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 September 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 September 30, 2008 and the results of operations for the three months and nine months ended September 30, 2008.

Statement Regarding Forward-Looking Statements

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.

Statement Regarding Non-GAAP Financial Measures

This release contains supplemental financial information determined by methods other than in accordance with Accounting Principles Generally Accepted in the United States of America ("GAAP"). The Company's management believes that such non-GAAP financial measures are useful to management and investors as it enhances their ability to evaluate and compare the Company's operating results from period to period in a meaningful manner, as operating results excluding other than temporary impairment charges on its investment security holdings are essential in understanding the financial performance of the Company, and is more representative of the basis that management utilizes to monitor financial performance. Readers are cautioned that non-GAAP measures should not be considered as an alternative to any measure of performance as promulgated under GAAP, and should consider the impairment charges recorded during 2008 in assessing the Company's performance. Non-GAAP measures have limitations as analytical tools, and investors should not consider them in isolation or as a substitute for analyzing the Company's performance under GAAP, nor are they necessarily comparable to non-GAAP measures presented by other companies.

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, the evaluation of investment securities for other than temporary impairment, and accounting for deferred income taxes 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 assessments during the nine months ended September 30, 2008, the Company held positions in a bond and two mutual funds whose fair value declines were expected to be other than temporary. As a result of these determinations, other-than-temporary impairment charges of $2,176,000 relating to the Company's holdings in these securities were recorded. These charges relate to Company holdings in a senior unsecured bond issued by Lehman Brothers Holdings, Inc., a position in the AMF Large Cap Equity Fund and its holdings in the AMF Ultra Short Mortgage Fund. The securities' value declines are the result of a corporate bankruptcy filing by the bond issuer, weakness in the trading market of the underlying securities and a deterioration in the credit quality of a portion of one mutual fund's underlying private label mortgage-backed security holdings.

Deferred income tax assets and liabilities are determined using the liability method. Under this method, the net deferred tax asset or liability is recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases as well as net operating and capital losses carry forwards. Deferred tax assets and liabilities are measured using enacted tax rates applied to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income tax expense in the period that includes the enactment date. To the extent that current available evidence about the future raises doubt about the likelihood of a deferred tax asset being realized, a valuation allowance is established. The judgment about the level of future taxable income, including that which is considered capital, is inherently subjective and is reviewed on a continual basis as regulatory and business factors change. A valuation allowance of $212,000 was established during the three and nine months ended September 30, 2008, as management believes it may not generate sufficient capital gains to offset its capital loss carry forward. The Company's effective tax rate differs from the statutory rate due to non-taxable investment securities, bank owned life insurance offset by the valuation allowance established on the capital loss carry forwards.

Overview

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.

The Company reported a net loss of $838,000, or $0.34 per basic and diluted share, for the three months ended September 30, 2008, as compared to net income of $306,000, or $0.12 per basic and diluted share, for the same period in 2007. For the nine months ended September 30, 2008, the Company reported a net loss of $206,000, or $0.08 per basic and diluted share as compared to net income of $637,000, or $0.26 per basic and diluted share for the same period in 2007. The 2008 losses were the result of the Company recording impairment charges on investment security holdings totaling $1.3 million, net of the related tax benefits of $522,000, during the third quarter of 2008. In addition, during the second quarter of 2008, the Company recorded an investment security impairment charge of $205,000, net of tax benefits of $137,000. Core earnings, which represent earnings exclusive of investment portfolio other-than-temporary impairment losses, resulted in net income of $474,000 or $0.19 per diluted share for the three months ended September 30, 2008 and $1.3 million, or $0.53 per diluted share for the nine months ended September 30, 2008.

The following table reconciles the Company's net loss to core earnings, including per share figures, for the periods presented.

                                                                   For the three           For the nine
                                                                    months ended           months ended
                                                                   September 30,           September 30,
                                                                        2008                   2008

Net Loss                                                           $     (838,000 )        $    (206,000 )
Other than temporary impairment charge - investments                    1,834,000              2,176,000
Related tax benefit                                                      (522,000 )  *          (659,000 ) *
Core earnings                                                      $      474,000          $   1,311,000

Diluted (loss) earnings per share                                  $        (0.34 )        $       (0.08 )
Other than temporary impairment charge, net of tax                           0.53                   0.61
Core earnings, diluted earnings per share                          $         0.19          $        0.53

*Net of a deferred tax asset valuation reserve of $212,000 for the three month and nine month period, respectively.

Results of Operations

The return on average assets and return on average shareholders' equity were
(0.97)% and (15.65)%, respectively, for the three months ended September 30, 2008, compared with 0.39% and 5.80%, respectively, for the three months ended September 30, 2007. During the third quarter of 2008, when compared to the third quarter of 2007, net interest income increased $628,000, and noninterest income before (losses) gains on sales and impairment of assets increased $48,000. The increase in net interest income was offset by an increased provision for loan losses of $115,000. Total noninterest income was negatively impacted by impairment charges of $1,834,000 on available-for-sale securities. Noninterest expenses increased $50,000.

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. 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 for most of 2007.

Net interest income, on a tax-equivalent basis, increased to $2.8 million for the three months ended September 30, 2008, from $2.2 million for the three months ended September 30, 2007. The Company's net interest margin for the third quarter of 2008 increased to 3.50% from 3.10% when compared to the same quarter in 2007. Recent actions by the Federal Reserve to reduce 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 73 basis points in the average cost of interest bearing liabilities, which was partially offset by a decrease of 29 basis points in the average yield earned on earning assets for the three-month period ended September 30, 2008 as compared to the same period in 2007. Average interest-earning assets increased 14% to $321.4 million for the three months ended September 30, 2008, as compared to $282.5 million for the three months ended September 30, 2007. The increase in average earning assets is primarily attributable to a $26.5 million increase in loans receivable, an $11.5 million increase in average investment securities and an $890,000 increase in interest earning deposits. Average interest-bearing liabilities increased $33.9 million to $294.5 million from $260.6 million for the three months ended September 30, 2007. The increase in the average balance of interest-bearing liabilities resulted primarily from a $26.8 million increase in borrowings and a $7.1 million increase in average deposits. The increase in borrowings is primarily comprised of short and mid-term advances from the Federal Home Loan Bank of New York.

For the nine months ended September 30, 2008, net interest income, on a tax-equivalent basis, increased to $7.9 million from $6.5 million for the nine months ended September 30, 2007. Net interest margin increased 34 basis points, to 3.38% for the nine months ended September 30, 2008 from 3.04% for the nine months ended September 30, 2007. Average interest-earning assets increased 10% to $313.2 million for the nine months ended September 30, 2008 as compared to $284.6 million for the nine months ended September 30, 2007, and the yield on interest-earning assets decreased 22 basis points to 5.86% from 6.08% for the comparable period. The increase in average interest-earning assets was primarily attributable to a $22.7 million increase in loans receivable and a $7.0 million increase in investment securities, partially offset by a $1.2 million decrease in interest earning deposits. Average interest-bearing liabilities increased $24.7 million, but the cost of funds decreased 59 basis points to 2.70% for the nine months ended September 30, 2008, from 3.29% for the same period in 2007. The increase in the average balance of interest-bearing liabilities resulted primarily from a $16.6 million, or 54.0%, increase in borrowings and an $8.0 million, or 3.5%, increase in average deposits.

Interest Income

Total interest income, on a tax-equivalent basis, for the quarter ended September 30, 2008, increased $366,000, or 8.5%, to $4.7 million from $4.3 million for the quarter ended September 30, 2007.

The average balance of loans increased $26.5 million to $237.4 million, with average yields decreasing 40 basis points to 6.35% during the third quarter of 2008. Average residential real estate loans increased $13.7 million, or 11.5%, and experienced a decrease in the average yield to 5.70% from 5.82% in the comparable quarter of 2007. Average commercial real estate loans increased $4.3 million, while the average yield on those loans decreased to 7.37% from 7.64% from the period a year earlier. Average commercial loans increased $6.4 million and experienced a decrease in the average yield of 175 basis points, to 6.72% for the quarter ended September 30, 2008, from 8.47%, in the quarter ended September 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 third quarter of 2008. Average consumer loans increased $2.6 million, or 10.7%, while the average yield decreased by 86 basis points. The Company's municipal loan portfolio decreased $545,000, or 17.2%, when comparing the third quarter of 2008 to the same period in 2007. The average tax-equivalent yield on the municipal loan portfolio decreased to 5.63% in the third quarter of 2008 from 6.55% for the same period in 2007.

Average investment securities (taxable and tax-exempt) for the quarter ended September 30, 2008, increased by $11.5 million, with an increase in tax-equivalent interest income from investments of $159,000, or 20.8%, when compared to the third quarter of 2007. The average tax-equivalent yield of the portfolio increased 17 basis points, to 4.46% from 4.29%. 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 nine months ended September 30, 2008 increased $786,000, or 6%, when compared to the nine months ended September 30, 2007.

Average loans increased $22.7 million, with average yields decreasing 35 basis points to 6.39% from 6.74% for the nine-month period ended September 30, 2008 when compared with the same period in 2007. Average residential real estate loans increased $11.3 million, or 9.5%, and experienced a slight decrease in the average yield of 5 basis points from the comparable nine-month period ended September 30, 2007. Average commercial real estate loans increased $4.8 million, while the average yield on those loans decreased to 7.38% from 7.71% from the period a year earlier. Average commercial loans increased $3.3 million and experienced a decrease in the average yield of 173 basis points, to 6.75% for the nine months ended September 30, 2008, from 8.48%, for the nine months ended September 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 16.3%, while the average yield decreased by 86 basis points. The Company's municipal loan portfolio decreased $324,000 when comparing the first three quarters of 2008 to the same period in 2007. The average tax equivalent yield on the municipal loan portfolio increased to 6.49%, for the first three quarters of 2008, from 6.36% for the same period in 2007.

For the nine months ended September 30, 2008, tax-equivalent interest income from investment securities increased $369,000, or 15.6%, compared to the same period in 2007. The average tax-equivalent yield of the portfolio increased 23 basis points, to 4.53% from 4.30%. Moreover, there was a $7.0 million increase in the average balance of investment securities, reflecting the purchase of mortgage-backed securities previously mentioned.

Interest Expense

Total interest expense decreased $269,000 for the three months ended September 30, 2008, compared to the same quarter in 2007, as the average cost of funds decreased 73 basis points to 2.55% in 2008 from 3.28% in 2007. Average money management accounts decreased $327,000, combined with a 41 basis point reduction in the cost of funds. Average balances of savings accounts decreased $1.5 million and the cost of these funds decreased 25 basis points. These decreases were offset by the increases noted in other deposit

types. The average balance of NOW accounts increased $2.5 million and the average cost of such deposits decreased by 13 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 September 30, 2008, increased $6.2 million from the three-month average at September 30, 2007. The average cost of these funds decreased to 1.70% for the three months ended September 30, 2008 from 3.93% for the three months ended September 30, 2007. Average time deposits increased by $251,000 while the average cost of time deposits decreased to 3.69% from 4.58% in 2007.

Interest expense on borrowings increased by 35.4%, from the prior three-month period as a result of $26.8 million in additional borrowings used to fund loan growth not covered by slower deposit growth. The increase in the average balance of borrowings was partially offset by the reduction in its average cost of funds to 3.95% from 5.53% in 2007.

Total interest expense decreased $669,000 for the nine months ended September 30, 2008, compared to the same period in 2007, as the average cost of funds decreased 59 basis points to 2.70% in 2008 from 3.29% in 2007. Average money management accounts decreased $974,000, combined with a 30 basis point reduction in the average cost of funds. Average savings deposits also decreased by $713,000 for the nine-month period. These decreases were offset by the increases noted in other deposit types. The average balance of NOW accounts increased $1.7 million and the resulting increase in interest expense was offset by a 10 basis point reduction in the average cost of funds from the nine-month period in 2007. Additionally, the average balance of money market demand accounts, for the nine months ended September 30, 2008, increased $6.0 million from the same period average at September 30, 2007. The average cost of money market demand accounts decreased to 2.06% from 4.09%. Average time deposits increased $2.1 million from the average balance for the nine months ended September 30, 2007. The average cost of time deposits decreased to 3.9% from 4.51% in 2007.

Interest expense on borrowings increased 16.7% from the prior nine-month period. The reduction in the average cost of borrowings to 4.23% from 5.58% in 2007, was offset by an increase in average borrowings of $16.6 million.

Provision for Loan Losses

Provision for loan losses increased $115,000 and $270,000 for the three-month and nine-month periods ended September 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 traditional 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 0.92% at September 30, 2008, as compared to 0.76% at December 31, 2007. Nonperforming loans to period end loans increased to 1.10% at September 30, 2008 from 0.71% at December 31, 2007. General delinquencies have risen above the lows experienced in recent years. While these current . . .