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 II are wholly owned subsidiaries of Pathfinder Bancorp, Inc., however, Pathfinder Statutory Trust II is not consolidated for reporting purposes. Pathfinder Commercial Bank, Pathfinder REIT, Inc. and Whispering Oaks Development Corp. are wholly owned subsidiaries of Pathfinder Bank. At March 31, 2009, Pathfinder Bancorp, M.H.C, the Company's mutual holding company parent, whose activities are not included in the consolidated financial statements or the MD&A, held 63.7% of the Company's outstanding common stock and public shareholders held the remaining 36.3% of the common stock.

Statement Regarding Forward-Looking Statements

When used in this quarterly report the words or phrases "will likely result", "are expected to", "will continue", "is anticipated", "estimate", "project" or similar expression are intended to identify "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements are subject to certain risks and uncertainties. By identifying these forward-looking statements for you in this manner, the Company is alerting you to the possibility that its actual results and financial condition may differ, possibly materially, from the anticipated results and financial condition indicated in these forward-looking statements. 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 various factors 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. Additionally, all statements in this document, including forward-looking statements, speak only as of the date they are made, and the Company undertakes no obligation to update any statement in light of new information or future events.

The Company's net income is primarily dependent on its net interest income, which is the difference between interest income earned on its investments in mortgage and other loans, investment securities and other assets, and its cost of funds consisting of interest paid on deposits and borrowings. The Company's net income also is affected by its provision for loan losses, as well as by the amount of noninterest income, including income from fees, service charges and servicing rights, net gains and losses on sales of securities, loans and foreclosed real estate, and noninterest expense such as employee compensation and benefits, occupancy and equipment costs, data processing costs 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, of which these events are beyond the control of the Company. In particular, the general level of market interest rates tends to be highly cyclical.

Application of Critical Accounting Policies

The Company's consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States 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 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 2008 Annual Report on Form 10-K ("the 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 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 allowance for loan losses, deferred income taxes, pension obligations, the evaluation of investment securities for other than temporary impairment and the estimation of fair values for accounting and disclosure purposes 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.

Pension and post-retirement benefit plan liabilities and expenses are based upon actuarial assumptions of future events, including fair value of plan assets, interest rates, rate of future compensation increases and the length of time the Company will have to provide those benefits. The assumptions used by management are discussed in Note 11 to the consolidated financial statements.

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. Management continually analyzes the portfolio to determine if further impairment has occurred that may be deemed as other-than-temporary. Further charges are possible depending on future economic conditions.

The estimation of fair value is significant to several of our assets, including investment securities available for sale, intangible assets and foreclosed real estate, as well as the value of loan collateral when valuing loans. These are all recorded at either fair value or the lower of cost or fair value. Fair values are determined based on third party sources, when available. Furthermore, accounting principles generally accepted in the United States require disclosure of the fair value of financial instruments as a part of the notes to the consolidated financial statements. Fair values may be influenced by a number of factors, including market interest rates, prepayment speeds, discount rates and the shape of yield curves.

Fair values for securities available for sale are obtained from an independent third party pricing service. Where available, fair values are based on quoted prices on a nationally recognized securities exchange. If quoted prices are not available, fair values are measured using quoted market prices for similar benchmark securities. Management made no adjustments to the fair value quotes that were provided by the pricing source. The fair values of foreclosed real estate and the underlying collateral value of impaired loans are typically determined based on appraisals by third parties, less estimated costs to sell. If necessary, appraisals are updated to reflect changes in market conditions.

Overview

Net income was $579,000, or $0.23 per basic and diluted share, for the three months ended March 31, 2009, as compared to $332,000, or $0.13 per basic and diluted share, for the same period in 2008. The Company has continued efforts to expand its lending and deposit relationships within the small business community. These efforts have helped the Company transform its statement of condition from one more concentrated in residential loans and retail deposits to a more diversified mix of residential, consumer, and commercial relationships. On an average balance basis, total commercial loans comprised 33.4% of the total gross loan portfolio for the quarter ended March 31, 2009 compared to 31.6% for the quarter ended March 31, 2008.

The Company sold approximately $4.5 million in municipal investment portfolio holdings and $5.5 million of fixed rate residential real estate loans during the first quarter. These efforts, combined with other deposit gathering efforts, were undertaken to improve the Company's overall liquidity position and reduce its reliance on wholesale borrowings. Short-term borrowings decreased $16.6 million, or 94%, when compared to December 31, 2008. Long-term borrowings increased $2.0 million, or 6%, when compared to December 31, 2008.

Results of Operations

The return on average assets and return on average shareholders' equity were 0.65% and 11.67%, respectively, for the three months ended March 31, 2009, compared with 0.40% and 5.94%, respectively, for the three months ended March 31, 2008. During the first quarter of 2009, when compared to the first quarter of 2008, net interest income increased $301,000. The provision for loan losses decreased $10,000, noninterest income increased $95,000 and noninterest expenses increased $48,000.

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

Net interest income, on a tax-equivalent basis increased to $2.7 million for the three months ended March 31, 2009, from $2.5 million for the three months ended March 31, 2008. The Company's net interest margin for the first quarter of 2009 increased to 3.37% from 3.21% when compared to the same quarter in 2008. Significant reductions in short-term interest rates have resulted in a positively sloped yield curve. Reductions in the Company's cost of funds, combined with efforts to maintain the current levels of earning asset yields have resulted in an expansion of the Company's net interest margin. The increase in net interest income is attributable to a decrease of 71 basis points in the average cost of interest bearing liabilities, and was offset by a decrease of 51 basis points in the average yield earned on earning assets. Average interest-earning assets increased 9% to $334.3 million at March 31, 2009, as compared to $305.8 million at March 31, 2008. The increase in average earning assets is primarily attributable to a $24.7 million increase in loans receivable, and a $3.6 million increase in interest earning deposits. Average interest-bearing liabilities increased $23.6 million to $306.4 million from $282.9 million at March 31, 2008. The increase in the average balance of interest-bearing liabilities resulted primarily from a $4.5 million increase in average borrowings and a $19.0 million increase in average deposits.

Interest Income

Total interest income, on a tax-equivalent basis, for the quarter ended March 31, 2009, decreased $70,000, or 1.6%, to $4.4 million from $4.5 million for the quarter ended March 31, 2008.

The average balance of loans increased $24.7 million to $248.2 million, with yields decreasing 68 basis points to 5.87% for the first quarter of 2009. Average residential real estate loans increased $7.2 million, or 6%, and experienced a decrease in the average yield to 5.61% from 5.85% in the comparable quarter of 2008. Average commercial real estate loans increased $9.9 million, while the average yield on those loans decreased to 6.76% from 7.58% from the year earlier period. Average commercial loans increased $5.8 million and experienced a decrease in the average yield of 203 basis points, to 5.08% for the quarter ended March 31, 2009, from 7.11%, in the quarter ended March 31, 2008. The decrease in the average yield on commercial loans was primarily the result of new commercial loan origination activity taking place at yields lower than the average yield on the existing commercial loan portfolio, combined with the downward repricing of the existing adjustable rate commercial loan portfolio into the current, historically low, interest rate environment Average consumer loans increased $2.0 million, or 8%, while the average yield decreased by 145 basis points.

Average investment securities (taxable and tax-exempt) for the quarter ended March 31, 2009, increased by $225,000, with an increase in tax-equivalent interest income from investments of $57,000, or 7%, when compared to the first quarter of 2008. The average tax-equivalent yield of the portfolio increased 30 basis points, to 4.82% from 4.52%.

Interest Expense

Total interest expense decreased $371,000 for the three months ended March 31, 2009, compared to the same quarter in 2008, as the cost of funds decreased 71 basis points to 2.24% in 2009 from 2.95% in 2008. Although each category of deposits, as well as the level of borrowings, increased in 2009 over the first quarter of 2008, the associated cost of funds decreased sufficiently to lower the overall interest expense incurred. Average time deposits increased $14.5 million, but were offset by a 77 basis point reduction in the cost of funds. The average balance of NOW accounts increased to $25.5 million at March 31, 2009 from $22.9 million in 2008, and was offset by a 34 basis point reduction in the cost of funds. Additionally, the average balance of money market demand accounts increased to $34.2 million at March 31, 2009 from $33.1 million at March 31, 2008 and was offset by a decrease in the cost of funds to 0.92% from 2.61%. Average money management accounts increased $515,000, but were also offset by a 34 basis point reduction in the cost of funds. Interest expense on borrowings decreased by $69,000, or 14%, from the prior period as a result of a 295 basis point decrease in the cost of funds on the junior subordinated debenture that resulted from a reduction in its index rate which is based on 3-month LIBOR combined with the cost of funds on other borrowings decreasing 81 basis points to 3.74% at March 31, 2009. The decrease in the cost of funds was partially offset by a $4.5 million increase in the average balance of total borrowed funds.

Provision for Loan Losses

The provision for loan losses for the quarter ended March 31, 2009 decreased $10,000, or 6.9%, from the same period in 2008. , The Company continues to provide for loan losses to reflect the growing loan portfolio and to reflect a loan portfolio composition that is more heavily weighted to commercial term and commercial real estate, which have higher inherent risk characteristics than a consumer real estate portfolio, as well as a general weakening in economic conditions. The Company's ratio of allowance for loan losses to period-end

Noninterest Income

The Company's noninterest income is primarily comprised of fees on deposit
account balances and transactions, loan servicing, commissions, and net gains
(losses) on securities, loans and foreclosed real estate.

The following table sets forth certain information on noninterest income for the
quarters indicated:

                                                                    Three Months Ended March 31,
(in thousands)                                                 2009            2008               Change
Service charges on deposit accounts                             $351            $379       $(28 )       -7.4 %
Earnings on bank owned life insurance                             56              67        (11 )      -16.4 %
Loan servicing fees                                               56              90        (34 )      -37.8 %
Debit card interchange fees                                       64              66         (2 )       -3.0 %
Other charges, commissions and fees                              105              96          9          9.4 %
Noninterest income before gains (losses)                         632             698        (66 )       -9.5 %
Net gains on sales of investment securities                       87               -         87       -100.0 %
Net gains on sales of loans and foreclosed real estate            80               6         74       1233.3 %
Total noninterest income                                        $799            $704        $95         13.5 %

For the three months ended March 31, 2009, noninterest income before gains (losses) decreased $66,000, or 9.5%, when compared with the three months ended March 31, 2008. The decrease in service charges on deposit accounts was primarily attributable to the decrease in usage of our extended overdraft product. This is attributed to a reduction in consumer spending as a result of the current stressed economic conditions. The decrease in loan servicing fees was primarily attributable to non-recurring fees that were collected for commercial loans in 2008. The decrease in noninterest income before gains (losses) was offset by an increase in net gains on sales of investment securities and loans. The increase in net gains on sales of investment securities and net gains on sales of loans and foreclosed real estate is due to the gains recognized on the sale of $4.5 million in municipal securities and $5.5 million in 30-year fixed rate residential mortgages.

Noninterest Expense

The following table sets forth certain information on noninterest expense for
the quarters indicated:

                                                 Three Months Ended March 31,
        (In thousands)                        2009         2008          Change
        Salaries and employee benefits      $1,372       $1,337       $35         2.6 %
        Building occupancy                     323          346       (23 )      -6.6 %
        Data processing                        339          309        30         9.7 %
        Professional and other services        172          219       (47 )     -21.5 %
        Other operating                        367          314        53        16.9 %
        Total noninterest expense           $2,573       $2,525       $48         1.9 %

Total noninterest expense increased $48,000 for the three months ended March 31, 2009 when compared to the same period for 2008. The increase in salaries and employee benefits was primarily due to normal merit increases and incentive based compensation costs. Data processing costs increased $30,000, or 9.7% due to an increase in maintenance fees and Internet banking charges from greater customer access. A $53,000, or 16.9%, increase in other expenses was due to an increase in FDIC assessments on deposits. Pathfinder Bank offset 90% of its Deposit Insurance Fund assessments with available one-time assessment credits during the first two quarters of 2008 and took the remaining balance of the credit against the third quarter assessment. For the first nine months of 2008, credits utilized to offset amounts assessed for Pathfinder Bank totaled $76,000. Assessments for Pathfinder Bank in March 2009 were not offset by credits. These increases were offset by decreases of $47,000 and $23,000 in professional and other services and building occupancy, respectively. The decreases were the result of non-recurring charges that were expensed in 2008.

Income Tax Expense

Income taxes increased $111,000 for the quarter ended March 31, 2009, as compared to the same period in 2008. The effective tax rate was 28% and 25.6% for the three months ended March 31, 2009 and March 31, 2008, respectively. The increase in income tax expense and effective tax rate in 2009 in comparison to 2008, resulted from a higher pretax income of $358,000, combined with a reduction of income earned on tax-exempt investment securities. The Company has reduced its tax rate from the statutory rate primarily through the ownership of tax-exempt investment securities, bank owned life insurance and other tax saving strategies.

Changes in Financial Condition

Assets

Total assets increased approximately $8.8 million, or 2.5%, to $361.6 million at March 31, 2009, from $352.8 million at December 31, 2008. The increase in total assets was primarily the result of an increase of $9.1 million, or 118%, in cash and cash equivalents and a $2.4 million increase in investment securities, offset by a $2.0 million decrease in net loans receivable. The increase in cash and cash equivalents was primarily the result of interest earning deposits held at the Federal Home Loan Bank, which were generated from increased deposits combined with the proceeds received from the sale of municipal investments and residential real estate loans. Investment securities portfolio growth is being driven by the purchase of mortgage-backed securities and agency securities with excess liquidity generated by deposit growth. The decrease in loans reflects normal amortization of the lending portfolio, which was only partially offset by new loan originations in the first quarter. The Company continues to transform its traditional thrift balance sheet toward that of a community bank with a more diverse mix of residential, consumer and commercial loans.

The Company presently holds in its investment portfolio a $2.8 million investment in a no-load mutual fund, which invests primarily in mortgage-related instruments. The fund holds mortgage-backed bonds and securities issued by government-sponsored mortgage entities and by private companies. The underlying assets are comprised of variable rate, adjustable rate and fixed-rate residential mortgage and home equity loans, . As a result of the recent problems in the real estate and mortgage securities markets, the fair value of the fund has declined and, accordingly, the Company's recorded other-than-temporary impairment charges of 18% of the value during 2008. The value of the investment in the fund has declined further below its cost basis by approximately $383,000 . . .