GENERAL
The principal objective of this discussion is to provide an overview of the financial condition and results of operations of the Company during the year ended December 31, 2008 and the preceding two years. The following analysis of financial condition and results of operations should be read in conjunction with the consolidated financial statements and related notes filed herewith in Part II, Item 8, "Financial Statements and Supplementary Data" and the description of the business filed herewith in Part I, Item 1, "Business." Income. The Company's results of operations are dependent primarily on net interest income, which is the difference between the income earned on loans and securities and the interest paid on deposits and borrowings. Results of operations are also affected by the (credit) provision for loan losses, service charges on deposits, financial services group fees and commissions, mortgage banking revenues, gain or loss on the sale of securities, gain or loss on sale of loans and other miscellaneous income.
Expenses. The Company's expenses primarily consist of salaries and employee benefits, occupancy and equipment, supplies and postage, amortization of other intangible assets, computer and data processing, professional fees and services, advertising and promotions and other miscellaneous expense and income tax expense (benefit). Results of operations are also significantly affected by general economic and competitive conditions, particularly changes in consumer and business spending, interest rates, government policies and the actions of regulatory authorities.
RECENT MARKET DEVELOPMENTS
The global and U.S. economies are experiencing significantly reduced business activity as a result of, among other factors, disruptions in the financial system during the past year. Dramatic declines in the housing market during the past year, with falling home prices and increasing foreclosures and unemployment, have resulted in significant write-downs of asset values by financial institutions, including government-sponsored entities and major commercial and investment banks. These write-downs, initially of residential-related loans and mortgage-backed securities, but spreading to credit default swaps and other derivative securities, have caused many financial institutions to seek additional capital, to merge with larger and stronger institutions and, in some cases, to fail.
Reflecting concern about the stability of the financial markets generally and the strength of counterparties, many lenders and institutional investors have reduced, and in some cases, ceased to provide funding to borrowers, including other financial institutions. The availability of credit, confidence in the financial sector, and level of volatility in the financial markets have been significantly adversely affected as a result. In recent months, volatility and disruption in the capital and credit markets have reached unprecedented levels. In some cases, the markets have produced downward pressure on stock prices and credit capacity for certain issuers without regard to those issuers' underlying financial strength.
In response to the financial crises affecting the banking system and financial markets and going concern threats to investment banks and other financial institutions, EESA was signed into law on October 3, 2008. The EESA authorizes the Treasury to, among other things, purchase up to $700 billion of mortgages, mortgage-backed securities and certain other financial instruments from financial institutions for the purpose of stabilizing and providing liquidity to the U.S. financial markets. The EESA also provided a temporary increase in deposit insurance coverage from $100,000 to $250,000 per insured account until December 31, 2009.
On October 14, 2008, the Secretary of the Treasury, after consulting with the Federal Reserve and the FDIC, announced that the Treasury will purchase equity stakes in certain banks and thrifts. Under this program, known as the CPP, the Treasury will make $250 billion of capital available to U.S. financial institutions in the form of preferred stock (from the $700 billion authorized by the EESA). In conjunction with the purchase of preferred stock, the Treasury will receive warrants to purchase common stock with an aggregate market price equal to 15% of the preferred investment. Participating financial institutions will be required to adopt the Treasury's standards for executive compensation and corporate governance for the period during which the Treasury holds equity issued under the CPP.
Also on October 14, 2008, after receiving a recommendation from the boards of the FDIC and the Federal Reserve, and consulting with the President, the Secretary of the Treasury signed the systemic risk exception to the FDIC Act, enabling the FDIC to temporarily provide a 100% guarantee of the senior unsecured debt of all FDIC-insured institutions and their holding companies, as well as deposits in noninterest-bearing transaction deposit accounts under the TLGP through December 31, 2009. All insured depository institutions automatically participated in the TLGP for 30 days following the announcement of the program without charge (subsequently extended to December 5, 2008) and thereafter, unless an institution opted out, at a cost of 75 basis points per annum for senior unsecured debt and 10 basis points per annum for noninterest-bearing transaction deposits.

The Company elected to participate in the CPP, and on December 23, 2008 received $37.5 million in additional capital through the program. In exchange, the Treasury received a like amount of the FII preferred stock that pays an annual dividend of 5% for the first five years, and an annual dividend of 9% in any years thereafter. The Company may redeem the preferred shares issued to Treasury in full during the first three years following issuance only with the proceeds of a qualifying equity offering. Thereafter, the preferred shares may be redeemed in full or in part at any time. The Company also issued a warrant to the Treasury to purchase 378,175 shares of FII common stock, which, upon issuance, would represent approximately 3.4% of our outstanding common shares, based upon current information. The warrant is exercisable at any time during the ten-year period following issuance at an exercise price of $14.88. Notwithstanding the foregoing, the ARRA, which was signed into law by President Obama on February 17, 2009, provides that the Secretary of the Treasury shall permit a recipient of funds under the TARP, subject to consultation with the recipient's appropriate Federal banking agency, to repay such assistance without regard to whether the recipient has replaced such funds from any other source or to any waiting period. ARRA further provides that when the recipient repays such assistance, the Secretary of the Treasury shall liquidate the warrants associated with the assistance at the current market price. While Treasury has not yet issued implementing regulations, it appears that ARRA will permit the Company, if it so elects and following consultation with the FRB, to redeem the Series A Preferred Stock at any time without restriction.
The FDIC Act also requires that the FDIC Board of Directors adopt a restoration plan when the Deposit Insurance Fund reserve ratio falls or is expected to fall below certain minimum levels. The bank failures that resulted in 2008 adversely impacted the deposit insurance funds loss provisions, resulting in a decline in the reserve ratio. As part of the restoration plan, the FDIC has increased the insurance assessment rates by seven basis points uniformly for the quarter beginning January 1, 2009. In addition, on February 27, 2009 the FDIC Board adopted an interim rule imposing a 20 basis point emergency special assessment on the industry on June 30, 2009. The assessment is to be collected on September 30, 2009. The interim rule would also permit the Board to impose an emergency special assessment after June 30, 2009, of up to 10 basis points if necessary to maintain public confidence in federal deposit insurance. The Company estimates the combined impact of the seven basis point increase and 20 basis point emergency special assessment to be an approximate increase of $4.6 million in its FDIC deposit insurance assessments for 2009. Subsequently, on March 5, 2009 the Chairman of the FDIC announced that it may cut the 20 basis point emergency special assessment to 10 basis points if legislation passes to expand the FDIC's existing line of credit with the U.S. Treasury Department. Additionally, the Company opted to continue to participate in the Transaction Account Guarantee portion of the TLGP following the expiration of the initial opt-out period. Participation includes the full guarantee of noninterest bearing deposit transaction accounts and eligible, low interest-earning demand accounts (interest rate equal to or less than 0.50%) regardless of dollar amount. It is not clear at this time what impact the EESA, the CPP, the TLGP, or other liquidity and funding initiatives will have on the financial markets and the other difficulties described above, including the high levels of volatility and limited credit availability currently being experienced, or on the U.S. banking and financial industries and the broader U.S. global economies. Further adverse effects could have an adverse effect on our business.
OVERVIEW
For the year ended December 31, 2008, the Company's net loss totaled $26.2 million (or $2.56 loss per share), which included a pre-tax non-cash charge of $68.2 million for OTTI on certain investment securities. The Company reported net income of $16.4 million ($1.33 per diluted share) and $17.4 million ($1.40 per diluted share) for the years ended December 31, 2007 and 2006, respectively.
Net interest income, the principal source of the Company's earnings, was $65.3 million in 2008, up from $58.1 million in 2007 and $59.5 million in 2006. Net interest margin improved substantially to 3.93% for the year ended December 31, 2008, compared with 3.53% and 3.55% for the two prior years. The improved net interest margin resulted principally from lower funding costs and the benefits associated with a higher percentage of earning assets being deployed in higher yielding loan assets. Total loans increased $156.9 million, or 16%, to $1.121 billion for the one year period ended December 31, 2008. Indirect auto loans increased $120.1 million or 89%, and commercial-related increased $35.5 million or 8% during that same one year period.
The Company recorded a provision for loan losses of $6.6 million for the year ended December 31, 2008, compared with $116 thousand in 2007. The increase in the provision for loan losses is primarily due to growth in the loan portfolio and the changing mix of the loan portfolio together with higher net charge offs. For the year ended December 31, 2008, net charge-offs were $3.3 million, or 32 basis points of average loans, compared with $1.6 million, or 18 basis points of average loans, for the year ended December 31, 2007. The allowance for loan losses was $18.7 million at December 31, 2008, compared with $15.5 million at December 31, 2007. Non-performing loans were $8.2 million at December 31, 2008, compared with $8.1 million at December 31, 2007. The ratio of allowance for loan losses to non-performing loans improved to 229% at December 31, 2008 versus 192% at December 31, 2007.
For the year ended December 31, 2008, noninterest income (loss) was $(48.8) million, compared with $20.7 million for the same period in 2007. The loss reflects OTTI charges on investment securities totaling $68.2 million for the year ended December 31, 2008. Exclusive of OTTI charges, noninterest income was $19.4 million for the year, compared with $20.7 million in 2007. Aside from the impact of the OTTI charges in 2007, most of the remaining decrease in noninterest income was due to the receipt of $1.1 million in proceeds from company owned life insurance.

For the year ended December 31, 2008, noninterest expense was $57.5 million compared with $57.4 million for the same period in 2007. Total salaries and benefits cost declined $1.7 million for the year ended December 31, 2008 compared with 2007, and was offset by a $599 thousand increase in occupancy and equipment expense, a $385 thousand increase in FDIC insurance, and a $557 thousand prepayment charge on borrowed funds.
The Company retained its "well-capitalized" equity position with total equity capital of $190.3 million, which includes $37.5 million in preferred equity issued in December 2008 under the U.S. Treasury Department's CPP. As of December, 31, 2008, the leverage capital ratio was 8.05% and total risk-based capital ratio was 13.08%.
The Company also expanded its branch network in the metro-Rochester area of New York State, adding de novo branches in Henrietta and Greece during the third and fourth quarters of 2008, respectively.
CRITICAL ACCOUNTING ESTIMATES
The Company's consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States and are consistent with predominant practices in the financial services industry. Application of critical accounting policies, which are those policies that management believes are the most important to the Company's financial position and results, requires management to make estimates, assumptions, and judgments that affect the amounts reported in the consolidated financial statements and accompanying notes and are based on information available as of the date of the financial statements. Future changes in information may affect these estimates, assumptions and judgments, which, in turn, may affect amounts reported in the financial statements.
The Company has numerous accounting policies, of which the most significant are presented in Note 1, Summary of Significant Accounting Policies, of the notes to consolidated financial statements. These policies, along with the disclosures presented in the other financial statement notes and in this discussion, provide information on how significant assets, liabilities, revenues and expenses are reported in the consolidated financial statements and how those reported amounts are determined. Based on the sensitivity of financial statement amounts to the methods, assumptions, and estimates underlying those amounts, management has determined that the accounting policies with respect to the allowance for loan losses, valuation of goodwill and deferred tax assets, the valuation of securities and determination of OTTI, and accounting for defined benefit plans require particularly subjective or complex judgments important to the Company's financial position and results of operations, and, as such, are considered to be critical accounting policies as discussed below. These estimates and assumptions are based on management's best estimates and judgment and are evaluated on an ongoing basis using historical experience and other factors, including the current economic environment. The Company adjusts these estimates and assumptions when facts and circumstances dictate. Illiquid credit markets and volatile equity have combined with declines in consumer spending to increase the uncertainty inherent in these estimates and assumptions. As future events cannot be determined with precision, actual results could differ significantly from the Company's estimates.
Adequacy of the Allowance for Loan Losses The allowance for loan losses represents management's estimate of probable credit 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 subjective measurements including management's assessment of the internal risk classifications of loans, changes in the nature of the loan portfolio, industry concentrations and the impact of current local, regional and national economic factors on the quality of the loan portfolio. Changes in these estimates and assumptions are reasonably possible and may have a material impact on the Company's consolidated financial statements, results of operations or liquidity.
A commercial-related loan is considered impaired when, based on current information and events, it is probable that a creditor will be unable to collect all amounts of principal and interest under the original terms of the agreement and all loans restructured in a troubled debt restructuring. Accordingly, the Company evaluates impaired commercial-related loans individually, primarily based on the net realizable value of the collateral, as the majority of the Company's impaired loans are collateral dependent.
Loans, including impaired loans, are generally classified as nonaccruing if they are past due as to maturity or payment of principal or interest for a period of more than 90 days, unless such loans are well-collateralized and in the process of collection. Loans that are on a current payment status or past due less than 90 days may also be classified as nonaccruing if repayment in full of principal and/or interest is uncertain.
For additional discussion related to the Company's accounting policies for the allowance for loan losses, see the sections titled "Analysis of Allowance for Loan Losses" and "Allocation of Allowance for Loan Losses" in Part II, Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" and Note 1, Summary of Significant Accounting Policies, of the notes to consolidated financial statements.

Valuation of Goodwill
Statement of Financial Accounting Standards ("SFAS") No. 142, "Goodwill and Other Intangible Assets" prescribes the accounting for goodwill and intangible assets subsequent to initial recognition. The provisions of SFAS No. 142 discontinue the amortization of goodwill and intangible assets with indefinite lives. Instead, these assets are subject to at least an annual impairment review and more frequently if certain impairment indicators are in evidence. Goodwill impairment testing is performed at the segment (or "reporting unit") level. Currently, the Company's goodwill is evaluated at the entity level as there is only one reporting unit. Goodwill is assigned to reporting units at the date it is initially recorded. Once goodwill has been assigned to reporting units, it no longer retains its association with a particular acquisition, and all of the activities within a reporting unit, whether acquired or organically grown, are available to support the value of the goodwill. Changes in the estimates and assumptions are reasonably possible and may have a material impact on the Company's consolidated financial statements, results of operations or liquidity. For additional discussion related to the Company's accounting policy for goodwill and other intangible assets, see Note 1, Summary of Significant Accounting Policies, of the notes to consolidated financial statements. Valuation of Deferred Tax Assets
The determination of deferred tax expense or benefit is based on changes in the carrying amounts of assets and liabilities that generate temporary differences. The carrying value of the Company's net deferred tax assets assumes that the Company will be able to generate sufficient future taxable income based on estimates and assumptions (after consideration of historical taxable income as well as tax planning strategies). If these estimates and related assumptions change, the Company may be required to record valuation allowances against its deferred tax assets resulting in additional income tax expense in the consolidated statements of operations. Management evaluates its deferred tax assets on a quarterly basis and assesses the need for a valuation allowance, if any. A valuation allowance is established when management believes that it is more likely than not that some portion of its deferred tax assets will not be realized. Changes in valuation allowance from period to period are included in the Company's tax provision in the period of change. For additional discussion related to the Company's accounting policy for income taxes see Note 14, Income Taxes, of the notes to consolidated financial statements. Valuation and Other Than Temporary Impairment of Securities The Company records all of its securities that are classified as available for sale at fair value. The fair value of equity securities are determined using public quotations, when available. Where quoted market prices are not available, fair values are estimated based on dealer quotes, pricing models, discounted cash flow methodologies, or similar techniques for which the determination of fair value may require significant judgment or estimation. Fair values of public bonds and those private securities that are actively traded in the secondary market have been determined through the use of third-party pricing services using market observable inputs. Private placement securities and other corporate fixed maturities where the Company does not receive a public quotation are valued by discounting the expected cash flows. Market rates used are applicable to the yield, credit quality and average maturity of each security. Private equity securities may also utilize internal valuation methodologies appropriate for the specific asset. Fair values might also be determined using broker quotes or through the use of internal models or analysis.
Securities are evaluated quarterly to determine whether a decline in their fair value is other than temporary. Management utilizes criteria such as, the magnitude and duration of the decline and, when appropriate, consideration of adverse changes in cash flows, in addition to the reasons underlying the decline, including creditworthiness, capital adequacy and near term prospects of issuers, the level of credit subordination, estimated loss severity, prepayments and future delinquencies, to determine whether the loss in value is other than temporary. The term "other than temporary" is not intended to indicate that the decline is permanent, but indicates that the prospect for a near-term recovery of value is not necessarily favorable. Once a decline in fair value is determined to be other than temporary the cost basis of the security is reduced through a charge to earnings.
Defined Benefit Pension Plan
Management is required to make various assumptions in valuing its defined benefit pension plan assets and liabilities. These assumptions include, but are not limited to, the expected long-term rate of return on plan assets, the weighted average discount rate used to value certain liabilities and the rate of compensation increase. The Company uses a third-party specialist to assist in making these estimates and assumptions. Changes in these estimates and assumptions are reasonably possible and may have a material impact on the Company's consolidated financial statements, results of operations or liquidity.

ANALYSIS OF FINANCIAL CONDITION
Overview
At December 31, 2008, the Company had total assets of $1.917 billion, an increase of 3% from $1.858 billion as of December 31, 2007, primarily a result of growth of its core business of loans and deposits. Loans totaled $1.121 billion as of December 31, 2008, up $156.9 million, or 16%, when compared to $964.2 million as of December 31, 2007. The increase in loans was primarily attributed to the expansion of the indirect lending program and commercial business development efforts. Nonperforming assets totaled $9.3 million as of December 31, 2008, down $246 thousand from a year ago despite the increase the loan portfolio. For the year ended December 31, 2008, net charge-offs were $3.3 million, or 32 basis points of average loans, compared with $1.6 million, or 18 basis points of average loans, for the year ended December 31, 2007. The increase in net charge-offs in 2008 related principally to the commercial mortgage and consumer indirect loan portfolios. Total deposits amounted to $1.633 billion and $1.576 billion as of December 31, 2008 and 2007, respectively. The increase in deposits was due in part to the Company's successfully expansion of its branch network in the metro-Rochester area, where de novo branches were added in Henrietta and Greece during the third and fourth quarters of 2008, respectively. As of December 31, 2008, total borrowed funds were $70.8 million, comparable to $68.2 million as of December 31, 2007. While the outstanding balance of borrowed funds is up slightly, the average cost of the borrowed funds is down considerably as the Company took advantage of the low interest rate environment and prepaid a portion of its higher cost long term debt in the fourth quarter of 2008. Book value per common share was $12.71 and $16.14 as of December 31, 2008 and 2007, respectively. As of December 31, 2008 the Company's total shareholders' equity was $190.3 million compared to $195.3 million a year earlier.
Goodwill
At December 31, 2008, the carrying amount of our goodwill totaled $37.4 million. On September 30, 2008, the Company performed the annual goodwill impairment test and determined the estimated fair value of our reporting unit to be in excess of its carrying amount. Accordingly, as of the Company's annual impairment test date, there was no indication of goodwill impairment. The Company tests its goodwill for impairment between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of our reporting unit below its carrying amount. Accordingly, an evaluation of the goodwill for impairment was performed as of December 31, 2008 due to the market's continued contraction. The estimated fair value of the Company's reporting unit was in excess of its carrying amount at December 31, 2008. No assurance can be given that the Company will not record an impairment loss on goodwill in 2009. However, the Company's tangible capital ratio and Bank's regulatory capital ratios would not be affected by this potential non-cash expense since goodwill is not included in these calculations.
Subsequent to December 31, 2008, the Company's stock price significantly declined as was the case for the financial services sector as a whole. The Company considers this to be primarily a financial services industry issue and not related specifically to the Company. If this decline does not reverse by March 31, 2009, there may be a triggering event requiring a goodwill impairment analysis under SFAS No. 142 that may result in an impairment charge. Investing Activities
The following table summarizes the composition of the available for sale and held to maturity security portfolios (in thousands).

                                                               At December 31,
                                     2008                           2007                           2006
                            Adjusted
                           Amortized         Fair         Amortized         Fair         Amortized         Fair
                              Cost           Value           Cost           Value           Cost           Value
Securities available
for sale:
U.S. Government agency
and
government-sponsored
enterprise securities      $   67,871      $  68,173      $  158,920      $ 158,940      $  235,863      $ 231,936
Mortgage-backed
securities:                   339,574        342,552         297,798        295,872         304,833        296,738
Other asset-backed
securities                      3,918          3,918          34,115         33,198           7,082          7,077
State and municipal
obligations                   129,572        131,711         171,294        172,601         198,428        198,310
Equity securities                 923          1,152          33,930         34,630              80          1,087

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