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 June 30, 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.

The following discussion reviews the Company's financial condition at June 30, 2009 and the results of operations for the three months and six months ended June 30, 2009 and June 30, 2008.

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.

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.

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 loss 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.

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 annual 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) if we intend to sell the security; (2) if it is "more likely than not" we will be required to sell the security before recovery of its amortized cost basis; or
(3) the present value of expected cash flows is not sufficient to recover the entire amortized cost basis. 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

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.

Net income was $31,000, or $0.01 per basic and diluted share, for the three months ended June 30, 2009, as compared to $300,000, or $0.12 per basic and diluted share, for the same period in 2008. For the six months ended June 30, 2009, the Company reported net income of $610,000, or $0.25 per basic and diluted share as compared to $632,000, or $0.25 per basic and diluted share for the same period in 2008. During the second quarter of 2009, the Company recorded an investment security impairment charge of $197,000, net of tax benefits of $101,000. During the second quarter of 2008, the Company recorded an investment security impairment charge of $205,000, net of tax benefits of $137,000.

The Company sold approximately $4.5 million in municipal investment portfolio holdings and $6.4 million of fixed rate residential real estate loans during the first half of the year. 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 $1.0 million, or 3%, when compared to December 31, 2008.

Results of Operations

The return on average assets and return on average shareholders' equity were 0.03% and 0.61%, respectively, for the three months ended June 30, 2009, compared with 0.35% and 5.41%, respectively, for the three months ended June 30, 2008. During the second quarter of 2009, when compared to the second quarter of 2008, net interest income increased $239,000, partially offset by an increased provision for loan losses of $137,000. Noninterest expense increased $395,000, which was primarily the result of increased pension plan expense to amortize losses recorded in the prior year, and the increase in FDIC regular assessment and special assessment charges. The provision for income tax expense during the second quarter of 2009 included $58,000 to increase the valuation allowance on deferred tax assets generated by capital losses in 2008.

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.

Net interest income, on a tax-equivalent basis increased to $2.8 million for the three months ended June 30, 2009, from $2.7 million for the three months ended June 30, 2008. The Company's net interest margin remained the same, at 3.41%, for the second quarter of 2009 when compared to the same quarter in 2008. Reductions in the Company's current levels of earning asset yields, due to falling short-term interest rates, have been offset by efforts to reduce the cost of funds, and have resulted in maintaining the Company's net interest margin. The small increase in net interest income is attributable to a decrease of 52 basis points in the average cost of interest bearing liabilities, and was offset by a decrease of 48 basis points in the average yield earned on earning assets. Average interest-earning assets increased 5% to $328.2 million for the three months ended June 30, 2009, as compared to $313.3 million for the three months ended June 30, 2008. The increase in average earning assets is primarily attributable to a $22.8 million increase in average loans receivable, and a $1.8 million increase in average interest earning deposits, offset by a $9.7 million decrease in average investment securities. Average interest-bearing liabilities increased $13.7 million to $301.3 million from $287.6 million for the three months ended June 30, 2008. The increase in the average balance of interest-bearing liabilities resulted primarily from a $15.7 million increase in average deposits and a $2.0 million decrease in average borrowings.

For the six months ended June 30, 2009, net interest income, on a tax-equivalent basis, increased to $5.6 million from $5.1 million for the six months ended June 30, 2008. Net interest margin increased 10 basis points, to 3.41% for the six months ended June 30, 2009 from 3.31% for the six months ended June 30, 2008. Average interest-earning assets increased 7% to $330.0 million for the six months ended June 30, 2009 as compared to $309.5 million for the six months ended June 30, 2008, and the yield on interest-earning assets decreased 48 basis points to 5.39% from 5.87% for the comparable period. The increase in average interest-earning assets was primarily attributable to a $23.8 million increase in average loans receivable and a $1.5 million increase in average interest earning deposits, partially offset by a $4.8 million decrease in average investment securities. Average interest-bearing liabilities increased $17.6 million but the cost of funds decreased 60 basis points to 2.17% for the six months ended June 30, 2009, from 2.77% for the same period in 2008. The increase in the average balance of interest-bearing liabilities resulted primarily from a $16.4 million, or 6.8%, increase in average deposits and an $1.2 million, or 2.9%, increase in average borrowings.

Interest Income

Total interest income, on a tax-equivalent basis, for the quarter ended June 30, 2009, decreased $175,000, or 3.9%, to $4.4 million from $4.5 million for the quarter ended June 30, 2008.

The average balance of loans increased $22.8 million to $249.1 million, with yields decreasing 36 basis points to 5.93% for the second quarter of 2009. Average residential real estate loans increased $4.3 million, or 3%, and experienced a decrease in the average yield to 5.62% from 5.70% in the comparable quarter of 2008. Average commercial real estate loans

Average investment securities (taxable and tax-exempt) for the quarter ended June 30, 2009, decreased by $9.7 million, with a decrease in tax-equivalent interest income from investments of $300,000, or 31%, when compared to the second quarter of 2008. The average tax-equivalent yield of the portfolio decreased 101 basis points, to 3.61% from 4.62%.

Total interest income, on a tax-equivalent basis, for the six months ended June 30, 2009 decreased $178,000, or 2%, when compared to the six months ended June 30, 2008.

Average loans increased $23.8 million, with average yields decreasing 52 basis points to 5.90% from 6.42% for the six-month period ended June 30, 2009 when compared with the same period in 2008. Average residential real estate loans increased $5.7 million, or 4.5%, and experienced a slight decrease in the average yield of 16 basis points from the comparable six-month period ended June 30, 2008. Average commercial real estate loans increased $10.8 million, while the average yield on those loans decreased to 6.87% from 7.52% from the period a year earlier. Average commercial loans increased $4.9 million and experienced a decrease in the average yield of 148 basis points, to 5.08% for the six months ended June 30, 2009, from 6.56%, for the six months ended June 30, 2008. The decrease in the average yield on commercial loans was the result of new commercial loan origination activity taking place at lower yields and variable rate loans pricing downwards. Average consumer loans increased $2.2 million, or 8.5%, while the average yield decreased by 133 basis points.

For the six months ended June 30, 2009, tax-equivalent interest income from investment securities decreased $243,000, or 13%, compared to the same period in 2008. The average tax-equivalent yield of the portfolio decreased 36 basis points, to 4.21% from 4.57%. Moreover, there was a $4.8 million decrease in the average balance of investment securities, reflecting the sale of municipal investment portfolio holdings in the first quarter.

Interest Expense

Total interest expense decreased $304,000 for the three months ended June 30, 2009, compared to the same quarter in 2008, as the cost of funds decreased 52 basis points to 2.08% in 2009 from 2.60% in 2008. Although average deposits increased in 2009 over the second quarter of 2008, the associated cost of funds decreased sufficiently to lower the overall interest expense incurred. Average time deposits increased $9.3 million, but were offset by a 76 basis point reduction in the cost of funds. The average balance of money market demand accounts increased to $33.6 million at June 30, 2009 from $26.8 million at June 30, 2008 and was offset by a decrease in the cost of funds to 0.69% from 1.75%. The average balances of other deposit categories showed small increases or decreases when comparing the second quarter averages between 2009 and 2008, but all categories had a reduction in the associated cost of funds.

Interest expense on borrowings decreased by $45,000, or 10%, when compared to the same quarter in 2008, as a result of a decrease in average borrowings of $2.1 million and a 23 basis point decrease in the cost of funds. The decrease in cost is attributed to the cost of the junior subordinated debenture, down 163 basis points, which resulted from a reduction in its index rate based on 3-month LIBOR.

Total interest expense decreased $675,000 for the six months ended June 30, 2009, compared to the same period in 2008, as the average cost of funds decreased 60 basis points to 2.17% in 2009 from 2.77% in 2008. Average time deposits increased $11.8 million, but were offset by a 76 basis point reduction in the cost of funds. The six-month average balance of money market demand accounts increased $4.0 million at June 30, 2009 from the prior year period and was offset by a decrease in the cost of funds to 0.81% from 2.23%. The average balances of other deposit categories showed small increases and decreases when comparing the six-month period results between 2009 and 2008, but all categories had a reduction in the associated interest expense as the result of a decrease in cost of funds of 59 basis points.

Interest expense on borrowings decreased by $114,000, or 12%, from the prior six-month period. The reduction in the average cost of borrowings to 3.78% from 4.43% in 2008, was offset by an increase in average borrowings of $1.2 million.

Provision for Loan Losses

The provision for loan losses increased $137,000 and $127,000 for the three-month and six-month periods ended June 30, 2009, respectively, when compared to the same periods 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 loans increased to 1.11% at June 30, 2009 as compared to 0.99% at December 31, 2008. Nonperforming loans to period end loans increased to 1.03% at June 30, 2009 from 0.93% at December 31, 2008. The increase in nonperforming loans is primarily the result of deterioration in the delinquency status of residential real estate loans. Management believes that the existing allowances provided on these loans are sufficient to cover anticipated losses.

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 June 30,
(in thousands)                                               2009       2008                 Change
Service charges on deposit accounts                          $360         $355         $5          1.4 %
Earnings on bank owned life insurance                          56           56          -          0.0 %
Loan servicing fees                                            55           61         (6 )       -9.8 %
Debit card interchange fees                                    73           70          3          4.3 %
Other charges, commissions and fees                           114          111          3          2.7 %
Noninterest income before gains (losses)                      658          653          5          0.8 %
Net losses on sales and impairment of investment
securities                                                   (298 )       (342 )       44        -12.9 %
Net losses on sales of loans and foreclosed real
estate                                                        (15 )          -        (15 )     -100.0 %
Total noninterest income                                     $345         $311        $34         10.9 %


                                                                  Six Months Ended June 30,
(in thousands)                                               2009       2008                 Change
Service charges on deposit accounts                          $711         $734       $(23 )       -3.1 %
Earnings on bank owned life insurance                         112          123        (11 )       -8.9 %
Loan servicing fees                                           111          151        (40 )      -26.5 %
Debit card interchange fees                                   137          136          1          0.7 %
Other charges, commissions and fees                           219          207         12          5.8 %
Noninterest income before gains (losses)                    1,290        1,351        (61 )       -4.5 %
Net losses on sales and impairment of investment
securities                                                   (211 )       (342 )      131        -38.3 %
Net gains on sales of loans and foreclosed real
estate                                                         65            6         59        983.3 %
Total noninterest income                                   $1,144       $1,015       $129         12.7 %

For the three months ended June 30, 2009, noninterest income before gains (losses) remained relatively level with only a $5,000 increase, when compared with the three months ended June 30, 2008. A $6,000 decrease in loan servicing fees was primarily attributable to non-recurring fees that were collected for commercial loans in 2008. This decrease was offset by small increases in service fees, debit card interchange, and other fees, all associated with increased activity. The majority of the increase in noninterest income is the result of net losses on sales of investment securities being less than that in the prior year, resulting in a positive impact when comparing the two periods. This was offset by losses taken on foreclosed property that did not occur in the second quarter of 2008.

For the six months ended June 30, 2009, noninterest income before gains (losses) decreased $61,000, or 4.5%, when compared with the six months ended June 30, 2008. The decrease was comprised of a decrease in service charges on deposit accounts, a decrease in earnings on bank owned life insurance and a decrease in loan servicing fees. The decrease in service charges on deposit accounts was primarily attributable to the decrease in usage of our extended overdraft product. The decrease in loan servicing fees was primarily attributable to . . .