General

Throughout Management's Discussion and Analysis ("MD&A") the term "the Company", refers to the consolidated entity of Pathfinder Bancorp, Inc. Pathfinder Bank and Pathfinder Statutory Trust I are wholly owned subsidiaries of Pathfinder Bancorp, Inc., however, Pathfinder Statutory Trust I is not consolidated for reporting purposes. Pathfinder Commercial Bank, Pathfinder REIT, Inc. and Whispering Oaks Development Corp. represent wholly owned subsidiaries of Pathfinder Bank. At June 30, 2008, Pathfinder Bancorp, M.H.C, the Company's mutual holding company parent, whose activities are not included in the MD&A, held 63.7% of the Company's outstanding common stock and the public held 36.3%.

The following discussion reviews the Company's financial condition at June 30, 2008 and the results of operations for the three months and six months ended June 30, 2008 and June 30, 2007.

This Quarterly Report contains certain "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements are subject to certain risks and uncertainties, including, among other things, changes in economic conditions in the Company's market area, changes in policies by regulatory agencies, fluctuations in interest rates, demand for loans in the Company's market areas and competition, that could cause actual results to differ materially from historical earnings and those presently anticipated or projected. The Company wishes to caution readers not to place undue reliance on any such forward-looking statements, which speak only as of the date made. The Company wishes to advise readers that the factors listed above could affect the Company's financial performance and could cause the Company's actual results for future periods to differ materially from any opinions or statements expressed with respect to future periods in any current statements.

The Company does not undertake, and specifically declines any obligation, to publicly release the results of any revisions that may be made to any forward-looking statements to reflect events or circumstances after the date of such statements or to reflect the occurrence of anticipated or unanticipated events.

The Company's net income is primarily dependent on its net interest income, which is the difference between interest income earned on its investments in mortgage loans, investment securities and other loans, and its cost of funds consisting of interest accrued on deposits and borrowed funds. The Company's net income is also affected by its provision for loan losses, as well as by the amount of other income, including income from fees and service charges on deposit accounts, net gains and losses on sales and the impairment of securities, loans and foreclosed real estate, and other expenses such as salaries and employee benefits, building occupancy and equipment costs, data processing and income taxes. Earnings of the Company also are affected significantly by general economic and competitive conditions, particularly changes in market interest rates, government policies and actions of regulatory authorities, which events are beyond the control of the Company. In particular, the general level of market interest rates which tend to be highly cyclical have a significant impact on our earnings.

Application of Critical Accounting Policies

The Company's consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America and follow practices within the banking industry. Application of these principles requires management to make estimates, assumptions and judgments that affect the amounts reported in the consolidated financial statements and accompanying notes. These estimates, assumptions and judgments are based on information available as of the date of the financial statements; accordingly, as this information changes, the financial statements could reflect different estimates, assumptions and judgments. Certain policies inherently have a greater reliance on the use of estimates, assumptions and judgments and as such have a greater possibility of producing results that could be materially different than originally reported. Estimates, assumptions and judgments are necessary when assets and liabilities are required to be recorded at fair value or when an asset or liability needs to be recorded contingent upon a future event. Carrying assets and liabilities at fair value inherently results in more financial statement volatility. The fair values and information used to record valuation adjustments for certain assets and liabilities are based on quoted market prices or are provided by other third-party sources, when available. When third party information is not available, valuation adjustments are estimated in good faith by management.

The most significant accounting policies followed by the Company are presented in Note 1 to the consolidated financial statements included in the 2007 Annual Report on Form 10-K ("the Consolidated Financial Statements"). Beginning with its 2007 Annual Report, the Company has elected to file its Exchange Act reports under the rules and regulations applicable to smaller reporting companies.

These policies, along with the disclosures presented in the other financial statement notes and in this discussion, provide information on how significant assets and liabilities are valued in the consolidated financial statements and how those values are determined. Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, assumptions and estimates underlying those amounts, management has identified the determination of the allowance for loan losses and the evaluation of investment securities for other than temporary impairment to be the accounting areas that require the most subjective and complex judgments, and as such could be the most subject to revision as new information becomes available.

The allowance for loan losses represents management's estimate of probable loan losses inherent in the loan portfolio. Determining the amount of the allowance for loan losses is considered a critical accounting estimate because it requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change. The loan portfolio also represents the largest asset type on the consolidated statement of condition. Note 1 to the Consolidated Financial Statements describes the methodology used to determine the allowance for loan losses, and a discussion of the factors driving changes in the amount of the allowance for loan losses is included in this report.

The Company carries all of its investments at fair value with any unrealized gains or losses reported net of tax as an adjustment to shareholders' equity, except for security impairment losses which are charged to earnings. The Company's ability to fully realize the value of its investments in various securities, including corporate debt securities, is dependent on the underlying creditworthiness of the issuing organization. In evaluating the security portfolio for other-than-temporary impairment losses, management considers (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. Based on management's assessment at June 30, 2008, the Company held a position in a mutual fund whose fair value decline was expected to be other than temporary. As a result of this determination, an other-than-temporary impairment charge of $342,000, relating to the Company's holdings in the fund, was recorded. The fund's value decline is a result of both weakness in the trading market of the underlying securities and a deterioration in the credit quality of a portion of the funds underlying private label mortgage-backed security holdings. The Company's ability to reduce its investment position in the fund is limited by the fund's redemption policy. In particular, the fund currently is limiting cash redemptions to $250,000 every 90 days, with any redemptions in excess of $250,000 paid by transferring underlying assets held by the fund. The Company has received its initial $250,000 cash redemption and currently expects, subject to market conditions, to request further cash redemptions when allowed in future quarters. At June 30, 2008, the total carrying value of the Company's remaining investment in the fund is approximately $3,073,000.

Overview

Net income was $300,000, or $0.12 per basic and diluted share, for the three months ended June 30, 2008, as compared to $166,000, or $0.07 per basic and diluted share, for the same period in 2007. For the six months ended June 30, 2008, the Company reported net income of $632,000, or $0.25 per basic and diluted share as compared to $331,000, or $0.13 per basic and diluted share for the same period in 2007. During the second quarter of 2008, the Company continued its efforts toward transforming its more traditional thrift balance sheet with mostly residential loans as earning assets, toward that of a community bank with a more diverse mix of residential, consumer and commercial loans. On an average balance basis, total commercial loans comprised 31.0% of the total gross loan portfolio for the quarter ended June 30, 2008.

Results of Operations

The return on average assets and return on average shareholders' equity were 0.35% and 5.41%, respectively, for the three months ended June 30, 2008, compared with 0.21% and 3.15%, respectively, for the three months ended June 30, 2007. During the second quarter of 2008, when compared to the second quarter of 2007, net interest income increased $514,000, partially offset by a decrease in core noninterest income of $22,000. The increase in net interest income was further offset by an increased provision for loan losses of $60,000 and an impairment charge of $342,000 on an available-for-sale security. Noninterest expenses decreased $106,000. The Company benefited from a steepening of the yield curve during 2008. This was in contrast to the flat and inverted yield curve that characterized the interest rate environment in 2006 and most of 2007.

Net Interest Income

Net interest income is the Company's primary source of operating income for payment of operating expenses and providing for loan losses. It is the amount by which interest earned on loans, interest-earning deposits and investment securities, exceeds the interest paid on deposits and other interest-bearing liabilities. Changes in net interest income and net interest margin result from the interaction between the volume and composition of interest-earning assets, interest-bearing liabilities, related yields and associated funding costs.

Net interest income, on a tax-equivalent basis, increased to $2.7 million for the three months ended June 30, 2008, from $2.1 million for the three months ended June 30, 2007. The Company's net interest margin for the second quarter of 2008 increased to 3.41% from 2.99% when compared to the same quarter in 2007. Recent actions by the Federal Reserve to decrease short-term interest rates have resulted in a positively sloped yield curve. Consequently, the Company's cost of funds in 2008 were lower than in 2007. This, combined with efforts to maintain the current levels of earning asset yields, has resulted in an expansion of the Company's net interest margin. The increase in net interest income reflects a decrease of 74 basis points in the average cost of interest bearing liabilities, which was only partially offset by a decrease of 29 basis points in the average yield earned on earning assets for the three-month period ended June 30, 2008 as compared to the same period in 2007. Average interest-earning assets increased 9% to $313.3 million for the three months ended June 30, 2008, as compared to $286.6 million for the three months ended June 30, 2007. The increase in average earning assets is primarily attributable to a $23.1 million increase in loans receivable, an $8.1 million increase in average investment securities and a $4.5 million decrease in interest earning deposits. Average interest-bearing liabilities increased $22.2 million to $287.6 million from $265.4 million at June 30, 2007. The increase in the average balance of interest-bearing liabilities resulted primarily from a $12.5 million increase in borrowings and a $9.7 million increase in average deposits.

For the six months ended June 30, 2008, net interest income, on a tax-equivalent basis, increased to $5.1 million from $4.3 million for the six months ended June 30, 2007. Net interest margin increased 31 basis points, to 3.31% at June 30, 2008 from 3.00% at June 30, 2007. Average interest-earning assets increased 8% to $309.5 million for the six months ended June 30, 2008 as compared to $285.9 million for the six months ended June 30, 2007, and the yield on interest-earning assets decreased 19 basis points to 5.87% from 6.06% for the comparable period. The increase in average interest-earning assets was primarily attributable to a $20.9 million increase in loans receivable and a $4.8 million increase in investment securities, partially offset by a $2.1 million decrease in interest earning deposits. Average interest-bearing liabilities increased $20 million but the cost of funds decreased 51 basis points to 2.77% for the six months ended June 30, 2008, from 3.28% for the same period in 2007. The increase in the average balance of interest-bearing liabilities resulted primarily from an $11.5 million, or 36.7%, increase in borrowings and an $8.5 million, or 3.6%, increase in average deposits.

Interest Income

Total interest income, on a tax-equivalent basis, for the quarter ended June 30, 2008, increased $175,000, or 4%, to $4.5 million from $4.4 million for the quarter ended June 30, 2007.

The average balance of loans increased $23.1 million to $226.3 million, with average yields decreasing 49 basis points to 6.29% during the second quarter of 2008. Average residential real estate loans increased $11.7 million, or 10%, and experienced a decrease in the average yield to 5.70% from 5.81% in the comparable quarter of 2007. Average commercial real estate loans increased $3.9 million, while the average yield on those loans decreased to 7.45% from 7.89% from the period a year earlier. Average commercial loans increased $4.9 million and experienced a decrease in the average yield of 235 basis points, to 6.07% for the quarter ended June 30, 2008, from 8.42%, in the quarter ended June 30, 2007. The decrease in the average yield on commercial loans was the result of new commercial loan origination activity taking place at lower yields, variable rate loans pricing downwards, and the reversal of interest due on nonperforming commercial loans during the second quarter of 2008. Average consumer loans increased $3.6 million, or 16%, while the average yield decreased by 111 basis points. The Company's municipal loan portfolio decreased $1 million, or 35%, when comparing the second quarter of 2008 to the same period in 2007. The average tax equivalent yield on the municipal loan portfolio increased to 6.83% in the second quarter of 2008 from 6.18% for the same period in 2007.

Average investment securities (taxable and tax-exempt) for the quarter ended June 30, 2008, increased by $8.1 million, with an increase in tax-equivalent interest income from investments of $150,000, or 18.3%, when compared to the second quarter of 2007. The average tax-equivalent yield of the portfolio increased 30 basis points, to 4.62% from 4.32%. The increase in average investment securities was primarily due to the purchase of $16.1 million of mortgage-backed securities that were acquired with excess liquidity resulting from retail deposit growth outpacing loan portfolio growth during the first six months of the year. The security activity was also a result of a pre-funding strategy whereby securities were acquired in advance of significant scheduled maturity activity anticipated over the next 9 to 12 months. These purchases were offset by the scheduled maturity of short-term investments that were acquired during the first quarter of 2007 in connection with the collateralization of increasing municipal deposit levels. In addition, the Company entered into a $5 million leverage transaction whereby investment securities were purchased and used as collateral associated with a new borrowing arrangement with a third party. Thus, $5 million of new long-term borrowings were used to fund the acquisition of $5 million in security purchases.

Total interest income, on a tax-equivalent basis, for the six months ended June 30, 2008 increased $420,000, or 5%, when compared to the six months ended June 30, 2007.

Average loans increased $20.9 million, with average yields decreasing 31 basis points to 6.42% from 6.73% for the six-month period ended June 30, 2008 when compared with the same period in 2007. Average residential real estate loans increased $10.1 million, or 8.5%, and experienced a very slight decrease in the average yield of only 1 basis point from the comparable six-month period ended June 30, 2007. Average commercial real estate loans increased $4.3 million, while the average yield on those loans decreased to 7.52% from 7.75% from the period a year earlier. Average commercial loans increased $2.5 million and experienced a decrease in the average yield of 193 basis points, to 6.56% for the six months ended June 30, 2008, from 8.49%, for the six months ended June 30, 2007. The decrease in the average yield on commercial loans was the result of new commercial loan origination activity taking place at lower yields, variable rate loans pricing downwards, and the reversal of interest due on nonperforming commercial loans during the second quarter of 2008. Average consumer loans increased $4.2 million, or 19%, while the average yield decreased by 86 basis points. The Company's municipal loan portfolio decreased $213,000 when comparing the first two quarters of 2008 to the same period in 2007. The average tax equivalent yield on the municipal loan portfolio increased to 6.91%, for the first half of 2008, from 6.26% for the same period in 2007.

For the six months ended June 30, 2008, tax-equivalent interest income from investment securities increased $210,000, or 13%, compared to the same period in 2007. The average tax-equivalent yield of the portfolio increased 27 basis points, to 4.57% from 4.30%. Moreover, there was a $4.8 million increase in the average balance of investment securities, reflecting the purchase of mortgage-backed securities mentioned above.

Total interest expense decreased $345,000 for the three months ended June 30, 2008, compared to the same quarter in 2007, as the average cost of funds decreased 74 basis points to 2.60% in 2008 from 3.34% in 2007. Average money management accounts decreased $521,000, combined with a 34 basis point reduction in the cost of funds. This decrease was an offset to the increases noted in other deposit types. The average balance of NOW accounts increased $1 million and the average cost of such deposits decreased by 19 basis points compared with the same three-month period in 2007. Additionally, the average balance of money market demand accounts, for the three months ended June 30, 2008, increased $3.8 million from the three-month average at June 30, 2007. The average cost of these funds decreased to 1.75% for the three months ended June 30, 2008 from 4.13% for the three months ended June 30, 2007. Average time deposits increased by $5.3 million while the average cost of funds decreased to 3.82% from 4.54% in 2007. Average balances of savings deposits increased by $92,000.

Interest expense on borrowings decreased by 1.6%, from the prior period as a result of the refinancing of trust preferred debt and the reduction in its average cost of funds to 4.50% from 7.81% in 2007, which occurred with the new issuance of trust preferred debt in March 2007 and retirement of the original subordinated debentures during June 2007. This savings was offset by the increase in average borrowings of $17.6 million.

Total interest expense decreased $400,000 for the six months ended June 30, 2008, compared to the same period in 2007, as the average cost of funds decreased 51 basis points to 2.77% in 2008 from 3.28% in 2007. Average money management accounts decreased $1.3 million, combined with a 26 basis point reduction in the average cost of funds. Average savings deposits also decreased by $318,000 for the six-month period. These decreases were offset by the increases noted in other deposit types. The average balance of NOW accounts increased $1.2 million and the resulting increase in interest expense was offset by a 9 basis point reduction in the average cost of funds from the six-month period in 2007. Additionally, the average balance of money market demand accounts, for the six months ended June 30, 2008, increased $5.9 million from the six-month average at June 30, 2007. The average cost of money market demand accounts decreased to 2.23% from 4.15%. Average time deposits increased $3 million from the average balance for the six months ended June 30, 2007. The average cost of time deposits decreased to 4.00% from 4.48% in 2007.

Interest expense on borrowings increased 8% from the prior six-month period. The reduction in the average cost of borrowings to 4.43% from 5.61% in 2007, was offset by an increase in average borrowings of $11.5 million.

Provision for Loan Losses

Provision for loan losses increased $60,000 and $155,000 for the three-month and six-month periods ended June 30, 2008 when compared to the same periods in 2007, respectively. The increased provision is reflective of a growing loan portfolio and one more heavily weighted to commercial term and commercial real estate, which have higher inherent risk characteristics than a consumer real estate portfolio, as well as a general weakening in economic conditions. The Company's ratio of allowance for loan losses to period end loans increased to 0.85% at June 30, 2008, as compared to 0.76% at December 31, 2007. Nonperforming loans to period end loans increased to 1.25% at June 30, 2008 from 0.71% at December 31, 2007. The increase in total non-performing loans is primarily the result of $497,000 in short-term, interest only, notes maturing during the period. These notes are currently awaiting permanent financing structures by the Company. In addition, one large commercial credit relationship, with approximately $1.1 million outstanding, is awaiting initial production orders in connection with a contract with a national distributor. Management believes the financial strength of the individual borrowers, combined with the related value of any underlying collateral, will not result in any recorded loss beyond currently established reserves.

Noninterest Income

The Company's noninterest income is primarily comprised of fees on deposit
account balances and transactions, loan servicing, commissions, and net gains
(losses) on securities, loans and foreclosed real estate. The following table
sets forth certain information on noninterest income for the periods indicated:

                                                       Three Months Ended June 30,
(Dollars in thousands)                       2008          2007                Change
Service charges on deposit accounts        $     355     $     366     $     (11 )        -3.0 %
Earnings on bank owned life insurance             56            57            (1 )        -1.8 %
Loan servicing fees                               61            81           (20 )       -24.7 %
Debit card interchange fees                       70            68             2           2.9 %
Other charges, commissions and fees              111           103             8           7.8 %
Core noninterest income                          653           675           (22 )        -3.3 %
Net losses on sales and impairment of
investment securities                           (342 )           -          (342 )      -100.0 %
Net gains on sales of loans and
foreclosed real estate                             -             7            (7 )      -100.0 %
Total noninterest income                   $     311     $     682     $    (371 )       -54.4 %


                                                        Six Months Ended June 30,
(Dollars in thousands)                       2008          2007                Change
Service charges on deposit accounts        $     734     $     694     $      40           5.8 %
Earnings on bank owned life insurance            123           113            10           8.8 %
Loan servicing fees                              151           145             6           4.1 %
Debit card interchange fees                      136           116            20          17.2 %
Other charges, commissions and fees              207           203             4           2.0 %
Core noninterest income                        1,351         1,271            80           6.3 %
Net losses on sales and impairment of
investment securities                           (342 )          (3 )        (339 )     11300.0 %
Net gains on sales of loans and
foreclosed real estate                             6             -             6         100.0 %
Total noninterest income                   $   1,015     $   1,268     $    (253 )       -20.0 %

For the three months ended June 30, 2008, core noninterest income decreased $22,000, or 3.3%, when compared with the three months ended June 30, 2007. The decrease in service charges on deposit accounts was primarily attributable to a decrease in both ATM fees and other miscellaneous fees charged to depositor accounts. The decrease in loan servicing fees was primarily due to reductions in commercial and installment loan late fees, combined with other loan related fee reductions in order to remain competitive in the local market. The increase in other charges, commissions and fees was primarily due to an increase in fees associated with ATM usage. The increase in net securities losses is a result of recording an other-than-temporary impairment charge of $342,000.

For the six months ended June 30, 2008, core noninterest income increased $80,000, or 6.3%, when compared with the six months ended June 30, 2007. The majority of the increase in core noninterest income was comprised of an increase in service charges on deposit accounts and an increase in debit card interchange fees. The overall increase in service charges on deposit accounts was primarily attributable to an increase in the number of deposit accounts. The increase in debit card interchange fees was due to an increase in issued Visa Debit cards and an increase in their usage. The large change in losses on securities is attributable to the other than temporary impairment of a security.

. . .