This section is intended to help investors understand the financial performance of Hampden Bancorp, Inc. and its subsidiaries through a discussion of the factors affecting the Company's financial condition at June 30, 2009 and June 30, 2008 and the Company's consolidated results of operations for the years ended June 30, 2009, 2008 and 2007. This section should be read in conjunction with the consolidated financial statements and related notes to the consolidated financial statements included elsewhere in this Annual Report on Form 10-K.

Forward-Looking Statements

Certain statements herein constitute "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are based on the beliefs and expectations of management, as well as the assumptions made using information currently available to management. Because these statements reflect the views of management concerning future events, these statements involve risks, uncertainties and assumptions. As a result, actual results may differ from those contemplated by these statements. Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts. They often include words like "believe", "expect", "anticipate", "estimate", and "intend" or future or conditional verbs such as "will", "would", "should", "could", or "may." Certain factors that could have a material adverse affect on the operations of Hampden Bank include, but are not limited to, increased competitive pressure among financial service companies, national and regional economic conditions, changes in interest rates, changes in consumer spending, borrowing and savings habits, legislative and regulatory changes, adverse changes in the securities markets, inability of key third-party providers to perform their obligations to Hampden Bank, changes in relevant accounting principles and guidelines and our ability to successfully implement our branch expansion strategy. These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of this Annual Report on Form 10-K. The Company disclaims any obligation to update any forward-looking statements, whether in response to new information, future events or otherwise.

Overview

Income. The Company's results of operations are primarily dependent on net interest income, which is the difference between the income earned on its loan and investment portfolios and interest expense incurred on its deposits and borrowed funds. Results of operations are also affected by fee income from banking and non-banking operations, provisions for loan losses, gains (losses) on sales of loans and securities available for sale, loan servicing income and other miscellaneous income.

Expenses. The Company's expenses consist primarily of compensation and employee benefits, office occupancy, technology, marketing, general administrative expenses and income tax expense. In 2007, the Company made a charitable contribution to the Hampden Bank Charitable Foundation in the amount of $3.8 million.

Results of operations are also significantly affected by general economic and competitive conditions, particularly with respect to changes in interest rates, government policies and actions of regulatory authorities. Future changes in applicable law, regulations or government policies may materially impact the Company's financial condition and results of operations. See "Risk Factors."

Dividend. On July 28, 2009 the Company announced that its Board of Directors had declared a cash dividend of $0.03 per common share. The dividend will be paid on August 27, 2009 to shareholders of record as of August 13, 2009.

Stock-based Compensation. In accordance with the Company's 2008 Plan, which was approved by shareholders on January 29, 2008, the Company's Board of Directors awarded 317,996 shares of restricted stock with a grant date fair value of $10.18 per share to directors and certain employees on January 29, 2008 and 595,000 stock options with an exercise price of $10.90 per share on April 29, 2008. The shares of common stock underlying any awards that are forfeited, cancelled, reacquired by Hampden Bancorp or otherwise terminated (other than by exercise), shares that are tendered or withheld in payment of the exercise price of any award, and shares that are tendered or withheld for tax withholding obligations will be added back to the available shares of common stock with respect to which new awards may be granted under the plan. The 2008 Plan provides for total awards of 794,987 stock options and 317,996 shares of restricted stock. During the year ended June 30, 2009 11,741 shares of restricted stock and 30,000 shares of stock options were forfeited, leaving 11,741 shares of restricted stock and 229,987 stock options available for future awards as of June 30, 2009.

All stock options awarded as of June 30, 2009 are for a term of ten years and will vest over a period of five years, except the Company's options granted to its chief executive officer vest over a period of four years at 25% per year. Upon a change in control (as defined in the plan) or the death or disability of the individual to whom options or shares were awarded, all options and restricted shares awarded immediately vest. Of the options awarded, 400,000 were incentive stock options and 195,000 were non-qualified options. Of the 595,000 options granted to date, 30,000 options have been forfeited, 116,750 options have vested, and 565,000 remain outstanding at June 30, 2009. The following table presents the fair value and related assumptions using the Black-Scholes Option Pricing Model for stock options granted:

Options Granted in April 2008

Fair Value                                      $2.86
Risk-free interest rate                          4.25 %
Expected dividend yield                          1.16 %
Expected volatility                             19.40 %
Expected term (years)                            6.50

All of the restricted stock awards granted vest over a five year period, except the Company's awards to its chief executive officer vest over a four year period at 25% per year. Of the 317,996 shares awarded to date, 11,741 shares have been reacquired by the Company as a result of tax withholding obligations of certain plan participants, 65,824 shares have vested, and 240,431 remain outstanding at June 30, 2009.

For the year ended June 30, 2009, the Company recognized compensation expense on stock options of $337,000. For restricted stock awards, the compensation expense recognized during the year ended June 30, 2009 amounted to $655,000.

Critical Accounting Policies

We consider accounting policies that require management to exercise significant judgment or discretion, or make significant assumptions that have or could have a material impact on the carrying value of certain assets, liabilities, revenue, expenses, or related disclosures, to be critical accounting policies.

Management believes that the following accounting estimates are the most critical to aid in fully understanding and evaluating our reported financial results, and they require management's most difficult, subjective or complex judgments, resulting from the need to make estimates about the effect of matters that are inherently uncertain. Management has reviewed these critical accounting estimates and related disclosures with the Audit Committee of our Board.

Other-Than-Temporary Impairment of Investment Securities.

Critical Estimates. One of the significant estimates related to available for sale securities is the evaluation of investments for other-than-temporary impairment. If a decline in the fair value of an equity security is judged to be other-than-temporary, a charge is recorded equal to the difference between the fair value and cost or amortized cost basis of the security. Following such write-down in value, the fair value of the other-than-temporarily impaired investment becomes its new cost basis.

In estimating other-than-temporary impairment losses for equity securities, 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. For those debt securities for which the fair value of the security is less than its amortized cost and the Company does not intend to sell such security and it is likely that it will not be required to sell such security prior to the recovery of its amortized cost basis less any credit losses, FSP FAS 115-2 and FAS 124-2 requires that the credit component of the other-than-temporary impairment losses be recognized in earnings while the noncredit component is recognized in other comprehensive loss, net of related taxes.

Judgment and Uncertainties. The evaluation of securities for impairment is a quantitative and qualitative process, which is subject to risks and uncertainties and is intended to determine whether declines in the fair value of investments should be recognized in current period earnings. The risks and uncertainties include changes in general economic conditions, the issuer's financial condition or future prospects, the effects of changes in interest rates or credit spreads and the expected recovery period. Management evaluates securities for other-than-temporary impairment at least on a quarterly basis and more frequently when economic or market conditions warrant such evaluation.

Effect if Actual Results Differ from Assumptions. If actual results are not consistent with management's estimates or assumptions, we may be exposed to an other-than-temporary impairment loss that could be material and could have a negative impact on the company's earnings.

Allowance for loan losses

Critical Estimates. The allowance for loan losses is the estimated amount considered necessary to cover credit losses inherent in the loan portfolio at the balance sheet date. The allowance is established through the provision for loan losses that is charged against income. In determining the allowance for loan losses, we make significant estimates and therefore, have identified the allowance as a critical accounting policy. The methodology for determining the allowance for loan losses is considered a critical accounting policy by management because of the high degree of judgment involved, the subjectivity of the assumptions used, and the potential for changes in the economic environment that could result in changes to the amount of the recorded allowance for loan losses.

The allowance for loan losses has been determined in accordance with U.S. generally accepted accounting principles, under which we are required to maintain an allowance for probable losses at the balance sheet date. We are responsible for the timely and periodic determination of the amount of the allowance required. We believe that our allowance for loan losses is adequate to cover specifically identifiable losses, as well as estimated losses inherent in our portfolio for which certain losses are probable but not specifically identifiable.

Management performs a quarterly evaluation of the adequacy of the allowance for loan losses. The analysis of the allowance for loan losses has two components: specific and general allocations. Specific allocations are made for loans determined to be impaired. Impairment is measured by determining the present value of expected future cash flows or, for collateral-dependent loans, the fair value of the collateral adjusted for market conditions and selling expenses. The general allocation is determined by segregating the remaining loans, by type of loan and payment history. We also analyze historical loss experience, delinquency trends, changes in our underwriting standards as well as in lending policies, procedures and practices, experience and depth of management and lending staff, general economic conditions, and industry and peer comparisons. This analysis establishes factors that are applied to the loan groups to determine the amount of the general allocations. This evaluation is inherently subjective as it requires material estimates that may be susceptible to significant revisions based upon changes in economic and real estate market conditions. Actual loan losses may be significantly more than the allowance for loan losses we have established which could have a material negative effect on our financial results.

On a quarterly basis, management's Loan Review Committee reviews the current status of various loan assets in order to evaluate the adequacy of the allowance for loan losses. In this evaluation process, specific loans are analyzed to determine their potential risk of loss. This process includes all loans, concentrating on non-accrual and classified loans. Each impaired loan is evaluated for potential loss exposure. Any shortfall results in a recommendation of a specific allowance if the likelihood of loss is evaluated as probable. To determine the adequacy of collateral on a particular loan, an estimate of the fair market value of the collateral is based on the most current appraised value or other available information.

The results of this quarterly process are summarized by, and appropriate recommendations and loan loss allowances are approved by, the Loan Review Committee. All supporting documentation with regard to the evaluation process, loan loss experience, allowance levels and the schedules of classified loans are maintained by the Executive Vice President. The allowance for loan loss calculation is presented to the Board of Directors on a quarterly basis with recommendations on its adequacy.

Our allowance for loan losses reflects probable losses considering, among other things, the actual growth and change in composition of our loan portfolio, the level of our non-performing loans and our charge-off experience. We believe the allowance for loan losses reflects the inherent credit risk in our portfolio.

Judgment and Uncertainties. Management determines the adequacy of the allowance for loan losses by analyzing and estimating losses inherent in the portfolio. The allowance for loan losses contains uncertainties because the calculation requires management to use historical information as well as current economic data to make judgments on the adequacy of the allowance. This evaluation requires estimates that are susceptible to significant revision as more information becomes available.

Our primary lending emphasis has been the origination and purchase of residential mortgage loans, commercial real estate mortgages and commercial and industrial credits. We also originate home equity loans and home equity lines of credit. As a local community bank within a small footprint, these activities resulted in a loan concentration in mortgages secured by real property located in western Massachusetts. Based on the composition of our loan portfolio, we believe the primary risks to loan losses are increases in interest rates, a decline in the general economy, and a decline in real estate market values in western Massachusetts. Any one or combination of these events may adversely affect our loan portfolio resulting in increased delinquencies, loan losses and future levels of loan loss provisions. As a substantial amount of our loan portfolio is collateralized by real estate, appraisals of the underlying value of property securing loans are critical in determining the amount of the allowance required for specific loans. Assumptions for appraisal valuations are instrumental in determining the value of properties. Overly optimistic assumptions or negative changes to assumptions could significantly impact the valuation of a property securing a loan and the related allowance determined. The assumptions supporting such appraisals are carefully reviewed by management to determine that the resulting values reasonably reflect amounts realizable on the related loans.

Effect if Actual Results Differ from Assumptions. Although we believe we have established and maintained the allowance for loan losses at adequate levels, additions may be necessary if the current operating environment continues or deteriorates. Management uses the best information available; however, the level of the allowance for loan losses remains an estimate that is subject to significant judgment and short-term change. In addition, the Federal Deposit Insurance Corporation and the Massachusetts Department of Banking, as an integral part of their examination process, will periodically review our allowance for loan losses. Such agencies may require us to recognize adjustments to the allowance based on their judgments about information available to them at the time of their examination.

Income taxes

Critical Estimates. Deferred tax assets and liabilities are reflected at currently enacted income tax rates applicable to the period in which the deferred tax assets or liabilities are expected to be realized or settled. Quarterly, management reviews the deferred tax asset to identify any uncertainties to the collectability of the components of the deferred tax asset.

Judgment and Uncertainties. In determining the deferred tax asset valuation allowance, we use historical and forecasted operating results, based upon approved business plans, including a review of the eligible carryforward periods, tax planning opportunities and other relevant considerations. Management believes that the accounting estimate related to the valuation allowance is a critical accounting estimate because the underlying assumptions can change from period to period. For example, tax law changes or variances in future projected operating performance could result in a change in the valuation allowance.

Effect if Actual Results Differ from Assumptions. Should actual factors and conditions differ materially from those used by management, the actual realization of net deferred tax assets or deferred tax liabilities could differ materially from the amounts recorded in the financial statements. If we were not able to realize all or part of our net deferred tax assets in the future, and adjustment to our deferred tax assets valuation allowance would be charged to income tax expense in the period such determination was made and could have a negative impact on the company's earnings. In addition, if actual factors and conditions differ materially from those used by management, the Company could incur penalties and interest imposed by the Internal Revenue Service.

Average Balance Sheet and Analysis of Net Interest and Dividend Income

Net interest income represents the difference between income on interest-earning assets and expense on interest-bearing liabilities. Net interest income depends upon the relative amounts of interest-earning assets and interest-bearing liabilities, and the interest rates earned or paid on them.

The following tables set forth average balance sheets, average yields and costs, and certain other information for the periods indicated. All average balances are daily average balances. The yields set forth below include the effect of deferred fees, and discounts and premiums that are amortized or accreted to interest income or expense. The Company does not accrue interest on loans on non-accrual status, however, the balance of these loans is included in the total average balance, which has the effect of lowering average loan yields.

                                                               Years Ended June 30,
                                    2009                               2008                               2007
                         Average                            Average                            Average
                       Outstanding              Yield     Outstanding              Yield     Outstanding              Yield
                         Balance     Interest   /Rate       Balance     Interest   /Rate       Balance     Interest   /Rate
                                                              (Dollars in Thousands)
Interest-earning
assets:
Loans, net (1)            $381,941    $22,721     5.95 %     $344,563    $22,072     6.41 %     $316,971    $20,561     6.49 %
Investment securities      123,419      5,427     4.40 %      132,608      6,259     4.72 %      131,392      6,025     4.59 %
Federal funds sold and
other                       15,713        125     0.80 %       14,136        493     3.49 %       17,951        948     5.28 %
Total interest earning
assets                     521,073     28,273     5.43 %      491,307     28,824     5.87 %      466,314     27,534     5.90 %
Non-interest earning
assets                      32,370                             30,696                             32,240
Total assets              $553,443                           $522,003                           $498,554

Interest-bearing
liabilities:
Savings deposits           $68,967      1,014     1.47 %      $68,065      1,584     2.33 %      $59,575      1,580     2.65 %
Money market                33,124        507     1.53 %       19,958        433     2.17 %       27,239        714     2.62 %
NOW and other checking
accounts                    54,149        173     0.32 %       50,906        149     0.29 %       51,427        251     0.49 %
Certificates of
deposit                    196,567      6,972     3.55 %      170,849      7,743     4.53 %      185,393      8,585     4.63 %
Total deposits             352,807      8,666     2.46 %      309,778      9,909     3.20 %      323,634     11,130     3.44 %
Borrowed funds              97,431      3,679     3.78 %      104,901      4,431     4.22 %       98,843      4,351     4.40 %
Total interest-bearing
liabilities                450,238     12,345     2.74 %      414,679     14,340     3.46 %      422,477     15,481     3.66 %
Non-interest bearing
liabilities                  5,297                              3,996                             28,166
Total liabilities          455,535                            418,675                            450,643
Equity                      97,908                            103,328                             47,911
Total Liabilities and
equity                    $553,443                           $522,003                           $498,554


Net interest income                   $15,928                            $14,484                            $12,053
Net interest rate
spread (2)                                        2.69 %                             2.41 %                             2.24 %
Net interest-earning
assets (3)                 $70,835                            $76,628                            $43,837

Net interest margin
(4)                                               3.06 %                             2.95 %                             2.58 %
Average
interest-earning
assets to
interest-bearing
liabilities                                     115.73 %                           118.48 %                           110.38 %


(1) Includes loans
held for sale.

The following table presents the dollar amount of changes in interest income and interest expense for the major categories of the Company's interest-earning assets and interest-bearing liabilities. Information is provided for each category of interest-earning assets and interest-bearing liabilities with respect to (i) changes attributable to changes in volume (i.e., changes in average balances multiplied by the prior-period average rate) and (ii) changes attributable to rate (i.e., changes in average rate multiplied by prior-period average balances).

                                Years Ended June 30                 Years Ended June 30
                                   2009 vs. 2008                       2008 vs. 2007

                               Increase           Total            Increase           Total
                           (Decrease) Due to     Increase     (Decrease) Due to      Increase
                          Volume      Rate      (Decrease)    Volume       Rate     (Decrease)
                                                 (Dollars in Thousands)
Interest income:
Loans, net (1)             $2,291    $(1,642)         $649     $1,770      $(259)       $1,511
Investment securities       (419)       (413)        (832)         56         178          234
Federal funds sold and
other                          50       (418)        (368)      (175)       (280)        (455)
Total interest income       1,922     (2,473)        (551)      1,651       (361)        1,290

Interest expense:
Savings deposits               21       (591)        (570)        210       (206)            4
Money market                  227       (153)           74      (171)       (110)        (281)
NOW and other checking
accounts                       10          14           24        (3)        (99)        (102)
Certificates of deposits    1,062     (1,833)        (771)      (662)       (180)        (842)
Total deposits              1,320     (2,563)      (1,243)      (626)       (595)      (1,221)
Borrowed funds              (302)       (450)        (752)        260       (180)           80
Total interest expense      1,018     (3,013)      (1,995)      (366)       (775)      (1,141)
Change in net interest
income                       $904        $540       $1,444     $2,017        $414       $2,431

(1) Includes loans held for sale.

Comparison of Operating Results For the Years Ended June 30, 2009 and June 30, 2008

Net Income. Net income was $286,000, or $0.04 per fully diluted share, for the year ended June 30, 2009 as compared to $1.2 million, or $0.16 per fully diluted share, for the year ended June 30, 2008. The primary reasons for the decrease in net income of $884,000 included an increase in provision for loan losses of $761,000, an increase in FDIC expenses of $685,000, an increase in salary and employee benefit expenses related to the 2008 Plan of $572,000, an increase in other salary and employee benefit expenses of $393,000 and a write-down for other-than-temporary impairment of investment securities of $388,000.

Net Interest Income. The tables on pages 45 and 46 set forth the components of the Company's net interest income, yields on interest-earning assets and interest-bearing liabilities, and the effect on net interest income arising from changes in volume and rate. There was an increase in net interest income for the year ended June 30, 2009 of $1.5 million, or 10.0%, to $15.9 million from $14.5 million for the same period in 2008. The increase in volume of interest-earning assets increased interest income by $1.9 million, while the increase in the volume of interest-bearing liabilities increased interest expense by $1.0 million. The changes in volume had the effect of increasing net interest income by $904,000. The increase in net interest income associated with . . .