GENERAL

First Litchfield Financial Corporation (the "Company"), a Delaware corporation formed in 1988, is the one-bank holding company for The First National Bank of Litchfield (the "Bank"), a national bank supervised and examined by the Office of the Comptroller of the Currency (the "OCC"). The Bank is the Company's primary subsidiary and only source of income. The Bank has three subsidiaries, The Lincoln Corporation and Litchfield Mortgage Service Corporation, which are Connecticut corporations, and First Litchfield Leasing Corporation ("First Litchfield Leasing"), which is a Delaware corporation. The purpose of The Lincoln Corporation is to hold property such as real estate, personal property, securities, or other assets, acquired by the Bank through foreclosure or otherwise to compromise a doubtful claim or collect a debt previously contracted. The purpose of Litchfield Mortgage Service Corporation is to operate as a passive investment company in accordance with Connecticut law. The purpose of First Litchfield Leasing is to provide equipment financing and leasing products to complement the Bank's array of commercial products.

Both the Company and the Bank are headquartered in Litchfield, Connecticut. The Bank is a full-service commercial bank serving both individuals and businesses generally within Litchfield County Connecticut. Deposits are insured up to specific limits of the Federal Deposit Insurance Act by the Deposit Insurance Fund, which is administered by the Federal Deposit Insurance Corporation. The Bank's lending activities include loans secured by residential and commercial mortgages. Other loan products include consumer and business installment lending, as well as other secured and nonsecured lending. The Bank has nine banking locations located in the towns of Canton, Torrington, Litchfield, Washington, Marble Dale, Goshen, Roxbury and New Milford, Connecticut. In 1975, the Bank was granted Trust powers by the OCC. The Bank's Trust Department provides trust and fiduciary services to individuals, nonprofit organizations and commercial customers. Additionally, the Bank offers nondeposit retail investment products such as mutual funds, annuities and insurance through its relationship with Infinex Investments, Inc.

On June 26, 2003, the Company formed First Litchfield Statutory Trust I for the purpose of issuing trust preferred securities and investing the proceeds in subordinated debentures issued by the Company, and on June 26, 2003, the first series of trust preferred securities were issued. During the second quarter of 2006, the Company formed a second statutory trust, First Litchfield Statutory Trust II ("Trust II"). The Company owns 100% of Trust II's common stock. Trust II exists for the sole purpose of issuing trust securities and investing the proceeds in subordinated debentures issued by the Company. In June 2006, Trust II issued its first series of trust preferred securities.

The following discussion and analysis of the Company's consolidated financial condition and results of operations should be read in conjunction with the consolidated financial statements and notes to the consolidated financial statements.

FINANCIAL CONDITION

Total assets as of September 30, 2008 were $506,538,437, and substantially unchanged from total assets of $507,653,629 at December 31, 2007.

Net loans and leases increased $24,261,774 over the year-end 2007 amount. Net loans and leases as of September 30, 2008 were $351,737,145, as compared to the year-end 2007 level of $327,475,371.

Consistent with Management's strategy to migrate to a more profitable loan composition, commercial loan and lease growth was strong during the third quarter of 2008. Leases, net of unearned income, were $18,586,319 at September 30, 2008, which was an increase of $9,952,120 from the year-end 2007 balance of $8,634,199. Commercial loans totaled $43,636,144, which is an increase of $9,994,465, from year-end 2007. Growth in commercial loans has been in both lines of credit and in term financing and continues to be a result of the sales development and commercial calling initiatives for traditional and contiguous markets. The residential mortgage loan portfolio totaled $190,518,998, which substantially unchanged from year-end 2007.

As of September 30, 2008, the securities portfolio totaled $104,949,264, which is a 18.65% decrease from the year-end 2007 balance. During the first quarter of 2008 the Company had executed a leverage strategy whereby $25,000,000 of fixed rate mortgage backed securities were purchased and funded by borrowings from repurchase agreements. During the third quarter of 2008 the Company sold approximately $35,000,000 in investment securities. These sales were executed to increase liquidity as well as to decrease the total assets of the Bank in order to ensure capital adequacy as of September 30, 2008. Additionally, the Company wrote down for other than temporary impairment ("OTTI") $5,030,000 of the Bank's investments in Fannie Mae and Freddie Mac preferred stock/auction rate securities holding such stock holdings during the third quarter. During the third quarter the Company also recorded an OTTI loss of $1,916,100 on the Bank's investment in a pooled trust preferred security.

The due from broker for security sales totaled $11,643,821, as a result of securities traded on September 30, 2008 and proceeds not received until October 2008.

Cash and cash equivalents totaled $7,044,123, which is a decrease of $14,453,071, or 67.23% from year-end 2007. During 2008, funds temporarily invested in interest bearing correspondent bank balances at year-end were used to pay down wholesale borrowings as well as to fund loan growth.

Total liabilities were $486,427,263 as of September 30, 2008, which was an increase of $7,136,246 from total liabilities of $479,291,017 as of year-end 2007. Total deposits increased by $5,109,439, or 1.52% from their year-end levels. Money market deposits increased by $8,858,837, or 11.25% as a result of higher balances held for the Bank's trust customers as well as increased money market balances due to a third quarter rate promotion. Time certificates of deposit totaled $123,171,913 as of September 30, 2008, which was a decrease of 5.23%, or $6,797,900 from year-end 2007. The decrease in time deposits is reflective of the customer's desire for liquidity and the shifting of the reinvestment of maturing certificate of deposits into the money market deposits.

As of September 30, 2008, repurchase agreements with customers totaled $13,269,417, which was a decrease of $873,356 from the year-end 2007 balance. Because these accounts represent overnight investments by commercial and municipal cash management customers, fluctuations in the balances of these accounts are reflective of the temporary nature of these funds. During the third quarter of 2008, advances under Federal Home Loan Bank borrowings decreased by $3,559,000, while repurchase agreements with financial institutions increased by $4,900,000 as a result of the first quarter leverage strategy discussed above.

Shareholders' equity totaled $20,061,174 as of September 30, 2008 as compared with $28,312,612 as of December 31, 2007. The decrease in shareholders' equity of $8,251,438 is due primarily to the OTTI losses taken on available for sale securities in the third quarter of 2008. These losses net of taxes totaled $6,294,626. Additionally, the change in the Company's unrealized losses on available for sale securities during 2008 reduced equity by $2,129,230.

RESULTS OF OPERATIONS- THREE MONTHS ENDED SEPTEMBER 30, 2008 COMPARED TO THREE MONTHS ENDED SEPTEMBER 30, 2007

Summary

Net loss for the Company for the third quarter of 2008 totaled $5,425,890 versus net income of $677,836 for the third quarter of 2007. Basic and diluted loss per share for the third quarter of 2008 were both $2.30, compared to basic and diluted income per share of $.29 for the third quarter of 2007.

The decrease in net income is due primarily to the OTTI losses on available for sale securities resulting from the OTTI losses on Freddie Mac and Fannie Mae securities recorded during the third quarter, when the United States Government placed Fannie Mae and Freddie Mac into conservatorship. As a result, the Company had to take a $5,030,000 write down of Freddie Mac and Fannie Mae preferred stock during the quarter ended September 30, 2008. No tax benefit was recognized as a result of these charges for the quarter ended September 30, 2008, because applicable law at the time required financial institutions to treat the loss as a capital loss. On October 3, 2008, the Emergency Economic Stabilization Act of 2008 was enacted, which includes a provision that permits financial institutions to recognize losses relating to the Freddie Mac and Fannie Mae preferred stock as an ordinary loss, thereby allowing a tax benefit for both tax and financial reporting purposes. Therefore, a tax benefit of approximately $1,710,200 was not recognized in the quarter ended September 30, 2008, and will be recognized in the quarter ending December 31, 2008. This tax benefit, had it been recognized in the same quarter as the losses were taken, would have added approximately $.73 to the Company's book value and reduced the third quarter loss by $.73 per share. (See Footnote 7 of the Consolidated Financial Statements.)

Additionally during the third quarter the Company recorded an OTTI loss on a pooled trust preferred security as a result of this security being downgraded below investment grade. This loss, net of taxes, totaled $1,264,626.

Net Interest Income

Net interest income is the largest component of the Company's operations. Net interest income is defined as the difference between interest and dividend income from earning assets, primarily loans and investment securities, and interest expense on deposits and borrowed money. Interest income is the product of the average balances outstanding on loans, securities and interest-bearing deposit accounts multiplied by their effective yields. Interest expense is similarly calculated as the result of the average balances of interest-bearing deposits and borrowed funds multiplied by the average rates paid on those funds. Other components of operating income are the provision for loan losses, noninterest income such as service charges and trust fees, noninterest expenses and income taxes.

Net interest income on a fully tax-equivalent basis is comprised of the following for the three months ended September 30,

                                               2008             2007
                                           -----------      -----------
        Interest and dividend income       $ 7,140,667      $ 7,113,345
        Tax-equivalent adjustments (1)         156,436          152,617
        Interest expense                    (3,255,785)      (3,775,752)
                                           -----------      -----------
        Net interest income                $ 4,041,318      $ 3,490,210
                                           ===========      ===========

(1) Interest income is presented on a tax-equivalent basis which reflects a federal tax rate of 34% for all periods presented.

The following table presents on a tax-equivalent basis, the Company's average balance sheet amounts (computed on a daily basis), net interest income, interest rates, interest spread and net interest margin for the three months ended September 30, 2008 and 2007. Average loans outstanding include nonaccruing loans.