Summary of LSB FINANCIAL CORP

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

Executive Summary

LSB Financial Corp. (the "Company" or "LSB Financial") is an Indiana corporation which was organized in 1994 by Lafayette Savings Bank, FSB ("Lafayette Savings") for the purpose of becoming a thrift institution holding company. Lafayette Savings is a federally chartered stock savings bank headquartered in Lafayette, Indiana. References in this Form 10-Q to "we," "us," and "our" refer to LSB Financial and/or Lafayette Savings as the context requires.

Lafayette Savings has been, and intends to continue to be, a community-oriented financial institution. Our principal business consists of attracting retail deposits from the general public and investing those funds primarily in permanent first mortgage loans secured by owner-occupied, one- to four-family residences and, to a lesser extent, non-owner occupied one- to four-family residential, commercial real estate, multi-family, construction and development, consumer and commercial business loans. Our revenues are derived principally from interest on mortgage and other loans and interest on securities.

We have an experienced and committed staff and enjoy a good reputation for serving the people of the community and understanding their financial needs and for finding a way to meet those needs. We contribute time and money to improve the quality of life in our market area and many of our employees volunteer for local non-profit agencies. We believe this sets us apart from the other 19 banks and credit unions that compete with us. We also believe that operating independently under the same name for over 138 years is a benefit to us-especially as acquisitions and consolidations of local financial institutions continue. Focusing time and resources on acquiring customers who may be feeling disenfranchised by their no-longer-local bank has proved to be a successful strategy.

Tippecanoe County and the eight surrounding counties comprise Lafayette Savings' primary market area. Lafayette is the county seat of Tippecanoe County and West Lafayette is the home of Purdue University. The greater Lafayette area enjoys diverse employment including major manufacturers such as Subaru, Caterpillar, Wabash National and Greater Lafayette Health Services; a strong education sector with Purdue University and a large local campus of Ivy Tech Community College; government offices of Lafayette, West Lafayette and Tippecanoe County; and a growing high-tech presence with the Purdue Research Park. This diversity typically provides a buffer against economic downturns, but the slowdown of the last few years had a noticeable effect on the area. More recently we have seen signs of returning growth and development. Housing values appreciated 1.3% in the second quarter of 2008, and 4.9% over the last five years. According to the Lafayette-West Lafayette Development Corporation (LWLDC), in the first quarter of 2008 expansions were announced in manufacturing, life sciences, technology employment and healthcare. Two new hospitals are scheduled to open, one in the fourth quarter of 2008 and one in 2009. The LWLDC also notes that five new hotels are in progress, and the retail/restaurant sector is welcoming newcomers. The unemployment rate in Tippecanoe County most recently measured at 4.5% in September 2008.

The community has made good progress in working through the effects of the overbuilding of one- to four-family housing. Information from the Lafayette Board of Realtors

indicates that 1,690 properties were sold in Tippecanoe County from January 1, 2007 through January 1, 2008 with an average market time of 82 days. Existing home sales for the first half of 2008 for homes under $200,000 were down only 1% from that level. Our loan portfolio showed a $26 million, or 8.6%, increase in the first nine months of 2008.

While the local economy continues to improve, we continue to work with borrowers who have fallen substantially behind on their loans. The majority of our delinquent loans are secured by real estate and we believe we have sufficient reserves to cover probable losses. The challenge is to get delinquent borrowers back on a workable payment schedule or if that is not possible, to get control of their properties through an overburdened court system. In September 2008, loans delinquent more than 30 days were at $9.8 million compared to $14.9 million in September 2007.

Our primary source of income is net interest income, which is the difference between the interest income earned on our loan and investment portfolios and the interest expense incurred on deposits and borrowings. Our net interest income depends on the balance of our loan and investment portfolios and the size of our net interest margin, which is the difference between the income generated from loans and the cost of the funding. Our net interest income also depends on the shape of the yield curve. In 2008, the yield curve has generally had a more normal upward slope although in a lower range than usual. Deposits are generally tied to shorter-term market rates, but liquidity pressure from financial institutions concerned about their funding levels has kept deposit rates higher than would ordinarily be expected. Loans are generally tied to longer-term rates but the flight to safety by investors has driven long-term treasury rates down to a level where loans priced at a typical spread over treasury rates no longer yield an adequate spread over deposits. Our expectation is for the yield curve to go even lower while maintaining a generally upward slope throughout the rest of the year.

Rate changes could be expected to have an impact on interest income. Rising rates generally increase borrower preference for variable-rate products which we typically keep in our portfolio, and existing adjustable rate loans can be expected to reprice to higher rates, both of which could be expected to have a favorable impact on interest income. Alternatively, continuing low interest rates could have a negative impact on our interest income as new loans are put on the books at comparatively low rates and our existing adjustable rate loans reprice to lower rates, as is the case now. Because of the uncertainty in the economy, we do not expect to see a return to a high volume of refinancing. However, we may see borrowers looking for financing for their existing loans as some banks pare their borrowing base because of liquidity and loan quality concerns.

We consider expected changes in interest rates when structuring our interest-earning assets and our interest-bearing liabilities. If rates are expected to increase we try to book shorter-term assets that will reprice relatively quickly to higher rates over time, and book longer-term liabilities that will remain for a longer time at lower rates. Conversely, if rates are expected to fall, we intend to structure our balance sheet such that loans will reprice more slowly to lower rates and deposits will reprice more quickly. We currently offer a three-year and a five-year certificate of deposit that allows depositors one opportunity to have their rate adjusted to the market rate at a future date to encourage them to choose longer-term deposit products. However, since we are not able to predict market interest rate fluctuations, our asset/liability management

strategy may not prevent interest rate changes from having an adverse effect on our results of operations and financial condition.

Our results of operations may also be affected by general and local competitive conditions, particularly those with respect to changes in market interest rates, government policies and actions of regulatory authorities.

Effect of Current Events

Management continues to assess the impact on the Company of the uncertain economic and regulatory environment affecting the country at large and the financial services industry in particular. The Company is considering filing an application under the Troubled Asset Relief Program ("TARP") Capital Purchase Program ("CPP") with the U. S. Department of Treasury seeking approval to sell $8.6 million in preferred stock to the Treasury. See Note 6, Subsequent Event, to the Company's Unaudited Consolidated Condensed Financial Statements, included in this Form 10-Q and incorporated herein, for further information related to this decision.

Both the level of turmoil in the financial services industry and the Company's participation in the TARP's CPP, if it decides to participate, will present unusual risks and challenges for the Company, as described below:

The Current Economic Environment Poses Challenges For Us and Could Adversely Affect Our Financial Condition and Results of Operations. We are operating in a challenging and uncertain economic environment, including generally uncertain national conditions and local conditions in our markets. The capital and credit markets have been experiencing volatility and disruption for more than 12 months. In recent weeks, the volatility and disruption has reached unprecedented levels. The risks associated with our business become more acute in periods of a slowing economy or slow growth. Financial institutions continue to be affected by sharp declines in the real estate market and constrained financial markets. While we are taking steps to decrease and limit our exposure to problem loans, we nonetheless retain direct exposure to the residential and commercial real estate markets, and we are affected by these events.

Our loan portfolio includes commercial real estate loans, residential mortgage loans, and construction and land development loans. Continued declines in real estate values, home sales volumes and financial stress on borrowers as a result of the uncertain economic environment, including job losses, could have an adverse effect on our borrowers or their customers, which could adversely affect our financial condition and results of operations. In addition, a possible national economic recession or further deterioration in local economic conditions in our markets could drive losses beyond that which is provided for in our allowance for loan losses and result in the following other consequences:
increases in loan delinquencies, problem assets and foreclosures may increase; demand for our products and services may decline; deposits may decrease, which would adversely impact our liquidity position; and collateral for our loans, especially real estate, may decline in value, in turn reducing customers' borrowing power, and reducing the value of assets and collateral associated with our existing loans.

Impact of Recent and Future Legislation. Congress and the Treasury Department have recently adopted legislation and taken actions to address the disruptions in the financial system and declines in the housing market. See Note 6, Subsequent Event, to the Company's Unaudited

Consolidated Condensed Financial Statements, included in this Form 10-Q and incorporated herein. It is not clear at this time what impact the Emergency Economic Stabilization Act ("EESA"), TARP, other liquidity and funding initiatives of the Treasury and other bank regulatory agencies that have been previously announced, and any additional programs that may be initiated in the future, will have on the financial markets and the financial services industry. The extreme levels of volatility and limited credit availability currently being experienced could continue to affect the U.S. banking industry and the broader U.S. and global economies, which will have an effect on all financial institutions, including the Company.

In addition to the legislation mentioned above, federal and state governments could pass additional legislation responsive to current credit conditions. As an example, the Bank could experience higher credit losses because of federal or state legislation or regulatory action that reduces the amount the Bank's borrowers are otherwise contractually required to pay under existing loan contracts. Also, the Bank could experience higher credit losses because of federal or state legislation or regulatory action that limits its ability to foreclose on property or other collateral or makes foreclosure less economically feasible.

Possible Increases in Insurance Premiums. The Federal Deposit Insurance Corporation ("FDIC") insures the Bank's deposits up to certain limits. The FDIC charges us premiums to maintain the Deposit Insurance Fund. The Bank intends to obtain unlimited deposit insurance protection for non-interest bearing transaction deposit accounts under the FDIC's Temporary Liquidity Guarantee Program, which will increase its insurance premiums by 10 basis points per annum.

Current economic conditions have increased expectations for bank failures. The FDIC takes control of failed banks and ensures payment of deposits up to insured limits using the resources of the Deposit Insurance Fund. The FDIC has designated the Deposit Insurance Fund long-term target reserve ratio at 1.25 percent of insured deposits. Due to recent bank failures, the FDIC insurance fund reserve ratio has fallen below 1.15 percent, the statutory minimum. The FDIC has developed a proposed restoration plan that will uniformly increase insurance assessments by 7 basis points (annualized). The plan also proposes changes to the deposit insurance assessment system requiring riskier institutions to pay a larger share. Further increases in premium assessments would increase the Company's expenses.

Future Reduction in Liquidity in the Banking System. The Federal Reserve Bank has been providing vast amounts of liquidity in to the banking system to compensate for weaknesses in short-term borrowing markets and other capital markets. A reduction in the Federal Reserve's activities or capacity could reduce liquidity in the markets, thereby increasing funding costs to the Bank or reducing the availability of funds to the Bank to finance its existing operations.

Our Possible Participation in the TARP Capital Purchase Program May Adversely Affect the Value of Our Common Stock and the Rights of Our Common Stockholders. The terms of the preferred stock the Company would issue under the TARP CPP if the Company decides to apply and its application is accepted by the Treasury and the transaction closes could reduce investment returns to the Company's common stockholders by restricting dividends, diluting existing shareholders' ownership interests, and restricting capital management practices. Without the prior consent of the Treasury, the Company would be prohibited from increasing its

common stock dividends or repurchasing shares of its common stock for the first three years while the Treasury holds the preferred stock.

Also, the preferred stock requires quarterly dividends to be paid at the rate of 5% per annum for the first five years and 9% per annum thereafter until the stock is redeemed by the Company. The payments of these dividends would decrease the excess cash the Company otherwise has available to pay dividends on its common stock and to use for general corporate purposes, including working capital, if the Company decides to participate.

Finally, the Company would be prohibited from continuing to pay dividends on its common stock unless it has fully paid all required dividends on the preferred stock issued to the Treasury. Although the Company fully expects to be able to pay all required dividends on the preferred stock (and to continue to pay dividends on its common stock at current levels) if it decides to participate in the TARP CPP, there is no guarantee that it will be able to do so in the future.

Critical Accounting Policies

Generally accepted accounting principles are complex and require management to apply significant judgments to various accounting, reporting and disclosure matters. Management of LSB Financial must use assumptions and estimates to apply these principles where actual measurement is not possible or practical. For a complete discussion of LSB Financial's significant accounting policies, see Note 1 to the Consolidated Financial Statements as of September 30, 2008. Certain policies are considered critical because they are highly dependent upon subjective or complex judgments, assumptions and estimates. Changes in such estimates may have a significant impact on the financial statements. Management has reviewed the application of these policies with the Audit Committee of LSB Financial's Board of Directors. These policies include the following:

Allowance for Loan Losses

The allowance for loan losses represents management's estimate of probable losses inherent in Lafayette Savings' loan portfolios. In determining the appropriate amount of the allowance for loan losses, management makes numerous assumptions, estimates and assessments.

The strategy also emphasizes diversification on an industry and customer level, regular credit quality reviews and quarterly management reviews of large credit exposures and loans experiencing deterioration of credit quality.

Lafayette Savings' allowance consists of three components: probable losses estimated from individual reviews of specific loans, probable losses estimated from historical loss rates, and probable losses resulting from economic or other deterioration above and beyond what is reflected in the first two components of the allowance.

Larger commercial loans that exhibit probable or observed credit weaknesses are subject to individual review. Where appropriate, reserves are allocated to individual loans based on management's estimate of the borrower's ability to repay the loan given the availability of collateral, other sources of cash flow and legal options available to Lafayette Savings. Included

in the review of individual loans are those that are impaired as provided in SFAS No. 114, Accounting by Creditors for Impairment of a Loan. Any allowances for impaired loans are determined by the present value of expected future cash flows discounted at the loan's effective interest rate or fair value of the underlying collateral. Historical loss rates are applied to other commercial loans not subject to specific reserve allocations.

Homogenous smaller balance loans, such as consumer installment and residential mortgage loans are not individually risk graded. Reserves are established for each pool of loans based on the expected net charge-offs for one year. Loss rates are based on the average net charge-off history by loan category.

Historical loss rates for commercial and consumer loans may be adjusted for significant factors that, in management's judgment, reflect the impact of any current conditions on loss recognition. Factors which management considers in the analysis include the effects of the national and local economies, trends in the nature and volume of loans (delinquencies, charge-offs and nonaccrual loans), changes in mix, asset quality trends, risk management and loan administration, changes in the internal lending policies and credit standards, collection practices and examination results from bank regulatory agencies and Lafayette Savings' internal loan review.

Allowances on individual loans are reviewed quarterly and historical loss rates are reviewed annually and adjusted as necessary based on changing borrower and/or collateral conditions and actual collection and charge-off experience.

Lafayette Savings' primary market area for lending is Tippecanoe County, Indiana. When evaluating the adequacy of allowance, consideration is given to this regional geographic concentration and the closely associated effect of changing economic conditions on Lafayette Savings' customers.

Mortgage Servicing Rights

Mortgage servicing rights (MSRs) associated with loans originated and sold, where servicing is retained, are capitalized and included in other intangible assets in the consolidated balance sheet. The value of the capitalized servicing rights represents the present value of the future servicing fees arising from the right to service loans in the portfolio. Critical accounting policies for MSRs relate to the initial valuation and subsequent impairment tests. The methodology used to determine the valuation of MSRs requires the development and use of a number of estimates, including anticipated principal amortization and prepayments of that principal balance. Events that may significantly affect the estimates used are changes in interest rates, mortgage loan prepayment speeds and the payment performance of the underlying loans. The carrying value of the MSRs is periodically reviewed for impairment based on a determination of fair value. For purposes of measuring impairment, the servicing rights are compared to a valuation prepared based on a discounted cash flow methodology, utilizing current prepayment speeds and discount rates. Impairment, if any, is recognized through a valuation allowance and is recorded as amortization of intangible assets.

Financial Condition

Comparison of Financial Condition at September 30, 2008 and December 31, 2007

Our total assets increased $25.3 million, or 7.41%, during the nine months from December 31, 2007 to September 30, 2008. Primary components of this increase were a $26.1 million increase in net loans receivable including loans held for sale and a $3.4 million increase in short term investments, offset by a $2.5 million decrease in other assets due partly to a $2.4 million decrease in other real estate owned, and a $1.3 million decrease in investments available for sale. Management attributes the increase in loans to an increase in commercial loan activity due to borrowers either moving their lending relationships to a local bank or seeing opportunities as the community shows signs of recovery, and from the decision to take advantage of the Bank's minimal interest rate risk exposure, as measured by the OTS Interest Rate Risk Exposure Report, to book, rather than sell, fixed rate residential mortgages. Because of the increase in lending, we raised $22.2 million of deposits including a $6.3 million increase in demand deposit accounts. Additionally, we increased Federal Home Loan Bank advances by $2.5 million.

Non-performing assets, which include non-accruing loans, accruing loans 90 days past due, restructured but performing loans, and foreclosed assets, decreased from $13.9 million at December 31, 2007 to $10.4 million at September 30, 2008. Non-performing loans and accruing loans 90 days past due totaled $8.7 million at September 30, 2008 and consisted of $5.6 million, or 64.78%, of one- to four-family or multi-family residential real estate loans, $2.7 million, or 30.54%, of loans on land or commercial property, $381,000, or 4.38%, of commercial business loans and $26,000, or 0.30%, of consumer loans. Included in this group are $1.8 million of loans that have been restructured and are performing as agreed. Non-performing assets also include $1.7 million of foreclosed assets. At September 30, 2008, our allowance for loan losses equaled 1.11% of total loans compared to 1.23% at December 31, 2007. The allowance for loan losses at September 30, 2008 totaled 34.85% of non-performing assets compared to 26.56% at December 31, 2007, and 41.62% of non-performing loans at September 30, 2008 compared to 37.04% at December 31, 2007. Our non-performing assets equaled 2.82% of total assets at September 30, 2008 compared to 4.08% at December 31, 2007. Non-performing assets totaling $959,000 were charged off in the first nine months of 2008, offset by recoveries of $19,000. These charge-offs were largely covered by existing reserves and there was no need for additional provisions to the allowance for the amounts charged off. Although we believe we use the best information available to determine the adequacy of our allowance for loan losses, future adjustments to the allowance may be necessary, and net income could be significantly affected, if circumstances and/or economic conditions cause substantial changes in the estimates we use in making the determinations about the levels of the allowance for losses. Additionally, various regulatory agencies, as an integral part of their examination process, periodically review our allowance for loan losses. These agencies may require the recognition of additions to the allowance based upon their judgments of information available at the time of their examination.

Shareholders' equity increased from $33.9 million at December 31, 2007 to $34.1 million at September 30, 2008, an increase of $177,000, or 0.52%, primarily as a result of net income of $1.4 million, partially offset by our payment of $1.2 million of dividends on common stock, and the repurchase of 8,900 shares of our stock as part of a stock repurchase program. Shareholders' equity to total assets was 9.28% at September 30, 2008 compared to 9.92% at December 31, 2007.

Results of Operations

Comparison of Operating Results for the Nine Months and the Quarter Ended September 30, 2008 and September 30, 2007

General. Net income for the nine months ended September 30, 2008 was $1.4 million, a decrease of $517,000, or 26.57%, over the nine months ended September 30, 2007. The decrease for the nine month period was primarily due to a $1.1 million decrease in net interest income and a $111,000 increase in non-interest expenses partially offset by a $508,000 decrease in taxes on income, a $115,000 increase in non-interest income, and a $68,000 decrease in the provision for loan losses. Net income for the quarter ended September 30, 2008 was $392,000, a decrease of $325,000, or 45.33%, over the comparable quarter in 2007. The decrease for the three month period was primarily due to a $400,000 decrease in net interest income, a $172,000 increase in the provision for losses and a $122,000 increase in non-interest expenses partially offset by a $272,000 decrease in taxes on income and a $97,000 increase in non-interest income.

Net Interest Income. Net interest income for the nine months ended September 30, 2008 decreased $1.1 million, or 12.64%, over the same period in 2007. This decrease was due to a 47 basis point decrease in our net interest margin (net interest income divided by average interest-earning assets) from 3.49% for the nine months ended September 30, 2007 to 3.02% for the nine months ended September 30, 2008 together with a $3.3 million decrease in average net interest-earning assets. The decrease in net interest margin is primarily due to the 57 basis point decrease in the average rate on interest-earning assets from 6.99% for the nine months ended September 30, 2007 to 6.42% for the nine months ended September 30, 2008. The average rate on interest-bearing liabilities decreased from 3.70% to 3.55% for the same respective periods. Net interest income for the three months ended September 30, 2008 decreased $400,000, or 14.08%, over the same period in 2007 for similar reasons.

Interest income on loans decreased $1.2 million, or 7.01%, for the nine months ended September 30, 2008 compared to the same nine months in 2007. The average rate on loans fell from 7.26% to 6.67% as the lower market interest rates are affecting not only new loans but our variable rate loans, both those that are tied to treasury rates and those tied to prime rate. Some of the prime rate loans have reached their rate floor due to the decrease in rates by the Federal Reserve, which had already lowered rates a total of 300 basis points from September 2007 to March 2008. The average balance of loans increased by $4.1 million due to an increase in commercial loan activity due to borrowers either moving their lending relationships to a local bank or seeing opportunities as the community shows signs of recovery, and from management's decision to take advantage of the Bank's minimal interest rate risk exposure, as measured by the . . .