compensation upon adoption of SFAS 123R		-			(7,130	)
Unallocated Employee Stock Ownership Plan shares		(115	)		(56	)
Shares issued upon exercise of stock options		38			125
Share-based compensation expense		930			839
Amortization of compensation related to the Management Recognition and Retention Plan		1,584			1,601
Ending balance		340,843			337,523

Retained earnings, substantially restricted
Beginning balance		142,519			127,471
Net income		11,601			17,297
Cash dividends paid		(7,409	)		(6,405	)
Ending balance		146,711			138,363

Unallocated common stock held by the Employee Stock Ownership Plan
Beginning balance		(13,556	)		(14,366	)
Allocation of Employee Stock Ownership Plan stock		607			607
Ending balance		(12,949	)		(13,759	)

Unearned common stock held by the Management Recognition and Retention Plan
Beginning balance		-			(7,130	)
Reclass of unearned compensation upon adoption of SFAS 123R		-			7,130
Ending balance		-			-

Accumulated other comprehensive income (loss)
Beginning balance		(10,426	)		(9,898	)
Other comprehensive income (loss) net of taxes and reclassification adjustments		2,840			(1,765	)
Ending balance		(7,586	)		(11,663	)

Treasury stock
Beginning balance		(101,247	)		(61,999	)
Repurchase of common stock		(16,398	)		(39,080	)
Ending balance		(117,645	)		(101,079	)

Total Shareholders' Equity	$	349,704		$	349,715

The accompanying notes are an integral part of these financial statements.

KNBT BANCORP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

	Nine Months Ended September 30,
(dollars in thousands)	2007			2006
	(unaudited)
OPERATING ACTIVITIES:
Net income	$	11,601		$	17,297
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for loan losses		1,458			2,315
Depreciation and amortization		6,870			6,791
Compensation expense, stock option plan		930			839
Management Recognition and Retention Plan expense		1,584			1,601
ESOP expense		492			551
Amortization and accretion of securities premiums and discounts, net		(252	)		(273	)
Loss (gain) on sale of other real estate owned		14			(26	)
Loss (gain) on sales of investment securities, net		1,622			(3,175	)
Loss (gain) on sale of other assets		291			(2	)
Gain on sale of mortgage loans		(327	)		(233	)
Gain on extinguishment of debt		-			(1,179	)
Mortgage loans originated for sale		(37,765	)		(24,960	)
Mortgage loan sales		38,862			23,485
Changes in assets and liabilities:
Increase in bank owned life insurance		(2,623	)		(2,390	)
(Increase) decrease in accrued interest receivable		(495	)		740
Decrease (increase) in other assets		647			(7,075	)
(Decrease) increase in other liabilities and accrued interest payable		(2,970	)		2,919
Net cash provided by operating activities		19,939			17,225
INVESTING ACTIVITIES:
Proceeds from calls and maturities of securities available-for-sale		115,945			163,655
Proceeds from calls and maturities of securities held-to-maturity		4,874			7,993
Proceeds from sales of securities available-for-sale		169,763			111,128
Proceeds from sales of securities held to maturity		-			5,488
Purchase of securities available-for-sale		(70,029	)		(37,077	)
Purchase of securities held to maturity		-			(750	)
Purchase of FHLBank Pittsburgh stock		(251	)		(1,436	)
Redemption of FHLBank Pittsburgh stock		7,378			8,309
Net increase in loans		(199,232	)		(108,924	)
Cash paid for acquisitions		(2,869	)		(8,034	)
Cash and cash equivalents obtained through acquisitions		-			1,249
Purchase of premises and equipment		(3,087	)		(7,140	)
Proceeds from the sale of other assets		623			1,033
Proceeds from the sale of other real estate owned		406			274
Net cash provided by investing activities		23,521			135,768
FINANCING ACTIVITIES:
Net increase in deposits		15,053			36,385
Net increase in repurchase agreements and federal funds sold		143,067			9,124
Payment on extinguishment of debt, net		-			(49,595	)
Payment on the redemption of subordinated debentures		(22,997	)		-
Proceeds from long-term debt		-			92,000
Payments on long-term debt		(151,915	)		(216,863	)
Purchase of treasury stock		(16,398	)		(39,080	)
Proceeds from the exercise of stock options		38			125
Cash dividends paid		(7,409	)		(6,405	)
Net cash used in financing activities		(40,561	)		(174,309	)
Increase (decrease) in cash and cash equivalents		2,899			(21,316	)
Cash and cash equivalents January 1,		60,173			106,259
Cash and cash equivalents September 30,	$	63,072		$	84,943

Supplemental disclosure of cash flow information
Cash paid during the period for
Income taxes	$	6,805		$	5,199
Interest on deposits, advances and other borrowed money	$	59,483		$	51,739
Supplemental disclosure of non-cash investing activities
Reclassification of loans receivable to other real estate owned	$	247		$	335

The accompanying notes are an integral part of these financial statements.

KNBT BANCORP, INC. AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (unaudited)

NOTE A

PRINCIPLES OF CONSOLIDATION AND BASIS OF PRESENTATION

KNBT Bancorp, Inc. (“KNBT” or the “Company”) is a Pennsylvania corporation headquartered in Bethlehem, Pennsylvania. The Company is the registered bank holding company for Keystone Nazareth Bank & Trust Company (the “Bank”), a Pennsylvania-chartered savings bank.

The accompanying consolidated financial statements were prepared in accordance with instructions to Form 10-Q, and therefore, do not include information or footnotes necessary for a complete presentation of financial position, results of operations and cash flows in conformity with generally accepted accounting principles used in the United States (“GAAP”). However, all normal, recurring adjustments that, in the opinion of management, are necessary for a fair presentation of these financial statements have been included. These financial statements should be read in conjunction with the audited consolidated financial statements and the notes thereto for the Company for the year ended December 31, 2006, which are included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2006 (the “Form 10-K”). The results for the interim periods presented are not necessarily indicative of the results that may be expected for the year ended December 31, 2007.

The financial information presented herein is unaudited; however, in the opinion of management, all adjustments (which include normal recurring adjustments) necessary to present fairly the unaudited financial information have been made. The Company has prepared its accompanying consolidated financial statements in accordance with GAAP as applicable to the banking industry. The consolidated financial statements include the balances of the Company and its wholly owned subsidiaries. All material intercompany balances and transactions have been eliminated in consolidation. References to the Company include the Bank and both the Bank’s and the Company’s subsidiaries unless otherwise noted.

In preparing the consolidated financial statements, the Company is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the statement of financial condition and revenue and expense for the period. The principal estimates that are particularly susceptible to significant change in the near term relate to the allowance for loan losses, the evaluation of impairment of goodwill and the evaluation of deferred tax asset. The evaluation of the adequacy of the allowance for loan losses includes an analysis of the individual loans and overall risk characteristics and size of the different loan portfolios, and takes into consideration current economic and market conditions, the capability of specific borrowers to pay specific loan obligations, as well as current loan collateral values. However, actual losses on specific loans, which also are encompassed in the analysis, may vary from estimated losses.

In addition to the Bank, KNBT’s subsidiaries include KNBT Inv. I and KNBT Inv. II, and the Bank’s wholly owned subsidiaries KLVI, Inc., KLV, Inc., KNBT Settlement Services, LLC, Caruso Benefits Group, Inc. (“Caruso”), Higgins Insurance Associates, Inc. (“Higgins”), and KNBT Securities, Inc.

NOTE B

PENDING MERGER

The boards of directors of National Penn Bancshares, Inc. (“National Pen”) and KNBT have each unanimously approved an Agreement and Plan of Merger, dated as of September 6, 2007, pursuant to which KNBT will merge with and into National Penn, and the Bank, the wholly-owned subsidiary of KNBT, will subsequently merge with and into National Penn Bank, the wholly-owned subsidiary of National Penn.

Under the terms of the merger agreement, KNBT shareholders will be entitled to exchange each share of KNBT common stock they own for 1.03 shares of National Penn common stock on the effective date of the merger, which reflects a 3% stock dividend paid by National Penn on September 28, 2007. KNBT shareholders will receive cash for any fractional shares that they would otherwise receive in the merger. National Penn shareholders will continue to own their existing National Penn common shares.

KNBT incurred acquisition expenses of $410,000 relating to professional and advisory services during the quarter ended September 30, 2007 associated with the acquisition which have been appropriately reflected on the consolidated statements of income. The transaction is expected to close in the first quarter of 2008. The merger is subject to regulatory approval and the separate approvals of the shareholders of both KNBT and National Penn. For further information, reference is made to the joint proxy statement/prospectus included as a part of the Registration Statement on Form S-4, file No. 146617, filed on October 10, 2007 by National Penn with respect to the proposed merger and in particular to the sections “Risk Factors”, “The Merger” and “Unaudited Pro Forma Financial Information”.

NOTE C

ACQUISITIONS

The Trust Company of Lehigh Valley

On February 28, 2006, the Bank completed its acquisition of Paragon Group, Inc. (“Paragon”), the parent holding company for the Trust Company of Lehigh Valley (“TCLV”), a Pennsylvania-chartered non-depository bank located in Allentown, Pennsylvania. TCLV provided estate, personal trust and investment management services, estate and financial planning and employee retirement benefits administration and had approximately $400 million in assets under administration and management at the time of its acquisition by the Bank. Paragon and TCLV were merged into the Bank in connection with the completion of the acquisition. The results of the acquired trust operations have been included in KNBT’s results since March 1, 2006.

Under the terms of the definitive merger agreement, the Bank acquired all of the capital stock of Paragon for a purchase price of $5.3 million in cash of which $4.3 million was paid at time of closing and $1.0 million was held in escrow. As a result of satisfaction of certain conditions set forth in the merger agreement, 50% of the escrow including interest earned was disbursed on February 28, 2007 and the balance was disbursed on August 28, 2007, the eighteenth-month anniversary of the completion of the acquisition of Paragon.

The acquisition price resulted in the recording of $2.6 million in goodwill, which is the excess cost of the entity over the net of the amounts assigned to assets acquired and liabilities assumed and $2.6 million of other intangible assets. The intangible assets consist of $1.7 million for Paragon’s customer list, $610,000 for a restrictive covenant agreement with the principals of Paragon and $280,000 for employment agreements with the principals of Paragon. The amortization periods for the intangible assets are 15 years, 5 years and 2.7 years, respectively. Amortization expense relating to these assets was $91,000 and $43,000 for the three month periods ended September 30, 2007 and 2006, respectively, and $272,000 and $101,000 for the nine month periods ended September 30, 2007 and 2006, respectively.

Caruso Benefits Group, Inc.

On April 1, 2005, the Bank acquired Caruso, a benefits management firm based in Bethlehem, Pennsylvania. Caruso specializes in benefits management with an emphasis on group medical, life and disability. Caruso’s results of operations have been included in KNBT’s results since the date of acquisition. Caruso operates as a wholly owned subsidiary of the Bank.

Under the terms of the stock purchase agreement, the Bank acquired all of the capital stock of Caruso for a purchase price of $28.0 million in cash of which $20.0 million was paid at the time of closing with the remaining $8.0 million payable over a three-year period, subject to Caruso maintaining certain levels of profitability. Caruso has exceeded profitability targets in each year during the first two years subsequent to the acquisition. KNBT paid $2.7 million to Caruso during the second quarter of 2006 and $2.9 million during the second quarter of 2007 that represents the aggregate obligation through September 30, 2007. The payments were made pursuant to the terms of the stock purchase agreement relating to the purchase price contingency.

The acquisition resulted in the recording of approximately $13.1 million of goodwill. KNBT also recorded an identifiable intangible asset for Caruso’s customer list of $9.9 million that is being amortized on a straight line basis over 15 years. The expense related to the amortization of the identifiable intangible asset arising from the Caruso acquisition totaled $165,000 and $496,000 for the three and nine-month periods ended September 30, 2007 and 2006, respectively.

Additional information and disclosures concerning the Paragon and Caruso acquisitions can be found in the Company’s Form 10-K for the year ended December 31, 2006.

NOTE D

EARNINGS PER SHARE

The Company calculates earnings per share as provided by the provisions of SFAS No. 128, “Earnings Per Share” (SFAS No. 128). Basic and diluted earnings per share for the three and nine months ended September 30, 2007 and 2006 were calculated as follows:

	For the Three Months Ended September 30,
	2007							2006
	Net		Average					Net		Average
	Income		Shares		Per Share			Income		Shares		Per Share
(in thousands, except per share data)	(numerator)		(denominator)		Amount			(numerator)		(denominator)		Amount

Basic earnings per share
Income available to common shareholders	$	4,103		25,520,303	$	0.16		$	5,911		26,355,973	$	0.22
Effect of dilutive securities
Stock options				147,274		-					141,185		-
Management Recognition and Retention Plan shares				28,894		-					43,502		-
Total effect of dilutive securities				176,168		-					184,687		-
Diluted earnings per share
Income available to common shareholders
plus assumed exercise of options	$	4,103		25,696,471	$	0.16		$	5,911		26,540,660	$	0.22

	For the Nine Months Ended September 30,
	2007							2006
	Net		Average					Net		Average
	Income		Shares		Per Share			Income		Shares		Per Share
(in thousands, except per share data)	(numerator)		(denominator)		Amount			(numerator)		(denominator)		Amount

Basic earnings per share
Income available to common shareholders	$	11,601		26,020,245	$	0.45		$	17,297		27,254,749	$	0.63
Effect of dilutive securities
Stock options				138,654		-					147,060		-
Management Recognition and Retention Plan shares				37,196		-					48,206		-
Total effect of dilutive securities				175,850		(0.01	)				195,266		-
Diluted earnings per share
Income available to common shareholders
plus assumed exercise of options	$	11,601		26,196,095	$	0.44		$	17,297		27,450,015	$	0.63

KNBT had outstanding stock options for the three and nine months ended September 30, 2007 to purchase 1,716,480 and 1,686,492 shares of common stock, respectively, with exercise prices ranging from $14.91 to $16.56 per share that were anti-dilutive. These options were not included in the computation of diluted earnings per share for the three and nine months ended September 30, 2007 because the option exercise price was greater than the average market price of KNBT common stock. KNBT also had outstanding stock options for the three and nine months ended September 30, 2006, to purchase 1,307,900 and 1,274,573 shares of common stock, respectively, at $16.13 to $16.56 per share that were anti-dilutive.

Common stock outstanding for the purpose of calculating basic earnings per share does not include 761,618 and 809,219 unallocated shares held by the Employee Stock Ownership Pan (“ESOP”) at September 30, 2007 and September 30, 2006, respectively. The exclusion of these unallocated shares held by the ESOP is in accordance with the provisions of Statement of Position (“SOP”) 93-6, “Employer’s Accounting for Employee Stock Ownership Plans”, issued by the Accounting Standards Division of the American Institute of Certified Public Accountants (“AICPA”).

Unearned and uncommitted shares of common stock held in the Management Recognition and Retention Plan (“MRRP”) are not considered to be outstanding for basic earnings per share calculations. At September 30, 2007, unearned MRRP shares totaled 378,600 and uncommitted MRRP shares totaled 55,147. At September 30, 2006, unearned MRRP shares totaled 379,700 and uncommitted MRRP shares totaled 176,547.

NOTE E

INVESTMENT SECURITIES

The amortized cost, unrealized gains and losses and fair value of KNBT’s investment securities held-to-maturity and available-for-sale at September 30, 2007 (unaudited) and December 31, 2006 are as follows:

	At September 30, 2007
			Gross		Gross
	Amortized		Unrealized		Unrealized			Fair
(in thousands)	Cost		Gains		Losses			Value
Held to maturity:
Mortgage-backed securities	$	28,710	$	-	$	(312	)	$	28,398
Total investments held to maturity		28,710		-		(312	)		28,398
Available for sale:
U.S. Government and agencies		33,874		314		(29	)		34,159
Obligations of state and political subdivisions		802		-		(22	)		780
Asset-managed funds		5,048		-		(191	)		4,857
Mortgage-backed securities		588,999		464		(11,185	)		578,278
Corporate and other debt securities		26,693		-		(893	)		25,800
Equity securities		2,377		14		(144	)		2,247
Total investments available for sale		657,793		792		(12,464	)		646,121
Total investment securities	$	686,503	$	792	$	(12,776	)	$	674,519

	At December 31, 2006
			Gross		Gross
	Amortized		Unrealized		Unrealized			Fair
(in thousands)	Cost		Gains		Losses			Value
Held to maturity:
Mortgage-backed securities	$	33,532	$	-	$	(484	)	$	33,048
Total investments held to maturity		33,532		-		(484	)		33,048
Available for sale:
U.S. Government and agencies		95,523		2		(949	)		94,576
Asset-managed funds		5,171		-		(167	)		5,004
Mortgage-backed securities		703,648		439		(15,595	)		688,492
Corporate and other debt securities		68,461		277		(100	)		68,638
Equity securities		2,091		79		(26	)		2,144
Total investments available for sale		874,894		797		(16,837	)		858,854
Total investment securities	$	908,426	$	797	$	(17,321	)	$	891,902

NOTE F

STOCK BASED COMPENSATION

Stock Option Plans

KNBT maintains the 2004 Stock Option Plan (“2004 Plan”), as well as the stock option plans assumed in prior acquisitions. The 2004 Plan allows KNBT to grant options covering up to an aggregate of 2,020,118 shares of common stock to key employees and directors. The options have a term of up to ten years when they are issued and typically vest over a five-year period, except for some options granted to directors that vest over an eight-year period. The exercise price of each option is the market price of KNBT’s stock on the date of grant.

On January 1, 2006, KNBT adopted SFAS No. 123(R) (revised 2004), “Share-Based Payment”. Statement 123(R) replaces SFAS No. 123, “Accounting for Stock-Based Compensation” and supersedes Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees”. SFAS No. 123(R) established accounting and disclosure requirements using a fair-value based method of accounting for stock-based employee compensation plans. Prior to January 1, 2006, KNBT accounted for stock options using APB Opinion No. 25 and included disclosures of pro forma net income and earnings per share, as if the fair value-based method of accounting defined in SFAS No. 123 had been used. KNBT elected the modified prospective transition method for adopting SFAS No. 123(R). Under SFAS No. 123(R), all forms of share-based payments to employees, including stock options, are treated the same as other forms of compensation by recognizing the related cost in the income statement. The provisions apply to all awards granted after the required effective date as well as existing awards not vested, or which are modified, repurchased, or canceled after that date.

As of January 1, 2006, KNBT began to expense these grants as required by SFAS No. 123(R). Stock-based employee compensation cost pertaining to stock options is reflected in net income with the fair value of each option being estimated as of the date of grant using the Black-Scholes option valuation model. The Black-Scholes model incorporates variable assumptions, which include: the expected volatility, which is based on the historical volatility of KNBT’s traded stock and peer group comparisons; the expected term calculated using the simplified method; the expected dividend yield based on historical patterns and peer group performance; and the risk free interest rate, based on the U.S. Treasury yield curve at the time of the grant. KNBT used historical data to estimate option exercises and forfeitures within the valuation model. KNBT used the following assumptions:

	For the Nine Months Ended
	September 30,
	2007	2006
Expected dividend yield	2.50%	2.50%
Expected volatility	22.81%	22.63%
Range of risk-free interest rates	4.87%	4.31% to 4.61%
Range of expected option lives	6.5 years	6.5 to 7 years
Range of fair values	$4.05	$3.77 to $3.85

During the three-month periods ended September 30, 2007 and 2006, KNBT did not grant any new options. For the nine-month periods ended September 30, 2007 and 2006, KNBT granted 180,050 and 217,400 new options to certain employees and directors under the 2004 Plan. These options vest ratably over a five-year period.

A summary of all of the stock option plans as of September 30, 2007 and changes during the quarters are as follows:

	For the Nine Months Ended September 30, 2007
						Weighted Average		Aggregate
				Weighted Average		Remaining Contractual		Intrinsic
	Shares			Exercise Price		Term (years)		Value
Outstanding as of beginning of year		1,961,432		$	14.07
Issued		180,050			16.40
Exercised		(6,236	)		6.08
Forfeited		-			-
Expired		-			-
Outstanding as of September 30		2,135,246		$	14.29		6.61		4,811,950

Options exercisable as of September 30		1,062,947		$	12.17		5.77		4,645,501

The following table summarizes information concerning KNBT’s stock options outstanding and exercisable at September 30, 2007:

	For the Nine Months Ended September 30, 2007
	Options Outstanding			Options Exercisable
Range of	Stock Options	Weighted Average		Stock Options	Weighted Average
Exercise Prices	Outstanding	Life (in Years)	Exercise Price	Exercisable	Exercise Price
$3.89 - $4.35	47,155	3.59	$ 4.20	47,155	$ 4.20
$4.36 - $6.37	314,431	4.22	5.67	314,431	5.67
$6.38 - $8.36	57,180	4.26	6.73	57,180	6.73
$11.35 - $16.56	1,716,480	7.21	16.40	644,181	16.41
	2,135,246			1,062,947

The following table is a summary of non-vested stock option activity for the nine months ended September 30, 2007:

	Number of			Average Grant Date
	Shares			Fair Value
Non-vested stock options at January 1, 2007		1,149,449		$	4.30
Options Granted		180,050			4.05
Options Vested		(257,200	)		4.29
Options Forfeited		-			-
Non-vested stock options at September 30, 2007		1,072,299		$	4.26

The aggregate intrinsic value represents the total pre-tax intrinsic value (the difference between KNBT’s closing stock price on the last trading day of the quarter ended and the exercise price, multiplied by the number of options outstanding). The total intrinsic value of stock options exercised during the quarters ended September 30, 2007 and 2006 was $55,662 and $33,831, respectively.

Compensation cost is generally recognized over the stated vesting period as provided in terms of the option grants. As of September 30, 2007, there was $3.9 million of unrecognized compensation cost related to unvested stock options that is expected to be recognized over a weighted-average period of approximately 2.04 years. However, assuming the merger with National Penn is consummated, all of such expense will be recognized during the quarter in which the merger is completed.

Management Recognition and Retention Plan

The MRRP, which is a stock-based incentive plan, provides for the ability to grant up to 808,047 restricted shares of KNBT’s common stock to the Company’s directors, advisory directors, officers and employees. KNBT, for the benefit of the MRRP Trust, purchased 808,047 shares of KNBT common stock at an average price of $16.44 per share, which was treated as a reduction of additional paid-in-capital. Shares awarded to date under the MRRP are generally earned by recipients at a rate of 20% per year beginning on the first anniversary date of the grant. (Certain grants made in 2006 vest 60% on the third anniversary and 20% per year thereafter.) On May 6, 2004, 638,000 restricted shares were awarded. For the year ended December 31, 2005, 10,000 additional MRRP shares were awarded. On January 26, 2007, 35,000 additional MRRP shares were awarded. Since the inception of the MRRP, awards covering 29,100 shares were forfeited and made available for future grants. Except as discussed below, compensation expense for this plan is being recorded over the vesting period and is based on the market value of KNBT’s stock as of the date the awards were made. The remaining unearned compensation cost of the MRRP shares granted is $4.2 million and the periodic amortization of such cost is recorded as an increase in shareholders’ equity. Expense under this plan for the three month periods ended September 30, 2007 and 2006 was $531,000 and $534,000, respectively. Expense under this plan for both the nine month periods ended September 30, 2007 and 2006 was $1.6 million. Assuming the merger with National Penn is consummated, any expense with respect to allocated but unvested MRRP shares not yet recognized will be recognized during the quarter in which the merger is completed.

The MRRP also provides for the ability to issue performance-based restricted share awards. There were no performance-based restricted shares awarded for the nine month period ended September 30, 2007. During the year ended December 31, 2006, the Board of Directors awarded performance-based restricted share awards covering 85,000 shares subject to increase as described below. These shares are earned if certain defined corporate performance targets are achieved for fiscal year 2008. If the targets are achieved, on the third anniversary of the date of grant, 60% of the shares granted will be earned with the remaining 40% being earned pro rata on the fourth and fifth anniversary dates of the grant assuming the recipient remains employed by KNBT at each of such dates. Furthermore, if the Company exceeds the performance targets for fiscal year 2008, the awards will increase in the aggregate by 14,000 shares. The grants specifically exclude accelerated vesting in the event of a change in control. To date, KNBT has not recorded any compensation expense related to these performance-based restricted share awards.

In January 2007, upon further consideration of the grants of the performance-based restricted share awards, the grantees agreed to forfeit any right to receive 40% of the shares subject to the performance-based MRRP grants made in 2006 that would vest on the fourth and fifth anniversary of the grant of such awards (assuming the performance targets are met). In return for such forfeitures, each grantee agreed to receive a cash bonus in an amount equal to the fair market value of the remaining unvested restricted shares on the third anniversary of the grant date of the performance-based restricted share awards. Such amount will be paid in a lump sum within five days of the third anniversary of the grant date of the performance-based restricted share awards. However, in connection with the merger with National Penn, the performance based restricted stock awards are expected to be cancelled.

NOTE G

LOANS

A summary of KNBT’s loans receivable at September 30, 2007 (unaudited) and December 31, 2006 is as follows:

	September 30,			December 31,
(in thousands)	2007			2006

Real estate
Residential	$	569,795		$	493,813
Commercial		389,745			362,244
Construction		62,529			61,288
Total real estate		1,022,069			917,345
Consumer loans		526,789			509,555
Commercial (non-real estate)		256,895			181,103
States and political subdivisions		12,919			13,056
Total gross loans		1,818,672			1,621,059
Mortgage loans held-for-sale		(900	)		(1,994	)
Deferred fees		1,242			1,101
Total loans		1,819,014			1,620,166
Allowance for loan losses		(18,118	)		(17,044	)
Total net loans	$	1,800,896		$	1,603,122

The following table shows the amounts of KNBT’s non-performing assets, defined as non-accruing loans, accruing loans 90 days or more past due and other real estate owned at September 30, 2007 (unaudited) and December 31, 2006.

	September 30,			December 31,
(dollars in thousands )	2007			2006

Non-accruing loans	$	4,131		$	4,869
Accruing loans 90 days or more past due		632			1,058
Total non-performing loans		4,763			5,927

Other real estate owned		119			32
Total non-performing assets	$	4,882		$	5,959

Total non-performing loans as a percentage of loans, net		0.26	%		0.37	%
Total non-performing loans as a percentage of total assets		0.17	%		0.20	%
Total non-performing assets as a percentage of total assets		0.17	%		0.21	%
Net charge-offs to average loans (net)		0.02	%		0.15	%

Interest on non-accrual loans which would have been
recorded at the original rate	$	512		$	459
Interest on non-accrual loans that was reflected in income		44			46
Net decrease in interest income	$	(468	)	$	(413	)

KNBT’s recorded investment in impaired loans was $1.1 million at September 30, 2007 and $1.6 million at December 31, 2006. The valuation allowance related to impaired loans is a part of the allowance for loan losses and was $146,000 at September 30, 2007 and $323,000 at December 31, 2006. The average impaired loan balance for the nine months ended September 30, 2007 was $1.1 million and $2.0 million for the nine months ended September 30, 2006. During the nine months ended September 30, 2007 and 2006, KNBT received principal payments on impaired loans of $305,000 and $1.1 million, respectively. Income on impaired loans is recognized by KNBT on a cash basis. KNBT recognized $44,000 in interest income on impaired loans for the nine month period ended September 30, 2007, and $40,000 for the nine month period ended September 30, 2006.

The following table shows the (unaudited) activity in KNBT’s allowance for loan losses during the periods indicated:

	For the Three Months						For the Nine Months
	Ended September 30,						Ended September 30,
(dollars in thousands)	2007			2006			2007			2006

Allowance for loan losses, beginning of period	$	17,313		$	16,600		$	17,044		$	15,964
Provision for loan losses		814			365			1,458			2,315
Charge-offs
One-to four-family residential		(44	)		(13	)		(62	)		(59	)
Commercial and industrial		(42	)		(8	)		(214	)		(310	)
Consumer		(250	)		(392	)		(938	)		(1,634	)
Total charge-offs		(336	)		(413	)		(1,214	)		(2,003	)
Recoveries on loans previously charged-off
One-to four-family residential		13			18			28			39
Commercial and industrial		258			9			673			158
Consumer		56			51			129			157
Total recoveries		327			78			830			354
Net loans charged-off		(9	)		(335	)		(384	)		(1,649	)

Allowance for loan losses, at period end	$	18,118		$	16,630		$	18,118		$	16,630

NOTE H

RETIREMENT PLANS

1.	Defined Benefit Plans

KNBT participates in a multiple employer defined benefit pension plan, which covered substantially all employees who had 1,000 hours of service during the plan year ended October 2003. On October 1, 2003, KNBT froze the future accrual of benefits under this plan. KNBT continues to contribute to this plan for benefits accrued prior to October 2003. KNBT’s contribution to this plan in the nine months ended September 30, 2007 and 2006 was $462,000 and $183,000, respectively, which is included in compensation and employee benefits expense.

As part of the Northeast Pennsylvania Financial Corp., (“NEPF”) merger, KNBT assumed the multiple employer defined benefit pension plan of NEPF. This plan covered all employees who were age 21 or older and had one year of service at the time the plan was frozen. NEPF had amended the plan and froze the benefits for the then current participants of the plan. For the nine months ended September 30, 2007 and 2006, KNBT contributed approximately $249,000 and $239,000, respectively, to the NEPF pension plan, which is included in compensation and employee benefits expense.

KNBT expects to contribute an additional $291,000 in the aggregate to the two pension plans through December 31, 2007.

2.	Directors’ Deferred Plan

KNBT, as a part of previous acquisitions, assumed the deferred compensation plan for certain former directors of First Colonial. This Plan has been subsequently frozen and no future deferrals are permitted. The plan requires annual payments for periods of five to fifteen years beginning at age 65 or death. The annual benefit is based upon the amount deferred plus interest. KNBT has recorded the deferred compensation liabilities using the present value method. The net periodic defined benefit expense for the nine months ended September 30, 2007 and September 30, 2006 was as follows:

	September 30,
(in thousands)	2007		2006

Service cost	$	-	$	-
Interest cost		12		12
Net amortization and deferral of prior service costs		-		-
Amortization of net loss		-		1
Net periodic benefit cost	$	12	$	13

KNBT currently expects to contribute a total of approximately $17,000 to this plan in the year ended December 31, 2007.

As a result of the NEPF acquisition, KNBT assumed a deferred compensation plan that existed for certain NEPF directors and employees. The deferred amounts will be paid in 120 consecutive monthly payments or the first day of the month following the participant’s sixty-fifth birthday or as otherwise provided by the plan agreements. A liability of $3.5 million was assumed by KNBT from NEPF upon the acquisition.

NOTE I

NEW ACCOUNTING PRONOUNCEMENTS

On February 15, 2007, the Financial Accounting Standards Board (“FASB”) issued Statement No. 159 (SFAS 159), “The Fair Value Option for Financial Assets and Financial Liabilities,” which gives entities the option to measure eligible financial assets and liabilities and firm commitments at fair value, on an instrument by instrument basis, that are otherwise not permitted to be accounted for at fair value under other accounting standards. The election to use the fair value option is available when an entity first recognizes a financial asset or liability or upon entering into a firm commitment. Subsequent changes in fair value must be recorded in earnings. Additionally, SFAS 159 allows for a one-time election for existing positions upon early adoption with the transition adjustment recorded to beginning retained earnings. The Company did not early adopt SFAS 159 and believes that the adoption, effective January 1, 2008, will not have a significant effect on its consolidated financial statements.

In September 2006, FASB Issued Statement No. 157 (SFAS 157), “Fair Value Measurements” which is effective for fiscal years beginning after November 15, 2007 and for interim periods within those years. This statement defines fair value, establishes a framework for measuring fair value and expands the related disclosure requirements. SFAS 157 clarifies that fair value is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. Under SFAS 157 fair value measurements are not adjusted for transactions costs. The Company has evaluated the impact the adoption of SFAS 157 and believes it will not have a significant effect on its consolidated financial statements.

In September 2006, the FASB ratified a consensus opinion reached by the Emerging Issues Task Force (“EITF”) on EITF Issue 06-4, “Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements,” which requires employers that enter into endorsement split-dollar life insurance arrangements that provide an employee with a postretirement benefit to recognize a liability for the future benefits promised based on the substantive agreement made with the employee. Whether the accrual is based on a death benefit or on the future cost of maintaining the insurance would depend on what the employer has effectively agreed to provide during the employee’s retirement. The purchase of an endorsement-type life insurance policy does not qualify as a settlement of the liability. The consensus in EITF Issue 06-4 is effective for fiscal years beginning after December 15, 2007. After performing an evaluation, the Company believes that the adoption of EITF Issue 06-4 will not have a significant effect on its consolidated financial statements.

In September 2006, the FASB ratified a consensus opinion reached by the EITF on EITF Issue 06-5, “Accounting for Purchases of Life Insurance - Determining the Amount That Could Be Realized in Accordance with FASB Technical Bulletin No. 85-4.” The guidance in EITF Issue 06-5 requires policyholders to consider other amounts included in the contractual terms of an insurance policy, in addition to cash surrender value, for purposes of determining the amount that could be realized under the terms of the insurance contract. If it is probable that contractual terms would limit the amount that could be realized under the insurance contract, those contractual limitations should be considered when determining the realizable amounts. The amount that could be realized under the insurance contract should be determined on an individual policy (or certificate) level and should include any amount realized on the assumed surrender of the last individual policy or certificate in a group policy. The consensus in EITF Issue 06-5 is effective for fiscal years beginning after December 15, 2006. The Company adopted EITF Issue 06-5 on January 1, 2007. The adoption did not have a significant effect on its consolidated financial statements.

In July 2006, FASB issued Interpretation 48 (FIN 48), “Accounting for Uncertainty in Income Taxes.” In summary, FIN 48 requires that all tax positions subject to SFAS No. 109, “Accounting for Income Taxes,” be analyzed using a two-step approach. The first step requires an entity to determine if a tax position is more-likely-than-not to be sustained upon examination. In the second step, the tax benefit is measured as the largest amount of benefit, determined on a cumulative probability basis that is more-likely-than-not to be realized upon ultimate settlement. FIN 48 is effective for fiscal years beginning after December 15, 2006, with any adjustment in a company’s tax provision being accounted for as a cumulative effect of accounting change in beginning equity. FIN 48 also addressed how interest and penalties should be accrued for uncertain tax positions, requiring that interest expense be recognized in the first period interest would be accrued under the tax law. KNBT’s policy, if any uncertain tax positions should occur, is that interest and penalties on unrecognized tax benefits would be part of income tax expense. KNBT adopted FIN 48 on January 1, 2007. The adoption of this standard did not result in a change to its beginning equity. As of the date of adoption and as of the quarter ended September 30, 2007, KNBT did not have any liabilities for unrecognized tax benefits. KNBT does not anticipate any significant changes in relation to unrecognized tax benefits within the next twelve months. With few exceptions, KNBT is no longer subject to U.S. Federal or State tax examinations by tax authorities for years before 2003.

In March 2006, FASB issued Statement No. 156 (SFAS 156), “Accounting for Servicing of Financial Assets”. SFAS 156 amends SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.” SFAS 156 permits, but does not require, an entity to choose either the amortization method or the fair value. SFAS 156 is effective for fiscal years beginning after September 15, 2006. The adoption of SFAS 156 by KNBT in January 2007 did not have a significant effect on the Company’s consolidated financial statements.

NOTE J

EXTINGUISHMENT OF DEBT

In March 2006, KNBT repaid $40.0 million of reverse repurchase agreements that had been assumed as part of the NEPF acquisition and repaid a $10.0 million Federal Home Loan Bank advance. The transactions settled at a price less than face value. The gain on the reverse repurchase agreement transaction was $965,000 and the net gain on the repayment of the Federal Home Loan Bank advance was $214,000 and included the effect of the write off of intangibles totaling $712,000.

NOTE K

TREASURY STOCK

On October 27, 2004, KNBT’s Board of Directors announced its first share repurchase program. Under the initial program, which was completed during the third quarter of 2005, KNBT repurchased a total of 3,062,486 shares at an average price per share of $15.91. On July 27, 2005, the Board of Directors authorized an additional repurchase of 3,151,297 shares, which was completed in July 2006 at an average cost of $16.30 per share. On June 26, 2006, the Board of Directors authorized another share repurchase program of up to ten percent or approximately 2,807,219 shares of the Company’s outstanding stock. For the nine months ended September 30, 2007, a total of 1.2 million shares were purchased at an average cost of $14.25.

NOTE L

INCOME TAXES

KNBT accounts for income taxes in accordance with SFAS No. 109, “Accounting for Income Taxes,” which requires that deferred tax assets and liabilities be recognized using enacted tax rates for the effect of temporary differences between the book and tax bases of recorded assets and liabilities. As of December 31, 2004, the Company had a $5.2 million deferred tax asset related to a charitable contribution carryover that expires in 2008. On April 1, 2005, the Company completed its acquisition of Caruso, which gave rise to $15.9 million of tax deductible goodwill and other identifiable intangible assets. On May 19, 2005, the Company completed its acquisition of NEPF which included a net operating loss carryover of approximately $20.0 million. The ability of KNBT to use the net operating loss carryforward acquired in connection with the acquisition of NEPF will be subject to certain limitations and can be carried forward for 20 years. In addition, the amount of KNBT’s income that can be offset by the net operating loss carryforward in any given tax year will be limited to an amount equal to the long-term tax-exempt rate as established by the Internal Revenue Service multiplied by the value of NEPF at the time of its acquisition by KNBT which is the price paid by KNBT to acquire all of the stock of NEPF. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which the temporary differences become deductible. During the third quarter ended September 30, 2005, management determined that it was necessary to provide a valuation allowance relating to the deferred tax asset pertaining to the federal income tax deductibility of its charitable contribution carryover. Consequently, KNBT recorded an initial $1.1 million allowance that was included in tax expense for the third quarter of 2005. During the second quarter of 2007, KNBT recorded an additional charge of $650,000 to the allowance related to the deductibility of the charitable contribution. During the third quarter of 2007, upon further evaluation, KNBT recorded an additional charge of $100,000 bringing the allowance to $1.85 million. KNBT believes this valuation is reasonable and will continue to evaluate the ultimate realization of their deferred tax assets.

NOTE M

BALANCE SHEET RESTRUCTURING

On April 17, 2007, KNBT sold $81.7 million of agency securities, classified as available for sale, with an average yield of 4.14% recognizing a pre-tax loss of $2.2 million. The transaction reduced diluted earnings per share by $0.05 for the second quarter of 2007. The proceeds from the security sales were used to repay FHLB debt, the redemption of trust preferred securities and the purchase of agency securities.

On April 23, 2007, KNBT exercised its option to redeem $7.0 million of subordinated debentures issued through a pooled trust preferred securities offering. KNBT assumed this debt in connection with the NEPF acquisition. The interest rate on these borrowings was variable and adjusted semi-annually at 370 basis points over six-month LIBOR. At April 23, 2007, the interest rate was 9.09%. The redemption reflects KNBT’s determination to pay down maturing or callable debt rather than refinancing.

On June 26, 2007, KNBT exercised its option to redeem $15.4 million of subordinated debentures. The interest rate on these securities was variable, adjusting quarterly at three-month LIBOR plus 345 basis points.

Item 2.

Management's Discussion and Analysis of Financial Condition and Results of Operations

Forward – Looking Statements

The information contained in this quarterly report on Form 10-Q may contain forward-looking statements (as defined in the Securities Exchange Act of 1934 and the regulations promulgated thereunder) which are not historical facts or as to KNBT management's intentions, plans, beliefs, expectations or opinions or with respect to the operation of the Company or its subsidiaries. These statements include, but are not limited to, financial projections and estimates and their underlying assumptions; statements regarding plans, objectives and expectations with respect to future operations, products and services; and statements regarding future performance. Such statements are subject to certain risks and uncertainties, many of which are difficult to predict and generally beyond the control of KNBT and its management, that could cause actual results to differ materially from those expressed in, or implied or projected by, the forward-looking information and statements.

The following factors, among others, could cause actual results to differ materially from the anticipated results or other expectations expressed in the forward-looking statements:

•

Economic and competitive conditions which could affect the volume of loan originations, deposit flows and real estate values;

•

The levels of non-interest income and expense and the amount of loan losses;

•

Competitive pressure among depository institutions increases significantly;

•

Changes in the interest rate environment may further reduce interest margins;

•

General economic conditions, either nationally or in the markets in which KNBT is doing business, are less favorable than expected;

•

Mergers may result in significant charges to income, may not produce revenue enhancements or cost savings at levels or within time frames originally anticipated and may result in unforeseen integration difficulties;

•

Disruptions may occur from the announced merger with National Penn and may create difficulties in maintaining relationships with customers and employees;

•

The failure to obtain shareholder or regulatory approval of the pending merger with National Penn;

•

Legislation or changes in regulatory requirements adversely affect the business in which KNBT is engaged; and

•

Other factors discussed in the documents filed by KNBT with the Securities and Exchange Commission ("SEC") from time to time.

These factors should be considered in evaluating the forward-looking statements and undue reliance should not be placed on such statements. KNBT undertakes no obligation to update these forward-looking statements to reflect events or circumstances that occur after the date of the filing of this Form 10-Q.

Available Information

The Company is a public company and files annual, quarterly and current reports, proxy statements and other information with the SEC. The Company maintains a website at www.knbt.com and makes available, free of charge, on its Internet web site copies of its Annual Report on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on From 8-K and any amendments to such documents as soon as reasonably practicable after the reports have been electronically filed or furnished to the SEC.

Critical Accounting Policies, Judgments and Estimates

The accounting and reporting policies of KNBT conform with accounting principles generally accepted in the United States of America and general practices within the financial services industry. The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the financial statements and the accompanying notes. Actual results could differ from those estimates.

KNBT considers that the determination of the allowance for loan losses involves a higher degree of judgment and complexity than its other significant accounting policies. The allowance for loan losses is calculated with the objective of maintaining a reserve level believed by management to be sufficient to absorb the known and inherent losses in the portfolio that are both probable and reasonable to estimate. 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 material estimates, including, among others, expected default probabilities, loss given default, expected commitment usage, the amounts and timing of expected future cash flows on impaired loans, mortgages, and general amounts for historical loss experience. The process also considers economic conditions, uncertainties in estimating losses and inherent risks in the loan portfolio. All of 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 that would adversely impact earnings in future periods.

KNBT recognizes deferred tax assets and liabilities for future tax 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 realization is more likely than not. In 2005, a valuation allowance of $1.1 million was established to write down the deferred tax asset to its net realizable value. Upon further analysis of the Company’s operations, the valuation allowance was increased by $650,000 in the second quarter of 2007 and by $100,000 in the third quarter of 2007. Management believes this valuation allowance is reasonable.

Goodwill and other identifiable intangible assets are subject to impairment testing at least annually to determine whether write-downs of the recorded balance are necessary. KNBT tests for impairment based on the goodwill maintained at each defined reporting unit. A fair value is determined for each reporting unit based on at least one of three different market valuation methodologies. If the fair values of the reporting units exceed their book values, no write-down of recorded goodwill is necessary. If the fair value of the reporting unit is less, an expense may be required to be recognized on KNBT’s books to write down the related goodwill to the proper carrying value. As of September 30, 2007, KNBT’s recorded goodwill totaled $109.9 million compared to $105.9 million at December 31, 2006. During the first quarter of 2007, KNBT finalized its valuations with respect to the Paragon acquisition resulting in an increase in goodwill.

On January 1, 2006, KNBT changed accounting policy related to share-based compensation in connection with the adoption of SFAS No.123(R). As a part of the transition to SFAS No.123(R), KNBT elected to use the modified version of prospective application (“modified prospective application”). Under modified prospective application, as it is applicable to KNBT, SFAS No. 123(R) applies to new awards and to awards which are modified, repurchased or cancelled after January 1, 2006. Additionally, compensation expense for the portion of each award for which the requisite service period has not been rendered, generally referring to nonvested awards) that was outstanding as of January 1, 2006, is now recognized as the remaining requisite service is rendered. Compensation expense for such awards granted prior to January 1, 2006 is based on the same method and on the same grant date fair values previously determined for the pro forma disclosures required for all companies that did not previously adopt the fair value accounting method for share-based compensation.

The fair value of our stock option grants is estimated at the date of grant using the Black-Scholes option-valuation model. The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions. KNBT utilizes the following assumptions when estimating fair value of its stock option grants under SFAS No. 123(R): expected volatility, based on the historical volatility of KNBT’s traded stock and peer group comparisons; expected term, calculated using the simplified method; expected dividend yield, based on historical patterns and peer group performance; and the risk free interest rate, based on the U.S. Treasury yield curve at the time of the grant. KNBT uses historical data to estimate the likelihood of option exercise and employee termination within the valuation model.

Comparison of Financial Condition as of September 30, 2007 and December 31, 2006

Assets. KNBT’s total assets were $2.9 billion at both September 30, 2007 and December 31, 2006. Although asset growth was flat, net loans receivable increased $197.8 million or 12.3% to $1.8 billion compared to $1.6 billion at December 31, 2006. The growth in loans receivable was primarily due to an increase of $76.0 million or 15.4% in residential real estate loans and an increase of $75.8 million or 41.9% in non-real estate commercial loans. The increase in net loans receivable was offset by a $217.6 million or 24.4% decrease in investment securities (including both available-for-sale and held-to-maturity) to $674.8 million at September 30, 2007 compared to $892.4 at December 31, 2006. Between December 31, 2006 and September 30, 2007, the available-for-sale category decreased $212.7 million or 24.8%, which was primarily attributable to a decrease of $110.2 million or 16.0% in mortgage-backed securities, a decrease of $60.4 million or 63.9% in agency securities and a decrease of $42.8 million or 62.4% in corporate and other debt securities. The proceeds from calls, maturities and principal repayments on investment securities during the nine months ended were used to repay FHLB debt, to fund the growth in the loan portfolio, purchase agency securities, and to fund repurchases of common stock pursuant to KNBT’s stock repurchase programs. (see NOTE M “Balance Sheet Restructuring”).

Non-Performing Assets. On loans where the collection of principal or interest payments is doubtful, the accrual of interest income ceases (“non-accrual” loans). On loans 90 days or more past due as to principal and interest payments, KNBT’s policy, with certain limited exceptions, is to discontinue accruing interest. On occasion, this action may be taken earlier if the financial condition of the borrower raises significant concern with regard to the borrower’s ability to service the debt in accordance with the terms of the loan agreement. Interest income is not accrued on these loans until the borrowers’ financial condition and payment record demonstrate an ability to service the debt. Real estate that is acquired as a result of foreclosure is classified as other real estate owned. Other real estate owned is recorded at the lower of cost or fair value less estimated selling costs. Costs associated with acquiring and improving a foreclosed property may be capitalized to the extent that the carrying value does not exceed fair value less estimated selling costs. Holding costs are charged to expense. Gains and losses on the sale of other real estate owned are credited or charged to operations, as incurred.

Non-performing loans decreased $1.2 million or 19.6% to $4.8 million at September 30, 2007 compared to $5.9 million at December 31, 2006. The decrease was primarily due to a decline of $495,000 or 22.9% in non-performing residential mortgage loans, a decrease of $424,000 or 27.3% in non-performing commercial loans and a decrease of $246,000 or 11.1% in non-performing consumer loans. Total non-performing loans as a percentage of net loans declined to 0.26% at September 30, 2007 compared to 0.37% at December 31, 2006.

Allowance for Loan Losses. The allowance for loan losses is established through a provision for loan losses. KNBT maintains the allowance at a level believed, to the best of management’s knowledge, to cover all known and inherent losses in the portfolio that are both probable and reasonable to estimate at each reporting date. Management reviews on a monthly basis all loans that are delinquent and performs regular reviews of the portfolio in order to identify those inherent losses and assess the overall adequacy of the allowance. Such reviews consist of a quantitative analysis by loan category, using historical loss experience and consideration of a series of qualitative loss factors. KNBT’s evaluation process includes, among other things, an analysis of delinquency trends, non-performing loan trends, the level of charge-offs and recoveries, prior loss experience, total loans outstanding, the volume of loan originations, the type, size and geographic concentration of its loans, the value of collateral securing the loan, the borrower’s ability to repay and repayment performance, the number of loans requiring heightened management oversight, local economic conditions and industry experience.

In addition, in establishing the allowance for loan losses, KNBT’s management uses a ten point internal rating system for all loans originated by the Commercial Lending Department. At the time of origination, each commercial loan is assigned a rating based on the assumed risk elements of the loan. Such risk ratings are periodically reviewed by management and revised as deemed appropriate.

The establishment of the allowance for loan losses is significantly affected by management’s judgment and uncertainties and there is likelihood that different amounts would be reported under different conditions or assumptions. Various regulatory agencies, as an integral part of their examination process, periodically review KNBT’s allowance for loan losses. Such agencies may require KNBT to make additional provisions for estimated loan losses based upon judgments different from those of management. As of September 30, 2007, KNBT’s allowance for loan losses was 1.00% of total loans receivable compared to 1.05% at December 31, 2006.

KNBT will continue to monitor and modify its allowance for loan losses as conditions dictate. No assurances can be given that its level of allowance for loan losses will cover all of the inherent losses on its loans or that future adjustments to the allowance for loan losses will not be necessary if economic and other conditions differ substantially from the economic and other conditions used by management to determine the current level of the allowance for loan losses.

Liabilities. KNBT’s total liabilities equaled $2.5 billion at September 30, 2007 and at December 31, 2006. Total deposits increased $15.1 million or 0.79% to $1.92 billion at September 30, 2007 compared to $1.91 billion at December 31, 2006. The increase reflects, in part, KNBT’s continuing efforts to boost the level of checking accounts, money market accounts and other core deposits. Core deposits consist of all deposits other than certificates of deposit. FHLB advances declined $152.1 million or 29.3% to $367.0 million at September 30, 2007 compared to $519.2 million at December 31, 2006. The repayment of maturing advances were the primary reason for the decline. Securities sold under agreements to repurchase increased $128.3 million or 283.2% to $173.6 million at September 30, 2007 compared to $45.3 million at December 31, 2006. The primary reason for the increase was the purchase of a $75.0 million structured repurchase agreement taking advantage of favorable funding opportunities. Subordinated debt decreased $22.9 million or 59.7% due primarily to the redemption of trust preferred securities. (See NOTE M “Balance Sheet Restructuring”)

Shareholders’ Equity. Shareholders’ equity totaled $349.7 million at September 30, 2007 compared to $356.0 million at December 31, 2006, a decrease of $6.3 million or 1.8%. The decrease in shareholders’ equity was primarily the result of the continued repurchase of shares of KNBT common stock through the Company’s stock repurchase programs and the payment of cash dividends offset in part by net income earned during the period. During the nine-month period ended September 30, 2007, KNBT repurchased 1,158,397 shares of its common stock at an aggregate cost of $16.4 million. Dividends declared and paid during the nine month period ended September 30, 2007 reduced retained earnings by $7.4 million. Net income for the nine months ended September 30, 2007 was $11.6 million. KNBT released 35,701 shares of the Company’s common stock during the nine months ended September 30, 2007 pursuant to the ESOP with a value as calculated in accordance with SOP 93-6 of approximately $493,000.

Regulatory capital for KNBT and the Bank at September 30, 2007 and December 31, 2006 are shown in the following tables.

	At September 30, 2007
						Required					To Be Well Capitalized
						For Capital					Under Prompt Corrective
	Actual					Adequacy Purposes					Action Provisions
(in thousands)	Amount		Ratio			Amount		Ratio			Amount		Ratio

Total Capital
(To risk-weighted assets)
Company (consolidated)	$	257,065		12.73	%	$	161,490		8.00	%	N/A		N/A
Bank	$	220,729		10.74	%	$	164,493		8.00	%	$	205,616		10.00	%
Tier I Capital
(To risk-weighted assets)
Company (consolidated)	$	238,947		11.84	%	$	80,745		4.00	%	N/A		N/A
Bank	$	202,864		9.85	%	$	82,246		4.00	%	$	123,369		6.00	%
Tier I Capital
(To average assets, leverage)
Company (consolidated)	$	238,947		8.79	%	$	108,726		4.00	%	N/A		N/A
Bank	$	202,864		7.36	%	$	110,121		4.00	%	$	137,652		5.00	%

	At December 31, 2006
						Required					To Be Well Capitalized
						For Capital					Under Prompt Corrective
	Actual					Adequacy Purposes					Action Provisions
(in thousands)	Amount		Ratio			Amount		Ratio			Amount		Ratio

Total Capital
(To risk-weighted assets)
Company (consolidated)	$	288,207		14.83	%	$	155,432		8.00	%	N/A		N/A
Bank	$	256,766		13.23	%	$	155,320		8.00	%	$	194,151		10.00	%
Tier I Capital
(To risk-weighted assets)
Company (consolidated)	$	271,163		13.96	%	$	77,716		4.00	%	N/A		N/A
Bank	$	239,722		12.35	%	$	77,660		4.00	%	$	116,490		6.00	%
Tier I Capital
(To average assets, leverage)
Company (consolidated)	$	271,163		9.77	%	$	111,068		4.00	%	N/A		N/A
Bank	$	239,722		8.55	%	$	112,157		4.00	%	$	140,196		5.00	%

Liquidity. KNBT’s primary sources of funds are from deposits, amortization of loans, loan prepayments and the maturity of loans, mortgage-backed securities and other investments, and other funds provided from operations. While scheduled payments from the amortization of loans and mortgage-backed securities and maturing investment securities are relatively predictable sources of funds, deposit flows and loan prepayments can be greatly influenced by general interest rates, economic conditions and competition. KNBT also maintains excess funds in short-term, interest-bearing assets that provide additional liquidity and also utilizes outside borrowings, primarily from the FHLB, as an additional funding source. KNBT uses its liquidity to fund existing and future loan commitments, to fund maturing certificates of deposit and demand deposit withdrawals, to invest in other interest-earning assets, and to meet operating expenses. In addition to cash flow from loan and securities payments and prepayments as well as from sales of available-for-sale securities and mortgage loans, KNBT has significant borrowing capacity available to fund liquidity needs. For the nine months ended September 30, 2007, the average balance of FHLB advances and Federal funds purchased were $439.7 million and $7.0 million, respectively. For the nine months ended September 30, 2006, the average balance of FHLB advances was $647.2 million. KNBT had no Federal funds purchased during the nine months ended September 30, 2006. To date, KNBT’s borrowings have consisted primarily of advances from the FHLB of Pittsburgh and overnight funds from banks.

“GAP” Analysis. The following interest rate sensitivity “GAP” table sets forth the amounts of KNBT’s interest-earning assets and interest-bearing liabilities outstanding at September 30, 2007, which are expected, based upon certain assumptions, to reprice or mature in each of the future time periods shown. Except as stated below, the amount of assets and liabilities shown which reprice or mature during a particular period were determined in accordance with the earlier of term to repricing or the contractual maturity of the asset or liability. The table sets forth an approximation of the projected repricing of assets and liabilities at September 30, 2007, on the basis of contractual maturities, anticipated prepayments, and scheduled rate adjustments within a three-month period and subsequent selected time intervals. The loan amounts in the table reflect principal balances expected to be repaid and/or repriced as a result of contractual amortization and anticipated prepayments of adjustable-rate loans and fixed-rate loans, and as a result of contractual rate adjustments on adjustable-rate loans. Annual prepayment rates for adjustable-rate and fixed-rate single-family and multi-family mortgage loans are assumed to range from 14% to 32%. The annual prepayment rate for mortgage-backed securities is assumed to range from 12% to 32%. Money market deposit accounts, savings accounts and interest-bearing checking accounts are assumed to have annual rates of withdrawal, or “decay rates,” in the first year of the analysis of 11%, 11% and 12%, respectively.

	At September 30, 2007
				More than			More than			More than			More than
	3 Months			3 Months			6 Months			1 Year			3 Years			More than
*(dollars in thousands)*	or Less			to 6 Months			to 1 Year			to 3 Years			to 5 Years			5 Years			Total
Interest-earning assets (1):
Deposits at other institutions	$	1,302		$	-		$	-		$	-		$	-		$	-		$	1,302
Loans receivable (2)		419,917			84,398			174,222			509,475			288,267			343,635			1,819,914
Investment securities, debt		68,326			33,995			76,463			249,253			123,909			120,389			672,335
Investment securities, equity		-			-			-			-			-			26,093			26,093
Total interest-earning assets	$	489,545		$	118,393		$	250,685		$	758,728		$	412,176		$	490,117		$	2,519,644
Cumulative total interest-
earning assets	$	489,545		$	607,938		$	858,623		$	1,617,351		$	2,029,527		$	2,519,644		$	2,519,644
Interest-bearing liabilities:
Savings deposits	$	8,107		$	5,354		$	10,237		$	35,296		$	27,732		$	101,661		$	188,387
Interest-bearing checking deposits		6,622			6,425			12,284			42,356			48,106			107,164			222,957
Money market deposits		16,697			16,201			30,972			106,794			216,976			174,518			562,158
Certificates of deposit		172,042			177,269			208,811			190,921			10,129			1,676			760,848
FHLB advances and other
borrowings		281,239			9,894			32,719			110,211			38,435			98,354			570,852
Total interest-bearing
liabilities	$	484,707		$	215,143		$	295,023		$	485,578		$	341,378		$	483,373		$	2,305,202
Cumulative total interest-
bearing liabilities	$	484,707		$	699,850		$	994,873		$	1,480,451		$	1,821,829		$	2,305,202		$	2,305,202
Interest-earning assets
less interest-bearing
liabilities	$	4,838		$	(96,750	)	$	(44,338	)	$	273,150		$	70,798		$	6,744		$	214,442
Cumulative interest-rate
sensitivity gap (3)	$	4,838		$	(91,912	)	$	(136,250	)	$	136,900		$	207,698		$	214,442
Cumulative interest-rate gap as a
percentage of total assets at
September 30, 2007		0.17	%		(3.20	%)		(4.74	%)		4.76	%		7.23	%		7.46	%
Cumulative interest-earning assets
as a percentage of
cumulative interest-bearing
liabilities at September 30, 2007		101.00	%		86.87	%		86.30	%		109.25	%		111.40	%		109.30	%

(1) Interest-earning assets are included in the period in which the balances are expected to be redeployed and/or repriced as a result of anticipated prepayments, scheduled rate adjustment and contractual maturity.
(2) For purposes of the gap analysis, loans receivable includes non-performing loans, gross of the allowance for loan losses, undisbursed loan funds and deferred loan fees.
(3) Interest-rate sensitivity gap represents the difference between net interest-earning assets and interest-bearing liabilities.

Comparison of Operating Results for the Three and Nine Months Ended September 30, 2007 and 2006

Results of Operations. Net income is affected by five major elements: (1) net interest income, or the difference between interest income earned on loans and investments and interest expense paid on deposits and borrowed funds; (2) the provision for loan losses, or the amount added to the allowance for loan losses to provide reserves for inherent losses on loans; (3) non-interest income, which is made up primarily of certain fees, wealth management income and gains and losses from sales of securities or other transactions; (4) non-interest expense, which consists primarily of salaries, employee benefits and other operating expenses; and (5) income taxes. Each of these major elements will be reviewed in more detail in the following discussion.

Net Interest Income. Net interest income represents the difference between income on interest-earning assets and expense paid on interest-bearing liabilities. Net interest income also depends upon the relative amounts of interest-earning assets and interest-bearing liabilities and the interest rate earned or paid on them. Net interest income is the primary source of earnings for KNBT. Therefore, the interest rate environment has material impact on KNBT’s earnings. The traditional view of the banking business holds that banks pay interest on their deposits based upon shorter term interest rates while making loans tied to longer term interest rates. As a result, KNBT is able to increase net interest income at a faster pace when the spread between short-term and long-term U.S. Treasury rates is positive. This embraces the view that funding costs are more directly tied to shorter term rates, while loan rates are more tied to intermediate and longer term rates. However, in 2004, the yield curve flattened and remained so during 2005 and 2006 and through the period ended September 30, 2007, resulting in a compressed net interest margin since long-term rates were the same as or increased less than short-term rates (an inverted yield curve). KNBT believes that net interest margins for its industry will continue to be challenged if the yield curve remains flat or inverted, as competition for loans and deposits remains intense, as customers continue to migrate from lower rate to higher rate deposits or other products, and as the benefit of adding or repricing investment securities is diminished.

For the three months ended September 30, 2007, KNBT’s net interest income was $17.3 million, a decrease of $680,000 or 3.8% compared to $18.0 million for the same period in 2006. For the nine months ended September 30, 2007, net interest income was $52.1 million, a decrease of $3.1 million or 5.7% compared to $55.2 million for the nine months ended September 30, 2006. The decrease in both periods was mainly the result of the effects of the flat to inverted yield curve that has persisted during this timeframe, combined with a continued shift in deposit mix away from lower-cost deposit products to higher-cost consumer and other time deposits. KNBT’s average interest-earning assets totaled $2.5 billion for the three months ended September 30, 2007 compared to $2.6 billion for the same period in 2006. Average interest-earning assets for the nine month period ended September 30, 2007 were $2.5 billion, a $107.5 million or 4.1% decrease from average interest-earning assets of $2.6 billion for the same period in 2006. Average interest-bearing liabilities were $2.3 billion for the three months ended September 30, 2007 compared to $2.4 billion for the comparable period in 2006. Average interest-bearing liabilities for the nine month period ended September 30, 2007 totaled $2.3 billion, a $106.9 million or 4.5% decrease from average interest-bearing liabilities of $2.4 billion for the same period in 2006. The decrease in both interest-earning assets and interest-bearing liabilities was primarily the result of KNBT’s continuing its efforts to reduce debt through paying-off rather than refinancing maturing FHLB advances, extinguishing debt as it did in March and June of 2006, calling its trust preferred debt and repurchasing shares as part of its ongoing share repurchase programs.

KNBT’s average interest rate spread on a tax equivalent basis was 2.49% and 2.47% for the three and nine month periods ended September 30, 2007, respectively, compared to 2.52% and 2.59% for the three and nine month periods ended September 30, 2006. The effective tax rate used for the taxable equivalent adjustment was 35%. The net interest margin, a measure of net interest income performance, is determined by dividing net interest income on a tax equivalent basis by the average balance of total interest-earning assets. The net interest margin on a tax-equivalent basis for the three and nine month periods ended September 30, 2007 was 2.80% and 2.79%, respectively, compared to 2.79% and 2.86% for the same three and nine month periods in 2006. KNBT’s net interest margin and average interest rate spread has contracted from the comparable 2006 levels due to increased deposit costs and the flat to inverted yield curve which has increased short-term funding costs at a faster rate than yields on interest-earning assets. The flattening of the yield curve that was experienced in 2006 as well as through the second quarter of 2007 and the associated impact of funding KNBT’s ongoing share repurchase programs has negatively impacted our margin and compressed the interest rate spread between our longer term assets and our shorter term liabilities.

KNBT presents its net interest margin on a tax-equivalent basis because management believes that presentation of its net interest margin and average interest rate spread on a tax-equivalent basis provides information that is useful for a proper understanding of the operating results of KNBT's business. These disclosures should not be viewed as a substitute for operating results determined in accordance with generally accepted accounting principles (“GAAP”) nor are they necessarily comparable to non-GAAP performance measures, which may be presented by other companies. Without the adjustment for tax-free income, the net interest margin was 2.76% and 2.75%, respectively, for the three and nine month periods ended September 30, 2007 compared to 2.76% and 2.80% for the same respective periods in 2006. See “-Average Balances, Net Interest Income, and Yields Earned and Rates Paid.”

Interest Income. KNBT’s total interest income was $37.8 million for the three-month period ended September 30, 2007, a $66,000 or 0.17% increase compared to the three-month period ended September 30, 2006. For the nine months ended September 30, 2007, total interest income was $112.6 million, a $1.9 million or 1.7% increase compared to $110.7 million for the nine months ended September 30, 2006. The increase in total interest income was primarily attributable to an increase in interest income on loans. Interest income on loans totaled $29.2 million for the three months ended September 30, 2007, an increase of $4.0 million, or 15.7%, compared to $25.3 million for the three months ended September 30, 2006.

For the nine months ended September 30, 2006, interest income on loans was $83.3 million, an increase of $12.0 million or 16.8% compared to $71.3 million for the same period in 2006 reflecting, in large part, the effects of the increase in the average balance of loans for the nine-month period ended September 30, 2007 by $202.7 million or 13.3% to $1.7 billion compared to $1.5 billion for the nine-month period ended September 30, 2006.

Interest income on investment securities for the three months ended September 30, 2007 was $8.5 million, a $3.6 million or 29.6% decrease compared to $12.1 million for the same period in 2006. For the nine months ended September 30, 2007, interest income on investment securities was $28.2 million, a decrease of $10.3 million or 26.8% compared to $38.5 million for the nine months ended September 30, 2006. The decrease in interest income on investment securities was primarily driven by a decrease in the average balance of investment securities caused by the sale and maturing of investment securities. Proceeds from security sales were used to fund the growth in the loan portfolio, repay FHLB debt and redeem subordinated debt securities and also used to fund common stock purchases pursuant to KNBT’s stock repurchase programs. The average balance of investment securities for the nine-month period ended September 30, 2007 decreased $312.0 million or 28.5% to $783.5 million compared to $1.1 billion for the nine-month period ended September 30, 2006.

Interest Expense. KNBT’s total interest expense for the three months ended September 30, 2007 was $20.5 million, an increase of $746,000 or 3.8%, compared to $19.8 million for the same period in 2006. For the nine months ended September 30, 2007, total interest expense was $60.5 million an increase of $5.0 million or 9.0% over the nine month period ended September 30, 2006. The growth in interest expense is primarily the result of KNBT customers shifting funds into higher yielding non-core deposits. KNBT’s strategy of using cheaper core deposits has partially mitigated the increase in interest expense caused by the shift. In addition, KNBT has offset the impact of increasing interest rates by redeeming subordinated debt securities and by paying off rather than refinancing maturing FHLB debt. Interest expense on deposits totaled $14.4 million for the three months ended September 30, 2007, an increase of $1.8 million or 14.5%, compared to $12.6 million for the three months ended September 30, 2006. For the nine months ended September 30, 2007, interest expense on deposits totaled $42.0 million, an increase of $8.9 million or 27.0% compared to $33.1 million for the nine months ended September 30, 2006. Interest on FHLB advances, subordinated debt and securities sold under agreements to repurchase for the three months ended September 30, 2007 totaled $6.1 million, a decrease of $1.1 million or 15.0% compared to $7.2 million for the same period in 2006. For the nine months ended September 30, 2007, interest on FHLB advances, subordinated debt and securities sold under agreements to repurchase for the totaled $18.4 million, a decrease of $3.9 million or 17.6% compared to $22.4 million for the same period in 2006.

The increase in interest expense on deposits for the three month and nine month periods ended September 30, 2007 compared to the same period in 2006 was primarily due to the increase in the average rate paid on deposits. The Federal Reserve Board’s increases in short-term rates in 2006 which increased market rates generally have resulted in KNBT having to increase rates paid on deposits. Consequently, due to the increase in short-term rates, combined with intense competitive pressure, higher cost, short-term time deposits have now become a more favorable funding source than short- term borrowing obligations. The average rate paid on deposits increased 40 basis points to 3.35% for the three-month period ended September 30, 2007 compared to the same period in 2006. For the nine month period ended September 30, 2007, the average rate paid on deposits increased 60 basis points to 3.25% compared to the same period in 2006. The average balance of interest-bearing deposits increased $60.5 million or 3.6% to $1.72 billion for the nine months ended September 30, 2007 compared to $1.7 billion for the same period in 2006.

Average Balances, Net Interest Income, and Yields Earned and Rates Paid. The following tables show for the periods indicated the total dollar amount of interest from average interest-earning assets and the resulting yields, as well as the interest expense and the resulting costs on average interest-bearing liabilities, expressed both in dollars and rates, and the net interest margin. The table includes information adjusted to a tax-equivalent basis for the Company’s tax-exempt investment securities and loans. The presentation on a tax-equivalent basis may be considered to include non-GAAP information.

	For the Three Months Ended September 30,
	2007								2006
				Interest		Average						Interest		Average
	Average			Income/		Yield/			Average			Income/		Yield/
(dollars in thousands)	Balance			Expense		Rate			Balance			Expense		Rate
Interest-earning assets
Interest-bearing balances with banks	$	1,336		$	15		4.49	%	$	6,294		$	80		5.08	%
Federal funds sold		4,757			62		5.21	%		22,529			297		5.27	%
Investment securities
Taxable (1)		719,560			8,545		4.75	%		1,010,334			12,099		4.79	%
Tax-exempt (2)		-			-		-			3,043			57		7.49	%
Loans receivable (2) (3)		1,795,209			29,443		6.56	%		1,579,827			25,429		6.44	%
Allowance for loan losses		(17,644	)							(16,617	)
Net loans		1,777,565			29,443		6.63	%		1,563,210			25,429		6.51	%
Total interest-earning assets		2,503,218			38,065		6.08	%		2,605,410			37,962		5.83	%
Non-interest-earning assets		355,043			-					359,340			-
Total assets, interest income	$	2,858,261			38,065				$	2,964,750			37,962
Interest-bearing liabilities
Demand deposits	$	229,284		$	516		0.90	%	$	236,346		$	424		0.72	%
Money market deposits		549,837			5,097		3.71	%		448,266			3,852		3.44	%
Savings deposits		197,106			234		0.47	%		239,887			279		0.47	%
Certificates of deposit		744,334			8,552		4.60	%		779,620			8,018		4.11	%
Total interest-bearing deposits		1,720,561			14,399		3.35	%		1,704,119			12,573		2.95	%
Securities sold under agreements
to repurchase		152,687			1,672		4.38	%		45,450			462		4.07	%
Federal funds purchased		12,470			165		5.29	%		-			-		-
FHLB advances		384,870			4,012		4.17	%		602,068			6,028		4.00	%
Other debt		15,483			292		7.54	%		38,585			731		7.58	%
Total interest-bearing liabilities		2,286,071			20,540		3.59	%		2,390,222			19,794		3.31	%
Non-interest-bearing liabilities
Non-interest-bearing deposits		191,170			-					195,523			-
Other liabilities		32,021			-					34,625			-
Total liabilities, interest expense		2,509,262			20,540					2,620,370			19,794
Shareholders' equity		348,999			-					344,380			-
Total liabilities
and shareholders' equity, interest expense	$	2,858,261			20,540				$	2,964,750			19,794

Net interest income on
tax-equivalent basis (2)					17,525								18,168
Net interest spread on
tax-equivalent basis (4)							2.49	%							2.52	%
Net interest margin on
tax-equivalent basis (5)							2.80	%

KNBT BANCORP INC 10-Q