UNITED STATES
 SECURITIES AND EXCHANGE COMMISSION
Washington, D.C.  20549
_____________________________

FORM 10-Q

[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
       EXCHANGE ACT OF 1934

       For the quarterly period ended June 30, 2013

OR
 
[  ]  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
       EXCHANGE ACT OF 1934
 
     For the transition period from _______ to _______

Commission File Number: 000-23601
 


 
PATHFINDER BANCORP, INC.
(Exact Name of Company as Specified in its Charter)

FEDERAL
16-1540137
(State or Other Jurisdiction of Incorporation or Organization)
(I.R.S. Employer Identification Number)

214 West First Street, Oswego, NY 13126
(Address of Principal Executive Office) (Zip Code)

(315) 343-0057
(Issuer's Telephone Number including area code)


Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
YES T        NO *                                

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (Section 232.405 of this Chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
YES T        NO *

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer*                                                    Accelerated filer*                                                      Non-accelerated filer*                                                           Smaller reporting company  T
(Do not check if a smaller reporting company)

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).   YES *    NO T

As of August 9, 2013, there were 2,979,969 shares issued and 2,618,182 shares outstanding of the registrant’s common stock.

 
 





PATHFINDER BANCORP, INC.
INDEX



PART I - FINANCIAL INFORMATION
 
PAGE NO.
       
Item 1.
Consolidated Financial Statements (Unaudited)
   
   
   
   
   
   
   
       
Item 2.
 
     
       
Item 3.
 
       
Item 4.
 
       
 
       
Item 1.
Legal proceedings
   
Item 1A.
Risk Factors
   
Item 2.
Unregistered sales of equity securities and use of proceeds
   
Item 3.
Defaults upon senior securities
   
Item 4.
Mine Safety Disclosures
   
Item 5.
Other information
   
Item 6.
Exhibits
   
       
 
       
     
 

 
 


PART I -  FINANCIAL INFORMATION
Item 1 – Consolidated Financial Statements

Pathfinder Bancorp, Inc.
Consolidated Statements of Condition
(Unaudited)

   
June 30,
   
December 31,
 
(In thousands, except share data)
 
2013
   
2012
 
ASSETS:
           
Cash and due from banks
  $ 7,194     $ 6,435  
Interest earning deposits
    2,834       2,230  
Total cash and cash equivalents
    10,028       8,665  
Interest earning time deposits
    1,500       2,000  
Investment securities, at fair value
    119,265       108,339  
Federal Home Loan Bank stock, at cost
    2,645       1,929  
Loans
    337,600       333,748  
Less: Allowance for loan losses
    4,864       4,501  
Loans receivable, net
    332,736       329,247  
Premises and equipment, net
    10,180       10,108  
Accrued interest receivable
    1,799       1,717  
Foreclosed real estate
    429       426  
Goodwill
    3,840       3,840  
Bank owned life insurance
    8,156       8,046  
Other assets
    3,789       3,479  
Total assets
  $ 494,367     $ 477,796  
                 
LIABILITIES AND SHAREHOLDERS' EQUITY:
               
Deposits:
               
Interest-bearing
  $ 351,466     $ 347,892  
Noninterest-bearing
    48,913       43,913  
Total deposits
    400,379       391,805  
Short-term borrowings
    27,860       9,000  
Long-term borrowings
    16,908       25,964  
Junior subordinated debentures
    5,155       5,155  
Accrued interest payable
    68       140  
Other liabilities
    3,854       4,985  
Total liabilities
    454,224       437,049  
Shareholders' equity:
               
Preferred stock - SBLF, par value $0.01 per share; $1,000 liquidation preference;
               
13,000 shares authorized; 13,000 shares issued and outstanding
    13,000       13,000  
Common stock, par value $0.01; authorized 10,000,000 shares; 2,979,969 and 2,980,469
               
 shares issued and 2,618,182 and 2,618,182 shares outstanding, respectively
    30       30  
Additional paid in capital
    8,175       8,120  
Retained earnings
    27,862       26,685  
Accumulated other comprehensive loss
    (3,215 )     (1,318 )
Unearned ESOP
    (881 )     (936 )
Treasury stock, at cost; 361,787 and 362,287 shares,  respectively
    (4,828 )     (4,834 )
Total shareholders' equity
    40,143       40,747  
Total liabilities and shareholders' equity
  $ 494,367     $ 477,796  

The accompanying notes are an integral part of the consolidated financial statements.
 
 
- 3 -

Pathfinder Bancorp, Inc.
Consolidated Statements of Income
(Unaudited)

   
For the three
   
For the three
   
For the six
   
For the six
 
 
 
months ended
   
months ended
   
months ended
   
months ended
 
(In thousands, except per share data)
 
June 30, 2013
   
June 30, 2012
   
June 30, 2013
   
June 30, 2012
 
Interest and dividend income:
                       
Loans, including fees
  $ 4,116     $ 3,977     $ 8,241     $ 7,988  
Debt securities:
                               
Taxable
    398       488       782       946  
Tax-exempt
    189       182       379       345  
Dividends
    25       26       60       59  
Interest earning time deposits
    5       6       11       12  
Federal funds sold and interest earning deposits
    2       1       3       2  
       Total interest income
    4,735       4,680       9,476       9,352  
Interest expense:
                               
Interest on deposits
    629       736       1,288       1,497  
Interest on short-term borrowings
    9       6       17       8  
Interest on long-term borrowings
    195       255       425       507  
       Total interest expense
    833       997       1,730       2,012  
          Net interest income
    3,902       3,683       7,746       7,340  
Provision for loan losses
    276       150       600       375  
          Net interest income after provision for loan losses
    3,626       3,533       7,146       6,965  
Noninterest income:
                               
Service charges on deposit accounts
    287       280       542       553  
Earnings and gain on bank owned life insurance
    52       96       112       188  
Loan servicing fees
    38       66       82       108  
Net gains on sales and redemptions of investment securities
    60       49       99       161  
Net gains on sales of loans and foreclosed real estate
    421       49       451       25  
Debit card interchange fees
    122       106       228       203  
Other charges, commissions & fees
    124       137       266       273  
          Total noninterest income
    1,104       783       1,780       1,511  
Noninterest expense:
                               
Salaries and employee benefits
    1,941       1,869       3,852       3,844  
Building occupancy
    361       346       726       729  
Data processing
    343       341       711       682  
Professional and other services
    168       146       327       298  
Advertising
    128       99       244       160  
FDIC assessments
    84       78       167       155  
Audits and exams
    63       56       123       111  
Other expenses
    513       419       955       830  
          Total noninterest expenses
    3,601       3,354       7,105       6,809  
Income before income taxes
    1,129       962       1,821       1,667  
Provision for income taxes
    306       241       493       418  
Net income
    823       721       1,328       1,249  
Preferred stock dividends
    -       116       -       254  
Net income available to common shareholders
  $ 823     $ 605     $ 1,328     $ 995  
                                 
Earnings per common share - basic
  $ 0.33     $ 0.24     $ 0.53     $ 0.40  
Earnings per common share - diluted
  $ 0.33     $ 0.24     $ 0.53     $ 0.40  
Dividends per common share
  $ 0.03     $ 0.03     $ 0.06     $ 0.06  

The accompanying notes are an integral part of the consolidated financial statements.
 
 
- 4 -

 
Pathfinder Bancorp, Inc.
Consolidated Statements of Comprehensive Income (Loss)
(Unaudited)



   
For the three
   
For the three
   
For the Six
   
For the Six
 
   
months ended
   
months ended
   
months ended
   
months ended
 
   
June 30,
   
June 30,
   
June 30,
   
June 30,
 
    2013      2012      2013      2012   
(In thousands)
 
 
   
 
   
 
   
 
 
Net Income
  $ 823     $ 721     $ 1,328     $ 1,249  
                                 
Other Comprehensive Income
                               
                                 
Retirement Plans:
                               
Retirement plan net losses recognized in plan expenses
    95       106       190       240  
Gain on pension plan curtailment  net of additional plan losses not recognized in plan expenses
    -       1,919       -       1,919  
Retirement plan net losses recognized in plan expenses
    95       2,025       190       2,159  
                                 
Unrealized holding gains (losses) on financial derivative:
                               
Change in unrealized holding gains (losses) on financial derivative
    13       (27 )     13       (35 )
Reclassification adjustment for interest expense included in net income
    15       16       30       30  
Net unrealized gain (loss) on financial derivative
    28       (11 )     43       (5 )
                                 
Unrealized holding (losses) gains on available-for-sale securities:
                               
Unrealized holding (losses) gains arising during the period
    (2,915 )     445       (3,289 )     612  
Reclassification adjustment for net gains included in net income
    (60 )     (49 )     (99 )     (161 )
Net unrealized (losses) gains on securities available-for-sale
    (2,975 )     396       (3,388 )     451  
                                 
Other comprehensive (loss) income , before tax
    (2,852 )     2,410       (3,155 )     2,605  
Tax effect
    1,137       (966 )     1,258       (1,043 )
Other comprehensive (loss)  income, net of tax
    (1,715 )     1,444       (1,897 )     1,562  
Comprehensive (loss) Income
  $ (892 )   $ 2,165     $ (569 )   $ 2,811  
                                 
Tax Effect Allocated to Each Component of Other Comprehensive Income (Loss)
                               
Retirement plan net losses recognized in plan expenses
  $ (38 )   $ (43 )   $ (76 )   $ (96 )
Gain on pension plan curtailment net of additional plan losses not recognized in plan expenses
    -       (768 )     -       (768 )
Change in unrealized holding (losses) gains on financial derivative
    (5 )     10       (5 )     14  
Reclassification adjustment for interest expense included in net income
    (6 )     (8 )     (12 )     (12 )
Unrealized holding (losses) gains arising during the period
    1,162       (176 )     1,311       (245 )
Reclassification adjustment for net gains included in net income
    24       19       40       64  
Income tax effect related to other comprehensive income (loss)
  $ 1,137     $ (966 )   $ 1,258     $ (1,043 )
                                 
The accompanying notes are an integral part of the consolidated financial statements.
                               
                                 

 
- 5 -


 
 


Pathfinder Bancorp, Inc.
 
Consolidated Statements of Changes in Shareholders’ Equity
 
Six months ended June 30, 2013 and June 30, 2012
(Unaudited)
 
                                                 
                           
Accumulated
                   
               
Additional
         
Other Com-
                   
   
Preferred
   
Common
   
Paid in
   
Retained
   
prehensive
   
Unearned
   
Treasury
       
 (In thousands, except share and per share data)
 
Stock
   
Stock
   
Capital
   
Earnings
   
Loss
   
ESOP
   
Stock
   
Total
 
                                                 
 Balance, January 1, 2013
  $ 13,000     $ 30     $ 8,120     $ 26,685     $ (1,318 )   $ (936 )   $ (4,834 )   $ 40,747  
                                                                 
 Net income
    -       -       -       1,328       -       -       -       1,328  
                                                                 
 Other comprehensive loss, net of tax:
    -       -       -       -       (1,897 )     -       -       (1,897 )
                                                                 
 ESOP shares earned (6,250 shares)
    -       -       22       -       -       55       -       77  
                                                                 
 Stock based compensation
    -       -       39       -       -       -       -       39  
                                                                 
 Stock options exercised
    -       -       (6 )     -       -       -       6       -  
                                                                 
 Common stock dividends declared ($0.06 per share)
    -       -       -       (151 )     -       -       -       (151 )
 Balance, June 30, 2013
  $ 13,000     $ 30     $ 8,175     $ 27,862     $ (3,215 )   $ (881 )   $ (4,828 )   $ 40,143  
                                                                 
 Balance, January 1, 2012
  $ 13,000     $ 30     $ 8,730     $ 24,618     $ (2,664 )   $ (1,039 )   $ (4,834 )   $ 37,841  
                                                                 
 Net income
    -       -       -       1,249       -       -       -       1,249  
                                                                 
 Other comprehensive income, net of tax:
    -       -       -       -       1,562       -       -       1,562  
                                                                 
 Purchase of CPP Warrants from Treasury
    -       -       (706 )     169       -       -       -       (537 )
                                                                 
 Preferred stock dividends - SBLF
    -       -       -       (254 )     -       -       -       (254 )
                                                                 
 ESOP shares earned (1,793 shares)
    -       -       2       -       -       48       -       50  
                                                                 
 Stock based compensation
    -       -       45       -       -       -       -       45  
                                                                 
 Common stock dividends declared ($0.06 per share)
    -       -       -       (150 )     -       -       -       (150 )
 Balance, June 30, 2012
  $ 13,000     $ 30     $ 8,071     $ 25,632     $ (1,102 )   $ (991 )   $ (4,834 )   $ 39,806  


The accompanying notes are an integral part of the consolidated financial statements.

 
- 6 -


Pathfinder Bancorp, Inc.
Consolidated Statements of Cash Flows
 (Unaudited)
   
For the six months ended June 30,
 
(In thousands)
 
2013
   
2012
 
OPERATING ACTIVITIES
           
Net income
  $ 1,328     $ 1,249  
Adjustments to reconcile net income to net cash flows from operating activities:
               
Provision for loan losses
    600       375  
Proceeds from sales of loans
    10,237       205  
Originations of loans held-for-sale
    (9,825 )     (195 )
Realized gains on sales and redemptions of:
               
Real estate acquired through foreclosure
    (39 )     (15 )
Loans
    (412 )     (10 )
Available-for-sale investment securities
    (99 )     (161 )
Depreciation
    350       401  
(Increase in) amortization of, mortgage servicing rights
    (76 )     5  
Amortization of deferred loan costs
    66       84  
Earnings on bank owned life insurance
    (110 )     (151 )
Realized gain on proceeds from bank owned life insurance
    (2 )     (37 )
Net amortization of premiums and discounts on investment securities
    403       559  
Stock based compensation and ESOP expense
    116       95  
Net change in accrued interest receivable
    (82 )     (106 )
Pension plan contribution
    -       (2,600 )
Net change in other assets and liabilities
    155       (21 )
Net cash flows from operating activities
    2,610       (323 )
INVESTING ACTIVITIES
               
Purchase of investment securities available-for-sale
    (33,716 )     (41,689 )
Net (purchases of) proceeds from the redemption of Federal Home Loan Bank stock
    (716 )     68  
Proceeds from maturities of interest earning time deposits
    500       -  
Proceeds from maturities and principal reductions of
               
investment securities available-for-sale
    13,526       11,434  
Proceeds from sales and redemptions of:
               
Available-for-sale investment securities
    5,572       6,974  
Real estate acquired through foreclosure
    188       222  
Proceeds from bank owned life insurance
    2       -  
Net change in loans
    (4,325 )     (8,230 )
Purchase of premises and equipment
    (422 )     (46 )
Net cash flows from investing activities
    (19,391 )     (31,267 )
FINANCING ACTIVITIES
               
Net change in demand deposits, NOW accounts, savings accounts,
               
money management deposit accounts, MMDA accounts and escrow deposits
    18,718       19,352  
Net change in time deposits and brokered deposits
    (10,144 )     14,182  
Net change in short-term borrowings
    18,860       -  
Payments on long-term borrowings
    (9,056 )     (1,055 )
Redemption of preferred stock - CPP
    -       (537 )
Cash dividends paid to preferred shareholder - SBLF
    (83 )     (281 )
Cash dividends paid to common shareholders
    (151 )     (150 )
Net cash flows from financing activities
    18,144       31,511  
Change in cash and cash equivalents
    1,363       (79 )
Cash and cash equivalents at beginning of period
    8,665       10,218  
Cash and cash equivalents at end of period
  $ 10,028     $ 10,139  
CASH PAID DURING THE PERIOD FOR:
               
Interest
  $ 1,802     $ 2,033  
Income taxes
    467       3  
NON-CASH INVESTING ACTIVITY
               
Real estate acquired in exchange for loans
    170       176  


The accompanying notes are an integral part of the consolidated financial statements.

 
- 7 -


Notes to Consolidated Financial Statements (Unaudited)
 
 
(1)  Basis of Presentation

The accompanying unaudited consolidated financial statements of Pathfinder Bancorp, Inc. and its wholly owned subsidiaries have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information, the instructions for Form 10-Q and Article 10 of Regulation S-X.  Accordingly, they do not include all of the information and footnotes necessary for a complete presentation of consolidated financial condition, results of operations and cash flows in conformity with generally accepted accounting principles.  In the opinion of management, all adjustments, consisting of normal recurring accruals considered necessary for a fair presentation, have been included.  Certain amounts in the 2012 consolidated financial statements may have been reclassified to conform to the current period presentation.  These reclassifications had no effect on net income or comprehensive income as previously reported.

The following material under the heading "Management's Discussion and Analysis of Financial Condition and Results of Operations" is written with the presumption that the users of the interim financial statements have read, or have access to, the Company's latest audited financial statements and notes thereto, together with Management's Discussion and Analysis of Financial Condition and Results of Operations as of December 31, 2012 and 2011 and for the two years then ended.  Therefore, only material changes in financial condition and results of operations are discussed in the remainder of Part 1.

Operating results for the three and six months ended June 30, 2013 are not necessarily indicative of the results that may be expected for the year ending December 31, 2013.

(2)  New Accounting Pronouncements

None that will materially impact the Company.

 
- 8 -



(3)  Earnings per Common Share

Basic earnings per share are calculated by dividing net income available to common shareholders by the weighted average number of common shares outstanding during the period.  Net income available to common shareholders is net income less the total of preferred dividends declared.  Diluted earnings per share include the potential dilutive effect that could occur upon the assumed exercise of issued stock options using the treasury stock method.  Unallocated common shares held by the ESOP are not included in the weighted-average number of common shares outstanding for purposes of calculating earnings per common share until they are committed to be released to plan participants.


The following table sets forth the calculation of basic and diluted earnings per share:


   
Three months ended June 30,
   
Six months ended June 30,
 
(In thousands, except  per share data)
 
2013
   
2012
   
2013
   
2012
 
Basic Earnings Per Common Share
                       
Net income available to common shareholders
  $ 823     $ 605     $ 1,328     $ 995  
Weighted average common shares outstanding
    2,515       2,503       2,514       2,502  
Basic earnings per common share
  $ 0.33     $ 0.24     $ 0.53     $ 0.40  
                                 
Diluted Earnings Per Common Share
                               
Net income available to common shareholders
  $ 823     $ 605     $ 1,328     $ 995  
Weighted average common shares outstanding
    2,515       2,503       2,514       2,502  
Effect of assumed exercise of stock options
    16       2       8       3  
Effect of assumed exercise of stock warrants
    -       -       -       7  
Diluted weighted average common shares outstanding
    2,531       2,505       2,522       2,512  
Diluted earnings per common share
  $ 0.33     $ 0.24     $ 0.53     $ 0.40  


 
- 9 -



(4) Investment Securities - Available-for-Sale

The amortized cost and estimated fair value of investment securities are summarized as follows:

   
June 30, 2013
 
         
Gross
   
Gross
   
Estimated
 
   
Amortized
   
Unrealized
   
Unrealized
   
Fair
 
(In thousands)
 
Cost
   
Gains
   
Losses
   
Value
 
Debt investment securities:
                       
US Treasury, agencies and GSEs
  $ 18,947     $ 2     $ (480 )   $ 18,469  
State and political subdivisions
    26,452       345       (657 )     26,140  
Corporate
    20,738       242       (408 )     20,572  
Residential mortgage-backed - US agency
    51,134       634       (952 )     50,816  
Residential mortgage-backed - private label
    -       -       -       -  
Total
    117,271       1,223       (2,497 )     115,997  
Equity investment securities:
                               
Mutual funds:
                               
Ultra short mortgage fund
    1,286       -       (11 )     1,275  
Large cap equity fund
    905       340       -       1,245  
Other mutual funds
    183       149       -       332  
Common stock - financial services industry
    402       14       -       416  
Total
    2,776       503       (11 )     3,268  
Total investment securities
  $ 120,047     $ 1,726     $ (2,508 )   $ 119,265  


   
December 31, 2012
 
         
Gross
   
Gross
   
Estimated
 
   
Amortized
   
Unrealized
   
Unrealized
   
Fair
 
(In thousands)
 
Cost
   
Gains
   
Losses
   
Value
 
Debt investment securities:
                       
US Treasury, agencies and GSEs
  $ 6,175     $ 16     $ (8 )   $ 6,183  
State and political subdivisions
    26,413       1,065       (7 )     27,471  
Corporate
    22,942       468       (404 )     23,006  
Residential mortgage-backed - US agency
    47,113       1,139       (1 )     48,251  
Residential mortgage-backed - private label
    296       9       -       305  
Total
    102,939       2,697       (420 )     105,216  
Equity investment securities:
                               
Mutual funds:
                               
Ultra short mortgage fund
    1,286       5       -       1,291  
Large cap equity fund
    905       176       -       1,081  
Other mutual funds
    183       136       -       319  
Common stock - financial services industry
    420       12       -       432  
Total
    2,794       329       -       3,123  
Total investment securities
  $ 105,733     $ 3,026     $ (420 )   $ 108,339  
 

 
 
- 10 -

The amortized cost and estimated fair value of debt investments at June 30, 2013 by contractual maturity are shown below.  Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without penalties.

   
Amortized
   
Estimated
 
   
Cost
   
Fair Value
 
(In thousands)
           
Due in one year or less
  $ 5,726     $ 5,750  
Due after one year through five years
    27,784       27,853  
Due after five years through ten years
    15,678       15,432  
Due after ten years
    16,949       16,146  
Mortgage-backed securities
    51,134       50,816  
Totals
  $ 117,271     $ 115,997  


The Company’s investment securities’ gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, are as follows:

                           
June 30, 2013
                   
 
       
Less than Twelve Months
         
Twelve Months or More
         
Total
 
   
Number of
               
Number of
               
Number of
             
   
Individual
   
Unrealized
   
Fair
   
Individual
   
Unrealized
   
Fair
   
Individual
   
Unrealized
   
Fair
 
   
Securities
   
Losses
   
Value
   
Securities
   
Losses
   
Value
   
Securities
   
Losses
   
Value
 
(Dollars in thousands)
       
 
                                           
US Treasury, agencies and GSE's
    17     $ (480 )   $ 18,446       -     $ -     $ -       17     $ (480 )   $ 18,446  
State and political subdivisions
    29       (657 )     12,473       -       -       -       29       (657 )     12,473  
Corporate
    3       (52 )     1,451       2       (356 )     1,615       5       (408 )     3,066  
Residential mortgage-backed - US agency
    21       (952 )     24,004       -       -       -       21       (952 )     24,004  
Ultra short mortgage fund
    1       (11 )     1,275       -       -       -       1       (11 )     1,275  
Totals
    71     $ (2,152 )   $ 57,649       2     $ (356 )   $ 1,615       73     $ (2,508 )   $ 59,264  
 
                                                                       
 
                                                                       
                                   
December 31, 2012
                         
 
         
Less than Twelve Months
           
Twelve Months or More
           
Total
 
   
Number of
                   
Number of
                   
Number of
                 
   
Individual
   
Unrealized
   
Fair
   
Individual
   
Unrealized
   
Fair
   
Individual
   
Unrealized
   
Fair
 
   
Securities
   
Losses
   
Value
   
Securities
   
Losses
   
Value
   
Securities
   
Losses
   
Value
 
(Dollars in thousands)
                                                                       
US Treasury, agencies and GSE's
    1     $ (8 )   $ 992       -     $ -     $ -       1     $ (8 )   $ 992  
State and political subdivisions
    8       (7 )     2,008       -       -       -       8       (7 )     2,008  
Corporate
    2       (14 )     974       2       (390 )     1,580       4       (404 )     2,554  
Residential mortgage-backed - US agency
    2       (1 )     1,411       -       -       -       2       (1 )     1,411  
Totals
    13     $ (30 )   $ 5,385       2     $ (390 )   $ 1,580       15     $ (420 )   $ 6,965  

The Company conducts a formal review of investment securities on a quarterly basis for the presence of other-than-temporary impairment (“OTTI”).  The Company assesses whether OTTI is present when the fair value of a debt security is less than its amortized cost basis at the statement of condition date.  Under these circumstances, OTTI is considered to have occurred (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 anticipated to be sufficient to recover the entire amortized cost basis.  The guidance requires that credit-related OTTI is recognized in earnings while non-credit-related OTTI on securities not expected to be sold is recognized in other comprehensive income (“OCI”).  Non-credit-related OTTI is based on other factors, including illiquidity and changes in the general interest rate environment.  Presentation of OTTI is made in the consolidated statement of income on a gross basis, including both the portion recognized in earnings as well as the portion recorded in OCI.  The gross OTTI would then be offset by the amount of non-credit-related OTTI, showing the net as the impact on earnings.
 

 
 
- 11 -

The Company’s investment securities portfolio includes two corporate securities representing trust preferred issuances from large money center financial institutions.  The securities have been in an unrealized loss position for more than 12 months.  The securities are both floating rate notes that adjust quarterly to LIBOR (“London Interbank Offered Rate”).  These securities are reflecting a net unrealized loss due to current similar offerings being originated at higher spreads to LIBOR, as the market currently demands a greater pricing premium for the associated risk. Management has performed a detailed credit analysis on the underlying companies and has concluded that neither issue is credit impaired.  Due to the fact that each security has approximately 14 years until final maturity, and management has determined that there is no related credit impairment, the associated pricing risk is managed similar to long-term, low yielding, 15 and 30-year fixed rate residential mortgages carried in the Company’s loan portfolio.  The risk is managed through the Company’s interest rate risk management procedures.  The Company expects the present value of expected cash flows will be sufficient to recover the amortized cost basis.  Thus, the securities are not deemed to be other-than-temporarily impaired.

Management does not believe any individual unrealized loss in other securities within the portfolio as of June 30, 2013 represents OTTI.  All related securities are rated A2 or better by Moody’s and have been in an unrealized loss position for eight months or less, with the exception of the two corporate securities noted above.  The unrealized losses in the portfolio are primarily attributable to changes in interest rates.  The Company does not intend to sell these securities, nor is it more likely than not that the Company will be required to sell these securities prior to the recovery of the amortized cost.

In determining whether OTTI has occurred for equity securities, the Company considers the applicable factors described above and the length of time the equity security’s fair value has been below the carrying amount. All of the Company’s equity securities had a fair value greater than the book value at June 30, 2013, with the exception of the Ultra Short Mortgage Fund.  This fund has been in an unrealized loss position for 1 month and incurred an $11,000, or .08% loss.  Management has determined that we have the intent and ability to retain the equity securities for a sufficient period of time to allow for recovery.

Gross realized gains on sales of securities for the indicated periods are detailed below:

   
For the three months
   
For the six months
 
   
ended June 30,
   
ended June 30,
 
(In thousands)
 
2013
   
2012
   
2013
   
2012
 
Realized gains
  $ 65     $ 49     $ 104     $ 161  
Realized losses
    (5 )     -       (5 )     -  
    $ 60     $ 49     $ 99     $ 161  


As of June 30, 2013 and December 31, 2012, securities with a fair value of $60.4 million and $46.0 million, respectively, were pledged to collateralize certain municipal deposit relationships.  As of the same dates, securities with a fair value of $25.0 million and $37.8 million were pledged against certain borrowing arrangements.  Total borrowings of $0 and $5.0 million were outstanding relating to the above noted collateralized borrowing arrangements as of June 30, 2013 and December 31, 2012, respectively.

Management has reviewed its loan and mortgage-backed securities portfolios and determined that, to the best of its knowledge, little or no exposure exists to sub-prime or other high-risk residential mortgages.  The Company is not in the practice of investing in, or originating, these types of investments or loans.

(5)  Pension and Postretirement Benefits

The Company had a non-contributory defined benefit pension plan that covered substantially all employees. On May 14, 2012, the Company informed its employees of its decision to freeze participation and benefit accruals under the plan, primarily to reduce some of the volatility in earnings that can accompany the maintenance of a defined benefit plan.  The freeze became effective June 30, 2012.  Compensation earned by employees up to June 30, 2012 is used for purposes of calculating benefits under the plan but there will be no future benefit accruals after this date.  Participants as of June 30, 2012 will continue to earn vesting credit with respect to their frozen accrued benefits as they continue to work.

 
 
- 12 -

Prior to being frozen, the plan provided defined benefits based on years of service and final average salary. Although the plan was frozen, the Company maintains the responsibility for funding the plan, and its funding practice is to contribute at least the minimum amount annually to meet minimum funding requirements.  The funded status of the plan has and will continue to be affected by market conditions.  The Company expects to continue to fund this plan on an as needed basis and do not foresee any issues or conditions that could negatively impact the payment of benefit obligations to plan participants.  In addition, the Company provides certain health and life insurance benefits for eligible retired employees.  The healthcare plan is contributory with participants’ contributions adjusted annually; the life insurance plan is noncontributory.  Employees with less than 14 years of service as of January 1, 1995, are not eligible for the health and life insurance retirement benefits.

The composition of net periodic pension plan and postretirement plan costs for the indicated periods is as follows:

   
Pension Benefits
   
Postretirement Benefits
   
Pension Benefits
   
Postretirement Benefits
 
   
For the three months ended June 30,
   
For the six months ended June 30,
 
(In thousands)
 
2013
   
2012
   
2013
   
2012
   
2013
   
2012
   
2013
   
2012
 
 
                                               
Service cost
  $ -     $ 55     $ -     $ -     $ -     $ 166     $ -     $ -  
Interest cost
    95       101       5       5       189       212       9       9  
Expected return on plan assets
    (214 )     (201 )     -       -       (426 )     (399 )     -       -  
Amortization of net losses
    90       103       5       3       180       233       10       7  
Net periodic benefit plan (benefit) cost
  $ (29 )   $ 58     $ 10     $ 8     $ (57 )   $ 212     $ 19     $ 16  


The Company made a contribution in the amount of $2.6 million to the defined benefit pension plan in January of 2012.  The Company will evaluate the need for further contributions to the defined benefit pension plan during 2013, and has determined that no contribution was necessary during the six months ended June 30, 2013.

 
- 13 -



(6)  Loans

Major classifications of loans at the indicated dates are as follows:

   
June 30,
   
December 31,
 
(In thousands)
 
2013
   
2012
 
Residential mortgage loans:
           
1-4 family first-lien residential mortgages
  $ 167,232     $ 173,955  
Construction
    1,461       2,655  
Total residential mortgage loans
    168,693       176,610  
                 
Commercial loans:
               
Real estate
    91,002       82,329  
Lines of credit
    12,615       13,748  
Other commercial and industrial
    34,438       31,477  
Municipal
    5,372       3,588  
Total commercial loans
    143,427       131,142  
                 
Consumer loans:
               
Home equity and junior liens
    21,272       22,073  
Other consumer
    3,858       3,469  
Total consumer loans
    25,130       25,542  
                 
Total loans
    337,250       333,294  
Net deferred loan costs
    350       454  
Less allowance for loan losses
    (4,864 )     (4,501 )
Loans receivable, net
  $ 332,736     $ 329,247  


The Company originates residential mortgage, commercial, and consumer loans largely to customers throughout Oswego and Onondaga counties. Although the Company has a diversified loan portfolio, a substantial portion of its borrowers’ abilities to honor their contracts is dependent upon the counties’ employment and economic conditions.

As of June 30, 2013 and December 31, 2012, residential mortgage loans with a carrying value of $114.3 million and $58.6 million, respectively, have been pledged by the Company to the Federal Home Loan Bank of New York (“FHLBNY”) under a blanket collateral agreement to secure the Company’s line of credit and term borrowings.


 
- 14 -


Loan Origination / Risk Management

The Company’s lending policies and procedures are presented in Note 5 to the consolidated financial statements included in the 2012 Annual Report filed on Form 10-K on March 18, 2013, and have not changed.

To develop and document a systematic methodology for determining the allowance for loan losses, the Company has divided the loan portfolio into three portfolio segments, each with different risk characteristics and methodologies for assessing risk.  Each portfolio segment is broken down into loan classes where appropriate.  Loan classes contain unique measurement attributes, risk characteristics, and methods for monitoring and assessing risk that are necessary to develop the allowance for loan losses.  Unique characteristics such as borrower type, loan type, collateral type, and risk characteristics define each class.  The following table illustrates the portfolio segments and classes for the Company’s loan portfolio:


Portfolio Segment
Class
   
Residential Mortgage Loans
1-4 family first-lien residential mortgages
 
Construction
   
Commercial Loans
Real estate
 
Lines of credit
 
Other commercial and industrial
 
Municipal
   
Consumer Loans
Home equity and junior liens
 
Other consumer


 
- 15 -


The following tables present the classes of the loan portfolio, not including net deferred loan costs, summarized by the aggregate pass rating and the classified ratings of special mention, substandard and doubtful within the Company's internal risk rating system as of the dates indicated:

   
As of June 30, 2013
 
         
Special
                   
(In thousands)
 
Pass
   
Mention
   
Substandard
   
Doubtful
   
Total
 
Residential mortgage loans:
                             
1-4 family first-lien residential mortgages
  $ 160,581     $ 792     $ 5,832     $ 27     $ 167,232  
Construction
    1,461       -       -       -       1,461  
Total residential mortgage loans
    162,042       792       5,832       27       168,693  
Commercial loans:
                                       
Real estate
    85,005       918       4,896       183       91,002  
Lines of credit
    10,980       466       1,169       -       12,615  
Other commercial and industrial
    32,419       461       1,267       291       34,438  
Municipal
    5,372       -       -       -       5,372  
Total commercial loans
    133,776       1,845       7,332       474       143,427  
Consumer loans:
                                       
Home equity and junior liens
    19,485       145       1,556       86       21,272  
Other consumer
    3,734       34       68       22       3,858  
Total consumer loans
    23,219       179       1,624       108       25,130  
Total loans
  $ 319,037     $ 2,816     $ 14,788     $ 609     $ 337,250  


   
As of December 31, 2012
 
         
Special
                   
(In thousands)
 
Pass
   
Mention
   
Substandard
   
Doubtful
   
Total
 
Residential mortgage loans:
                             
1-4 family first-lien residential mortgages
  $ 166,801     $ 1,323     $ 5,831     $ -     $ 173,955  
Construction
    2,655       -       -       -       2,655  
Total residential mortgage loans
    169,456       1,323       5,831       -       176,610  
Commercial loans:
                                       
Real estate
    76,719       1,685       3,925       -       82,329  
Lines of credit
    12,026       -       1,647       75       13,748  
Other commercial and industrial
    29,705       237       1,500       35       31,477  
Municipal
    3,588       -       -       -       3,588  
Total commercial loans
    122,038       1,922       7,072       110       131,142  
Consumer loans:
                                       
Home equity and junior liens
    20,078       145       1,801       49       22,073  
Other consumer
    3,199       133       111       26       3,469  
Total consumer loans
    23,277       278       1,912       75       25,542  
Total loans
  $ 314,771     $ 3,523     $ 14,815     $ 185     $ 333,294  

Management has reviewed its loan portfolio and determined that, to the best of its knowledge, no exposure exists to sub-prime or other high-risk residential mortgages.  The Company is not in the practice of originating these types of loans.

 
- 16 -



Nonaccrual and Past Due Loans

Loans are placed on nonaccrual when the contractual payment of principal and interest has become 90 days past due or management has serious doubts about further collectability of principal or interest, even though the loan may be currently performing.

Loans are considered past due if the required principal and interest payments have not been received within thirty days of the payment due date.

An age analysis of past due loans, segregated by portfolio segment and class of loans, as of June 30, 2013 and December 31, 2012, are detailed in the following tables:

   
As of June 30, 2013
 
                                     
   
30-59 Days
   
60-89 Days
   
90 Days
   
Total
         
Total Loans
 
(In thousands)
 
Past Due
   
Past Due
   
and Over
   
Past Due
   
Current
   
Receivable
 
Residential mortgage loans:
                                   
1-4 family first-lien residential mortgages
  $ 1,975     $ 826     $ 1,751     $ 4,552     $ 162,680     $ 167,232  
Construction
    -       -       -       -       1,461       1,461  
Total residential mortgage loans
    1,975       826       1,751       4,552       164,141       168,693  
Commercial loans:
                                               
Real estate
    694       1,488       2,932       5,114       85,888       91,002  
Lines of credit
    257       197       257       711       11,904       12,615  
Other commercial and industrial
    1,598       573       655       2,826       31,612       34,438  
Municipal
    -       -       -       -       5,372       5,372  
Total commercial loans
    2,549       2,258       3,844       8,651       134,776       143,427  
Consumer loans:
                                               
Home equity and junior liens
    316       241       175       732       20,540       21,272  
Other consumer
    68       29       30       127       3,731       3,858  
Total consumer loans
    384       270       205       859       24,271       25,130  
Total loans
  $ 4,908     $ 3,354     $ 5,800     $ 14,062     $ 323,188     $ 337,250  


   
As of December 31, 2012
 
   
30-59 Days
   
60-89 Days
   
90 Days
   
Total
         
Total Loans
 
(In thousands)
 
Past Due
   
Past Due
   
and Over
   
Past Due
   
Current
   
Receivable
 
Residential mortgage loans:
                                   
1-4 family first-lien residential mortgages
  $ 2,698     $ 1,161     $ 2,046     $ 5,905     $ 168,050     $ 173,955  
Construction
    -       -       -       -       2,655       2,655  
Total residential mortgage loans
    2,698       1,161       2,046       5,905       170,705       176,610  
Commercial loans:
                                               
Real estate
    1,706       1,833       1,794       5,333       76,996       82,329  
Lines of credit
    496       153       334       983       12,765       13,748  
Other commercial and industrial
    1,279       85       598       1,962       29,515       31,477  
Municipal
    -       -       -       -       3,588       3,588  
Total commercial loans
    3,481       2,071       2,726       8,278       122,864       131,142  
Consumer loans:
                                               
Home equity and junior liens
    207       405       730       1,342       20,731       22,073  
Other consumer
    26       42       46       114       3,355       3,469  
Total consumer loans
    233       447       776       1,456       24,086       25,542  
Total loans
  $ 6,412     $ 3,679     $ 5,548     $ 15,639     $ 317,655     $ 333,294  


 
- 17 -



Nonaccrual loans, segregated by class of loan, were as follows:

   
June 30,
   
December 31,
 
(In thousands)
 
2013
   
2012
 
Residential mortgage loans:
           
1-4 family first-lien residential mortgages
  $ 1,751     $ 2,046  
      1,751       2,046  
Commercial loans:
               
Real estate
    2,932       1,794  
Lines of credit
    257       334  
Other commercial and industrial
    655       598  
      3,844       2,726  
Consumer loans:
               
Home equity and junior liens
    175       730  
Other consumer
    30       46  
      205       776  
Total nonaccrual loans
  $ 5,800     $ 5,548  


There were no loans past due ninety days or more and still accruing interest at June 30, 2013 or December 31, 2012.

The Company is required to disclose certain activities related to Troubled Debt Restructurings (“TDR”s) in accordance with accounting guidance.  Certain loans have been modified in a TDR where economic concessions have been granted to a borrower who is experiencing, or expected to experience, financial difficulties.  These economic concessions could include a reduction in the loan interest rate, extension of payment terms, reduction of principal amortization, or other actions that it would not otherwise consider for a new loan with similar risk characteristics.

The Company is required to disclose new TDRs for each reporting period for which an income statement is being presented.  The Company has determined that there were no new TDRs for the six month period ending June 30, 2013.

There are five loans that have been in payment default during the six month period ended June 30, 2013 which were modified during the preceding twelve month period.  Two of these loans are commercial real estate loans that total to the amount of $744,000, one is a commercial line of credit in the amount of $87,000, one is a commercial loan in the amount of $110,000 and another is a home equity loan in the amount of $39,000.

When the Company modifies a loan within a portfolio segment, a potential impairment is analyzed either based on the present value of the expected future cash flows discounted at the interest rate of the original loan terms or the fair value of the collateral less costs to sell.  If it is determined that the value of the loan is less than its recorded investment, then impairment is recognized as a component of the provision for loan losses, an associated increase to the allowance for loan losses or as a charge-off to the allowance for loan losses in the current period.


 
- 18 -



Impaired Loans

The following tables summarize impaired loan information by portfolio class at the indicated dates:

   
June 30, 2013
   
December 31, 2012
 
         
Unpaid
               
Unpaid
       
   
Recorded
   
Principal
   
Related
   
Recorded
   
Principal
   
Related
 
(In thousands)
 
Investment
   
Balance
   
Allowance
   
Investment
   
Balance
   
Allowance
 
With no related allowance recorded:
                                   
1-4 family first-lien residential mortgages
  $ 356     $ 356     $ -     $ 844     $ 844     $ -  
Commercial real estate
    1,010       1,010       -       1,554       1,571       -  
Commercial lines of credit
    283       296       -       358       370       -  
Other commercial and industrial
    323       323       -       657       801       -  
Home equity and junior liens
    344       344       -       380       380       -  
Other consumer
    -       -       -       -       -       -  
With an allowance recorded:
                                               
1-4 family first-lien residential mortgages
    223       223       9       1,307       1,307       215  
Commercial real estate
    2,831       2,831       455       1,182       1,182       401  
Commercial lines of credit
    171       171       171       -       -       -  
Other commercial and industrial
    488       645       240       225       230       207  
Home equity and junior liens
    126       126       66       155       155       95  
Other consumer
    2       2       2       5       5       5  
Total:
                                               
1-4 family first-lien residential mortgages
    579       579       9       2,151       2,151       215  
Commercial real estate
    3,841       3,841       455       2,736       2,753       401  
Commercial lines of credit
    454       467       171       358       370       -  
Other commercial and industrial
    811       968       240       882       1,031       207  
Home equity and junior liens
    470       470       66       535       535       95  
Other consumer
    2       2       2       5       5       5  
Totals
  $ 6,157     $ 6,327     $ 943     $ 6,667     $ 6,845     $ 923  

The following table presents the average recorded investment in impaired loans for the periods indicated:

   
For the three months ended June 30,
   
For the six months ended June 30,
 
(In thousands)
 
2013
   
2012
   
2013
   
2012
 
1-4 family first-lien residential mortgages
  $ 1,475     $ 1,414     $ 1,700     $ 1,375  
Commercial real estate
    3,847       2,649       3,476       2,333  
Commercial lines of credit
    455       451       423       451  
Other commercial and industrial
    824       681       843       580  
Home equity and junior liens
    551       475       546       468  
Other consumer
    3       2       3       1  
Total
  $ 7,155     $ 5,672     $ 6,991     $ 5,208  




 
- 19 -



The following table presents the cash basis interest income recognized on impaired loans for the periods indicated:

   
For the three months ended June 30,
   
For the six months ended June 30,
 
(In thousands)
 
2013
   
2012
   
2013
   
2012
 
1-4 family first-lien residential mortgages
  $ (17 )   $ 31     $ 13     $ 46  
Commercial real estate
    27       37       72       60  
Commercial lines of credit
    7       13       11       18  
Other commercial and industrial
    7       13       12       19  
Home equity and junior liens
    3       3       18       7  
Other consumer
    -       -       -       -  
Total
  $ 27     $ 97     $ 126     $ 150  

For the three months ended June 30, 2013, the Company categorized residential mortgage loans as impaired if the total related credit to the borrower exceeded the minimum threshold of $300,000.  The prior threshold was $100,000.  This action caused the $(17) indicated in the above three month table.


 
- 20 -


(7)   Allowance for Loan Losses

Summarized in the tables below are changes in the allowance for loan losses for the indicated periods and information pertaining to the allocation of the allowance for loan losses, balances of the allowance for loan losses, loans receivable based on individual, and collective impairment evaluation by loan portfolio class.  An allocation of a portion of the allowance to a given portfolio class does not limit the Company’s ability to absorb losses in another portfolio class.

   
For the three months ended June 30, 2013
 
   
1-4 family
                         
   
first-lien
   
Residential
               
Other
 
   
residential
   
construction
   
Commercial
   
Commercial
   
commercial
 
(In thousands)
 
mortgage
   
mortgage
   
real estate
   
lines of credit
   
and industrial
 
Allowance for loan losses:
                             
Beginning Balance
  $ 828     $ -     $ 1,895     $ 473     $ 854  
   Charge-offs
    (92 )     -       -       -       (5 )
   Recoveries
    1       -       -       -       -  
   Provisions
    (152 )     -       160       (55 )     196  
Ending balance
  $ 585     $ -     $ 2,055     $ 418     $ 1,045  
Ending balance: related to loans
                                       
individually evaluated for impairment
    9       -       455       171       240  
Ending balance: related to loans
                                       
collectively evaluated for impairment
  $ 576     $ -     $ 1,600     $ 247     $ 805  
                                         
Loans receivables:
                                       
Ending balance
  $ 167,232     $ 1,461     $ 91,002     $ 12,615     $ 34,438  
Ending balance: individually
                                       
evaluated for impairment
    579       -       3,841       454       811  
Ending balance: collectively
                                       
evaluated for impairment
  $ 166,653     $ 1,461     $ 87,161     $ 12,161     $ 33,627  
                                         
                                         
           
Home equity
   
Other
                 
   
Municipal
   
and junior liens
   
Consumer
   
Unallocated
   
Total
 
Allowance for loan losses:
                                       
Beginning Balance
  $ 2     $ 489     $ 139     $ 6     $ 4,686  
   Charge-offs
    -       -       (11 )     -       (108 )
   Recoveries
    -       -       9       -       10  
   Provisions
    1       (35 )     (2 )     163       276  
Ending balance
  $ 3     $ 454     $ 135     $ 169     $ 4,864  
Ending balance: related to loans
                                       
individually evaluated for impairment
    -       66       2       -       943  
Ending balance: related to loans
                                       
collectively evaluated for impairment
  $ 3     $ 388     $ 133     $ 169     $ 3,921  
                                         
Loans receivables:
                                       
Ending balance
  $ 5,372     $ 21,272     $ 3,858             $ 337,250  
Ending balance: individually
                                       
evaluated for impairment
    -       470       2               6,157  
Ending balance: collectively
                                       
evaluated for impairment
  $ 5,372     $ 20,802     $ 3,856             $ 331,093  


 
- 21 -




   
For the six months ended June 30, 2013
 
   
1-4 family
                         
   
first-lien
   
Residential
               
Other
 
   
residential
   
construction
   
Commercial
   
Commercial
   
commercial
 
(In thousands)
 
mortgage
   
mortgage
   
real estate
   
lines of credit
   
and industrial
 
Allowance for loan losses:
                             
Beginning Balance
  $ 811     $ -     $ 1,748     $ 440     $ 750  
   Charge-offs
    (104 )     -       -       (49 )     (15 )
   Recoveries
    13       -       -       -       -  
   Provisions
    (135 )     -       307       27       310  
Ending balance
  $ 585     $ -     $ 2,055     $ 418     $ 1,045  
                                         
           
Home equity
   
Other
                 
   
Municipal
   
and junior liens
   
consumer
   
Unallocated
   
Total
 
Allowance for loan losses:
                                       
Beginning Balance
  $ 2     $ 494     $ 168     $ 88     $ 4,501  
   Charge-offs
    -       (81 )     (39 )     -       (288 )
   Recoveries
    -       13       25       -       51  
   Provisions
    1       28       (19 )     81       600  
Ending balance
  $ 3     $ 454     $ 135     $ 169     $ 4,864  


 
- 22 -



   
For the three months ended June 30, 2012
 
   
1-4 family
                         
   
first-lien
   
Residential
               
Other
 
   
residential
   
construction
   
Commercial
   
Commercial
   
commercial
 
(In thousands)
 
mortgage
   
mortgage
   
real estate
   
lines of credit
   
and industrial
 
Allowance for loan losses:
                             
Beginning Balance
  $ 719     $ -     $ 1,465     $ 515     $ 719  
   Charge-offs
    (15 )     -       -       -       (46 )
   Recoveries
    1       -       -       50       -  
   Provisions
    72       -       122       (167 )     25  
Ending balance
  $ 777     $ -     $ 1,587     $ 398     $ 698  
Ending balance: related to loans
                                       
individually evaluated for impairment
    226       -       277       113       269  
Ending balance: related to loans
                                       
collectively evaluated for impairment
  $ 551     $ -     $ 1,310     $ 285     $ 429  
                                         
Loans receivables:
                                       
Ending balance
  $ 166,233     $ 2,495     $ 78,001     $ 13,223     $ 20,766  
Ending balance: individually
                                       
evaluated for impairment
    1,623       -       2,805       449       568  
Ending balance: collectively
                                       
evaluated for impairment
  $ 164,610     $ 2,495     $ 75,196     $ 12,774     $ 20,198  
                                         
                                         
           
Home equity
   
Other
                 
   
Municipal
   
and junior liens
   
Consumer
   
Unallocated
   
Total
 
Allowance for loan losses:
                                       
Beginning Balance
  $ 2     $ 495     $ 134     $ 63     $ 4,112  
   Charge-offs
    -       (8 )     (43 )     -       (112 )
   Recoveries
    -       3       9       -       63  
   Provisions
    -       11       31       56       150  
Ending balance
  $ 2     $ 501     $ 131     $ 119     $ 4,213  
Ending balance: related to loans
                                       
individually evaluated for impairment
    -       61       3       -       949  
Ending balance: related to loans
                                       
collectively evaluated for impairment
  $ 2     $ 440     $ 128     $ 119     $ 3,264  
                                         
Loans receivables:
                                       
Ending balance
  $ 4,086     $ 23,609     $ 3,644             $ 312,057  
Ending balance: individually
                                       
evaluated for impairment
    -       502       3               5,950  
Ending balance: collectively
                                       
evaluated for impairment
  $ 4,086     $ 23,107     $ 3,641             $ 306,107  


 
- 23 -




   
For the six months ended June 30, 2012
 
   
1-4 family
                         
   
first-lien
   
Residential
               
Other
 
   
residential
   
construction
   
Commercial
   
Commercial
   
commercial
 
(In thousands)
 
mortgage
   
mortgage
   
real estate
   
lines of credit
   
and industrial
 
Allowance for loan losses:
                             
Beginning Balance
  $ 664     $ -     $ 1,346     $ 463     $ 649  
   Charge-offs
    (35 )     -       (54 )     -       (89 )
   Recoveries
    29       -       14       50       -  
   Provisions
    119       -       281       (115 )     138  
Ending balance
  $ 777     $ -     $ 1,587     $ 398     $ 698  
                                         
                                         
           
Home equity
   
Other
                 
   
Municipal
   
and junior liens
   
Consumer
   
Unallocated
   
Total
 
Allowance for loan losses:
                                       
Beginning Balance
  $ 2     $ 501     $ 162     $ 193     $ 3,980  
   Charge-offs
    -       (8 )     (84 )     -       (270 )
   Recoveries
    -       5       30       -       128  
   Provisions
    -       3       23       (74 )     375  
Ending balance
  $ 2     $ 501     $ 131     $ 119     $ 4,213  



 
- 24 -


(8)  Guarantees

The Company does not issue any guarantees that would require liability recognition or disclosure, other than its standby letters of credit.  Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party.  Generally, all letters of credit when issued have expiration dates within one year of issuance.  The credit risk involved in issuing letters of credit is essentially the same as those that are involved in extending loan facilities to customers.  The Company generally holds collateral and/or personal guarantees supporting these commitments.  The Company had $1.5 million of standby letters of credit outstanding as of June 30, 2013.  Management believes that the proceeds obtained through a liquidation of collateral and the enforcement of guarantees would be sufficient to cover the potential amount of future payments required under the corresponding guarantees.   The fair value of standby letters of credit was not significant to the Company’s consolidated financial statements.

(9)  Fair Value Measurements

Accounting guidance related to fair value measurements and disclosures specifies a hierarchy of valuation techniques based on whether the inputs to those valuation techniques are observable or unobservable. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect the Company’s market assumptions. These two types of inputs have created the following fair value hierarchy:

Level 1 – Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.

Level 2 – Quoted prices for similar assets and liabilities in active markets; quoted prices for identical or similar assets or liabilities in markets that are not active; and model-derived valuations in which all significant inputs and significant value drivers are observable in active markets.

Level 3 – Model-derived valuations in which one or more significant inputs or significant value drivers are unobservable.

An asset’s or liability’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement.

In determining fair value, the Company utilizes valuation techniques that maximize the use of observable inputs, minimize the use of unobservable inputs, to the extent possible, and considers counterparty credit risk in its assessment of fair value.

The Company used the following methods and significant assumptions to estimate fair value:

Investment securities:  The fair values of securities available for sale are obtained from an independent third party and are based on quoted prices on nationally recognized exchange where available (Level 1).  If quoted prices are not available, fair values are measured by utilizing matrix pricing, which is a mathematical technique used widely in the industry to value debt securities without relying exclusively on quoted prices for specific securities but rather by relying on the securities’ relationship to other benchmark quoted securities (Level 2).  Management made no adjustment to the fair value quotes that were received from the independent third party pricing service.

Interest rate swap derivative:  The fair value of the interest rate swap derivative is calculated based on a discounted cash flow model. All future floating cash flows are projected and both floating and fixed cash flows are discounted to the valuation date.  The curve utilized for discounting and projecting is built by obtaining publicly available third party market quotes for various swap maturity terms.

Impaired loans: Impaired loans are those loans in which the Company has measured impairment generally based on the fair value of the loan’s collateral.  Fair value is generally determined based upon market value evaluations by third parties of the properties and/or estimates by management of working capital collateral or discounted cash flows based upon expected proceeds.  These appraisals may include up to three approaches to value: the sales comparison approach, the income approach (for income-producing property), and the cost approach.  Management modifies the appraised values, if needed, to take into account recent developments in the market or other factors, such as, changes in absorption rates or market conditions from the time of valuation and anticipated sales values considering management’s plans for disposition.  Such modifications to the appraised values could result in lower valuations of such collateral. Estimated costs to sell are based on current amounts of disposal costs for similar assets.  These measurements are classified as Level 3 within the valuation hierarchy. Impaired loans are subject to nonrecurring fair value adjustment upon initial recognition or subsequent impairment.  A portion of the allowance for loan losses is allocated to impaired loans if the value of such loans is deemed to be less than the unpaid balance.

 
- 25 -

Foreclosed real estate:  Fair values for foreclosed real estate are initially recorded based on market value evaluations by third parties, less costs to sell (“initial cost basis”).  Any write-downs required when the related loan receivable is exchanged for the underlying real estate collateral at the time of transfer to foreclosed real estate are charged to the allowance for loan losses.  Values are derived from appraisals, similar to impaired loans, of underlying collateral or discounted cash flow analysis.  Subsequent to foreclosure, valuations are updated periodically and assets are marked to current fair value, not to exceed the initial cost basis.  In the determination of fair value subsequent to foreclosure, management also considers other factors or recent developments, such as, changes in absorption rates and market conditions from the time of valuation and anticipated sales values considering management’s plans for disposition.  Either change could result in adjustment to lower the property value estimates indicated in the appraisals.  These measurements are classified as Level 3 within the fair value hierarchy.

The following tables summarize assets measured at fair value on a recurring basis as of the indicated dates, segregated by the level of valuation inputs within the hierarchy utilized to measure fair value:

   
June 30, 2013
 
                     
Total Fair
 
(In thousands)
 
Level 1
   
Level 2
   
Level 3
   
Value
 
Debt investment securities:
                       
US Treasury, agencies and GSEs
  $ -     $ 18,469     $ -     $ 18,469  
State and political subdivisions
    -       26,140       -       26,140  
Corporate
    -       20,572       -       20,572  
Residential mortgage-backed - US agency
    -       50,816       -       50,816  
Residential mortgage-backed - private label
    -       -       -       -  
Equity investment securities:
                               
Mutual funds:
                               
Ultra short mortgage fund
    1,275       -       -       1,275  
Large cap equity fund
    1,245       -       -       1,245  
Other mutual funds
    -       332       -       332  
Common stock - financial services industry
    35       381       -       416  
Total investment securities
  $ 2,555     $ 116,710     $ -     $ 119,265  
                                 
Interest rate swap derivative
  $ -     $ (152 )   $ -     $ (152 )





 
- 26 -



   
December 31, 2012
 
                     
Total Fair
 
(In thousands)
 
Level 1
   
Level 2
   
Level 3
   
Value
 
Debt investment securities:
                       
US Treasury, agencies and GSEs
  $ -     $ 6,183     $ -     $ 6,183  
State and political subdivisions
    -       27,471       -       27,471  
Corporate
    -       23,006       -       23,006  
Residential mortgage-backed - US agency
    -       48,251       -       48,251  
Residential mortgage-backed - private label
    -       305       -       305  
Equity investment securities:
                               
Mutual funds:
                               
Ultra short mortgage fund
    1,291       -       -       1,291  
Large cap equity fund
    1,081       -       -       1,081  
Other mutual funds
    -       319       -       319  
Common stock - financial services industry
    33       399       -       432  
Total investment securities
  $ 2,405     $ 105,934     $ -     $ 108,339  
                                 
Interest rate swap derivative
  $ -     $ (195 )   $ -     $ (195 )


The Bank had the following assets measured at fair value on a nonrecurring basis as of June 30, 2013 and December 31, 2012:

   
June 30, 2013
 
                     
Total Fair
 
(In thousands)
 
Level 1
   
Level 2
   
Level 3
   
Value
 
 Impaired loans
  $ -     $ -     $ 995     $ 995  
                                 
                                 
   
December 31, 2012
 
                           
Total Fair
 
(In thousands)
 
Level 1
   
Level 2
   
Level 3
   
Value
 
 Impaired loans
  $ -     $ -     $ 1,951     $ 1,951  
 Foreclosed real estate
  $ -     $ -     $ 301     $ 301  


The following table presents additional quantitative information about assets measured at fair value on a nonrecurring basis and for which Level 3 inputs were used to determine fair value at the indicated dates.

   
Quantitative Information about Level 3 Fair Value Measurements
     
 
Valuation
Unobservable
 
         Range
 
 
Techniques
Input
 
      (Weighted Avg.)
 
 June 30, 2013
         
Impaired loans
Appraisal of collateral
Appraisal Adjustments
    5% - 30%(18%)  
   
Costs to Sell
    6% - 50%(13%)  
             
             
             
             


 
- 27 -




   
Quantitative Information about Level 3 Fair Value Measurements
     
 
Valuation
Unobservable
 
Range
 
 
Techniques
Input
 
(Weighted Avg.)
 
December 31, 2012
         
Impaired loans
Appraisal of collateral
Appraisal Adjustments
    5% - 30% (21%)  
   
Costs to Sell
    6% - 15% (12%)  
             
Foreclosed real estate
Appraisal of collateral
Appraisal Adjustments
    15% - 15% (15%)  
   
Costs to Sell
    6% - 7%   (6%)  
             

There have been no transfers of assets in or out of any fair value measurement level.

Required disclosures include fair value information of financial instruments, whether or not recognized in the consolidated statement of condition, for which it is practicable to estimate that value.  In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in immediate settlement of the instrument.

The Company has various processes and controls in place to ensure that fair value is reasonably estimated. A model validation policy governs the use and control of valuation models used to estimate fair value. This policy requires review and approval of models by personnel who are independent of the front office, and periodic reassessments of models to ensure that they are continuing to perform as designed. In addition, detailed reviews of trading gains and losses are conducted by personnel who are independent of the front office. A price verification group, which is also independent of the front office, utilizes available market information including executed trades, market prices and market-observable valuation model inputs to ensure that fair values are reasonably estimated. The Company performs due diligence procedures over third-party pricing service providers in order to support their use in the valuation process. Where market information is not available to support internal valuations, independent reviews of the valuations are performed and any material exposures are escalated through a management review process.
 
While the Company believes its valuation methods are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date.

Management uses its best judgment in estimating the fair value of the Company’s financial instruments; however, there are inherent weaknesses in any estimation technique.  Therefore, for substantially all financial instruments, the fair value estimates herein are not necessarily indicative of the amounts the Company could have realized in a sales transaction on the dates indicated.  The estimated fair value amounts have been measured as of their respective period-ends, and have not been re-evaluated or updated for purposes of these financial statements subsequent to those respective dates.  As such, the estimated fair values of these financial instruments subsequent to the respective reporting dates may be different than the amounts reported at each period-end.

The following information should not be interpreted as an estimate of the fair value of the entire Company since a fair value calculation is only provided for a limited portion of the Company’s assets and liabilities.  Due to a wide range of valuation techniques and the degree of subjectivity used in making the estimates, comparisons between the Company’s disclosures and those of other companies may not be meaningful.  The Company, in estimating its fair value disclosures for financial instruments, used the following methods and assumptions:

 
 
- 28 -

Cash and cash equivalents – The carrying amounts of these assets approximate their fair value and are classified as Level 1.

Interest earning time deposits – The carrying amounts of these assets approximate their fair value.

Investment securities – The fair values of securities available for sale are obtained from an independent third party and are based on quoted prices on nationally recognized exchange where available (Level 1).  If quoted prices are not available, fair values are measured by utilizing matrix pricing, which is a mathematical technique used widely in the industry to value debt securities without relying exclusively on quoted prices for specific securities, but rather by relying on the securities’ relationship to other benchmark quoted securities (Level 2).  Management made no adjustment to the fair value quotes that were received from the independent third party pricing service.

Federal Home Loan Bank stock – The carrying amount of these assets approximates their fair value.

Net loans – For variable-rate loans that re-price frequently, fair value is based on carrying amounts.  The fair value of other loans (for example, fixed-rate commercial real estate loans, mortgage loans, and commercial and industrial loans) is estimated using discounted cash flow analysis, based on interest rates currently being offered in the market for loans with similar terms to borrowers of similar credit quality.  Loan value estimates include judgments based on expected prepayment rates.  The measurement of the fair value of loans, including impaired loans, is classified within Level 3 of the fair value hierarchy.
 
 
Accrued interest receivable and payable – The carrying amount of these assets approximates their fair value and are classified as Level 1.

Deposits – The fair values disclosed for demand deposits (e.g., interest-bearing and noninterest-bearing checking, passbook savings and certain types of money management accounts) are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amounts) and are classified within Level 1 of the fair value hierarchy.  Fair values for fixed-rate certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered in the market on certificates of deposits to a schedule of aggregated expected monthly maturities on time deposits.  Measurements of the fair value of time deposits are classified within Level 2 of the fair value hierarchy.

Borrowings – Fixed/variable term “bullet” structures are valued using a replacement cost of funds approach.  These borrowings are discounted to the FHLBNY advance curve.  Option structured borrowings’ fair values are determined by the FHLB for borrowings that include a call or conversion option.  If market pricing is not available from this source, current market indications from the FHLBNY are obtained and the borrowings are discounted to the FHLBNY advance curve less an appropriate spread to adjust for the option. These measurements are classified as Level 2 within the fair value hierarchy.

Junior subordinated debentures – Current economic conditions have rendered the market for this liability inactive.  As such, the Company was formerly unable to determine a good estimate of fair value, resulting in a Level 3 classification at December 31, 2012.  As of June 30, 2013, the Company was able to secure a quote from its pricing service based on a DCF methodology which resulted in a Level 2 classification for this borrowing.

Interest rate swap derivative – The fair value of the interest rate swap derivative is obtained from a third party pricing agent and is calculated based on a discounted cash flow model. All future floating cash flows are projected and both floating and fixed cash flows are discounted to the valuation date.  The curve utilized for discounting and projecting is built by obtaining publicly available third party market quotes for various swap maturity terms, and therefore is classified within Level 2 of the fair value hierarchy.

 
- 29 -




The carrying amounts and fair values of the Company’s financial instruments as of the indicated dates are presented in the following table:
         
June 30, 2013
   
December 31, 2012
 
   
Fair Value
   
Carrying
   
Estimated
   
Carrying
   
Estimated
 
(Dollars In thousands)
 
Hierarchy
   
Amounts
   
Fair Values
   
Amounts
   
Fair Values
 
Financial assets:
                             
Cash and cash equivalents
    1     $ 10,028     $ 10,028     $ 8,665     $ 8,665  
Interest earning time deposits
    1       1,500       1,500       2,000       2,000  
Investment securities
    1       2,555       2,555       2,405       2,405  
Investment securities
    2       116,710       116,710       105,934       105,934  
Federal Home Loan Bank stock
    2       2,645       2,645       1,929       1,929  
Net loans
    3       332,736       338,741       329,247       341,389  
Accrued interest receivable
    1       1,799       1,799       1,717       1,717  
                                         
Financial liabilities:
                                       
Demand Deposits, Savings, NOW and MMDA
    1     $ 247,203     $ 247,203     $ 228,484     $ 228,484  
Time Deposits
    2       153,176       154,167       163,321       165,491  
Borrowings
    2       44,768       45,293       34,964       36,054  
Junior subordinated debentures
    2       5,155       4,415       -       -  
Junior subordinated debentures
    3       -       -       5,155       5,155  
Accrued interest payable
    1       68       68       140       140  
Interest rate swap derivative
    2       152       152       195       195  

(10)  Interest Rate Derivatives

Derivative instruments are entered into primarily as a risk management tool of the Company.  Financial derivatives are recorded at fair value as other assets and other liabilities.  The accounting for changes in the fair value of a derivative depends on whether it has been designated and qualifies as part of a hedging relationship. For a fair value hedge, changes in the fair value of the derivative instrument and changes in the fair value of the hedged asset or liability are recognized currently in earnings.  For a cash flow hedge, changes in the fair value of the derivative instrument, to the extent that it is effective, are recorded in other comprehensive income and subsequently reclassified to earnings as the hedged transaction impacts net income.  Any ineffective portion of a cash flow hedge is recognized currently in earnings.  See Note 9 for further discussion of the fair value of the interest rate derivative.

The Company has $5 million of floating rate trust preferred debt indexed to 3-month LIBOR.  As a result, it is exposed to variability in cash flows related to changes in projected interest payments caused by changes in the benchmark interest rate.  During the fourth quarter of fiscal 2009, the Company entered into an interest rate swap agreement, with a $2 million notional amount, to convert a portion of the variable-rate junior subordinated debentures to a fixed rate for a term of approximately 7 years at a rate of 4.96%.  The derivative is designated as a cash flow hedge.  The hedging strategy ensures that changes in cash flows from the derivative will be highly effective at offsetting changes in interest expense from the hedged exposure.

The following table summarizes the fair value of the outstanding derivative and its presentation on the statements of condition:

     
June 30,
   
December 31,
 
 (In thousands)
   
2013
   
2012
 
 Cash flow hedge:
             
 
 Other liabilities
  $ 152     $ 195  


 
- 30 -

The change in accumulated other comprehensive loss on a pretax basis and the impact on earnings from the interest rate swap that qualifies as a cash flow hedge for the periods indicated below were as follows:

   
Three Months Ended June 30,
 
(In thousands)
 
2013
   
2012
 
Balance as of March 31:
  $ (180 )   $ (194 )
Amount of gains (losses) recognized in other comprehensive income
    13       (27 )
Amount of loss reclassified from other comprehensive income
               
     and recognized as interest expense
    15       16  
Balance as of June 30:
  $ (152 )   $ (205 )
                 
                 
   
Six Months Ended June 30,
 
(In thousands)
    2013       2012  
Balance as of December 31:
  $ (195 )   $ (200 )
Amount of gains (losses) recognized in other comprehensive income
    13       (35 )
Amount of loss reclassified from other comprehensive income
               
     and recognized as interest expense
    30       30  
Balance as of June 30:
  $ (152 )   $ (205 )


No amount of ineffectiveness has been included in earnings and the changes in fair value have been recorded in other comprehensive income.  Some, or all, of the amount included in accumulated other comprehensive loss would be reclassified into current earnings should a portion of, or the entire hedge no longer be considered effective, but at this time, management expects the hedge to remain fully effective during the remaining term of the swap.

The Company posted cash, of $200,000, under arrangements to satisfy collateral requirements associated with the interest rate swap contract.

 
- 31 -



(11)  Accumulated Other Comprehensive Income (Loss)

Changes in the components of accumulated other comprehensive income (loss) (“AOCI”), net of tax, for the periods indicated are summarized in the table below.
 

   
For the three months ended June 30, 2013
   
For the six months ended June 30, 2013
 
   
Retirement Plans
   
Unrealized Gains and Losses on Financial Derivative
   
Unrealized Gains and Losses on Available-for-Sale Securities
   
Total
   
Retirement Plans
   
Unrealized Gains and Losses on Financial Derivative
   
Unrealized Gains and Losses on Available-for-Sale Securities
   
Total
 
Beginning balance
  $ (2,708 )   $ (108 )   $ 1,316     $ (1,500 )   $ (2,765 )   $ (117 )   $ 1,564     $ (1,318 )
Other comprehensive income
                                                               
    (loss) before reclassifications
    -       8       (1,753 )     (1,745 )     -       8       (1,978 )     (1,970 )
Amounts reclassified from AOCI
    57       9       (36 )     30       114       18       (59 )     73  
Ending balance
  $ (2,651 )   $ (91 )   $ (473 )   $ (3,215 )   $ (2,651 )   $ (91 )   $ (473 )   $ (3,215 )
                                                                 
   
For the three months ended June 30, 2012
   
For the six months ended June 30, 2012
 
   
Retirement Plans
   
Unrealized Gains and Losses on Financial derivative
   
Unrealized Gains and Losses on Available-for-Sale Securities
   
Total
   
Retirement Plans
   
Unrealized Gains and Losses on Financial derivative
   
Unrealized Gains and Losses on Available-for-Sale Securities
   
Total
 
Beginning balance
  $ (3,536 )   $ (117 )   $ 1,106     $ (2,547 )   $ (3,617 )   $ (120 )   $ 1,073     $ (2,664 )
Other comprehensive income
                                                               
   (loss) before reclassifications
    1,151       (16 )     269       1,404       1,151       (21 )     367       1,497  
Amounts reclassified from AOCI
    63       9       (31 )     41       144       17       (96 )     65  
Ending balance
  $ (2,322 )   $ (124 )   $ 1,344     $ (1,102 )   $ (2,322 )   $ (124 )   $ 1,344     $ (1,102 )





 
- 32 -



The following table presents the amounts reclassified out of each component of AOCI for the indicated period:

   
For the three months ended June 30, 2013
 
For the six months ended June 30, 2013
Details about AOCI components
 
Amount Reclassified from AOCI1
 
Affected Line Item in the Statement  of Income
 
Amount Reclassified from AOCI1
 
Affected Line Item in the Statement  of  Income
                 
Unrealized holding gain on financial derivative:
               
Reclassification adjustment for
               
   interest expense included in net income
  $ (15 )
 Interest on long term liabilities
  $ (30 )
 Interest on long term liabilities
      6  
 Provision for income taxes
    12  
 Provision for income taxes
    $ (9 )
 Net Income
  $ (18 )
 Net Income
Retirement plan items
                   
Retirement plan net losses
                   
   recognized in plan expenses2
  $ (95 )
 Salaries and employee benefits
  $ (190 )
 Salaries and employee benefits
      38  
 Provision for income taxes
    76  
 Provision for income taxes
    $ (57 )
 Net Income
  $ (114 )
 Net Income
                     
Available-for-sale securities
                   
Realized gain on sale of securities
  $ (60 )
Net gains on sales and redemptions of investment securities
  $ (99 )
Net gains on sales and redemptions of investment securities
      24  
 Provision for income taxes
    40  
 Provision for income taxes
    $ (36 )
 Net Income
  $ (59 )
 Net Income
                     
1 Amounts in parentheses indicates debits in net income.
             
2 These items are included in net periodic pension cost.
             
See Note 5 for additional information.
             




 
- 33 -


Item 2 - Management's Discussion and Analysis of Financial Condition and Results of Operations (Unaudited)

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., Pathfinder Risk Management, Inc., and Whispering Oaks Development Corp. are wholly owned subsidiaries of Pathfinder Bank.  At June 30, 2013, 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 60.5% of the Company’s outstanding common stock and public shareholders, including shares held by the Employee Stock Ownership Plan (“ESOP”), held the remaining 39.5% of the outstanding common stock.

The following discussion reviews the Company's financial condition at June 30, 2013 and the results of operations for the three and six months ended June 30, 2013 and 2012.

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 consolidated financial statements and accompanying notes.  These estimates, assumptions, and judgments are based on information available as of the date of the financial statements; accordingly, as this information changes, the financial statements could reflect different estimates, assumptions, and judgments.  Certain policies inherently have a greater reliance on the use of estimates, assumptions, and judgments and as such have a greater possibility of producing results that could be materially different than originally reported.  Estimates, assumptions, and judgments are necessary when assets and liabilities are required to be recorded at fair value or when an asset or liability needs to be recorded contingent upon a future event.  Carrying assets and liabilities at fair value inherently results in more financial statement volatility.  The fair values and information used to record valuation adjustments for certain assets and liabilities are based on quoted market prices or are provided by other third-party sources, when available.  When third party information is not available, valuation adjustments are estimated in good faith by management.

The most significant accounting policies followed by the Company are presented in Note 1 to the annual audited consolidated financial statements included in the 2012 Annual Report filed on form 10-K on March 18, 2013 (“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.  These areas could be the most subject to revision as new information becomes available.
 

 
 
- 34 -

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 on 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 Company establishes a specific allowance for all commercial loans in excess of the total related credit threshold of $100,000 and single borrower residential mortgage loans in excess of the total related credit threshold of $300,000 identified as being impaired which are on nonaccrual and have been risk rated under the Company’s risk rating system as substandard, doubtful, or loss. In addition, an accruing substandard loan could be identified as being impaired.  The measurement of impaired loans is generally based upon the present value of future cash flows discounted at the historical effective interest rate, except that all collateral-dependent loans are measured for impairment based on the fair value of the collateral, less costs to sell.  The majority of the Company’s impaired loans are collateral-dependent.  For all other loans and leases, the Company uses the general allocation methodology that establishes an allowance to estimate the probable incurred loss for each risk-rating category.  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.  This is attributable to the 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 affect 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.  If current available evidence about the future raises doubt about the likelihood of a deferred tax asset being realized, a valuation allowance is established.  The judgment about the level of future taxable income, including that which is considered capital, is inherently subjective and is reviewed on a continual basis as regulatory and business factors change.  A valuation allowance of $462,000 was maintained at June 30, 2013, as management believes it may not generate sufficient capital gains to offset its capital loss carry forward.  The Company’s effective tax rate differs from the statutory rate due primarily to non-taxable income from investment securities and bank owned life insurance.
 
 
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, and the length of time the Company will have to provide those benefits.  The assumptions used by management are discussed in Note 12 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 and included in accumulated other comprehensive income (loss), except for the credit-related portion of debt security impairment losses and other-than-temporary impairment (“OTTI”) of equity securities 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 debt 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) if the present value of expected cash flows is not sufficient to recover the entire amortized cost basis.  In determining whether OTTI has occurred for equity securities the Company considers the applicable factors described above and the length of time the equity security’s fair value has been below the carrying amount.  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.

 
- 35 -

The estimation of fair value is significant to several of our assets; including investment securities available for sale, the interest rate derivative, intangible assets, foreclosed real estate, and 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 on our available-for-sale securities 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 evaluations by third parties, less estimated costs to sell.  When necessary, appraisals are updated to reflect changes in market conditions.

Recent Events

As reported by the Company on its Form 10-K filed on March 29, 2012, the purchase of the 51% controlling interest in the Fitzgibbons Agency, pending the completion of the final stages of due diligence, was expected to close in the early part of the second quarter of 2012.  The Company and the Fitzgibbons Agency are addressing the final elements of the transaction and are working to expedite a closing at the earliest possible time.

Overview and Results of Operations

For the second quarter of 2013, net income was $823,000 as compared to $721,000 for the second quarter of 2012 due principally to an increase in net interest income and noninterest income, the latter stemming from the gain on the portfolio sale of approximately $8.8 million in longer term and lower yielding residential loans. Partially offsetting these increases in net income was an increase in the provision for loan losses and an increase in noninterest expense.

For the first half of 2013, net income was $1.3 million as compared to $1.2 million for the comparable prior year period.  The improvement was due to an increase in net interest income and the above mentioned residential loan sale, partially offset by an increase in the provision for loan losses and an increase in noninterest expense between the comparable six month periods.

The Company’s return on average assets and return on average equity for the second quarter of 2013 were 0.66% and 7.93%, respectively, as compared to 0.62% and 7.49% for the same prior year period.  Return on average assets and return on average equity for the first half of 2013 were 0.53% and 6.43%, respectively, as compared to 0.54% and 6.50% for the same prior year period.

Average assets for the second quarter of 2013 were $502.3 million, or 7.3% greater than the comparable prior year period.  The increase was attributable to increases in residential real estate loans, commercial loans, commercial real estate loans, and to a lesser extent, tax-exempt securities.  Average balances of commercial real estate loans increased $13.7 million or 18.6% and commercial loans increased $13.4 million or 33.8% between these same periods in direct support of the Company’s initiative to diversify its portfolio and increase its penetration within the commercial segments.  Additionally, average balances of real estate residential loans increased $8.2 million, or 4.9%, between these same two time periods.

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.

 
- 36 -

The following table sets forth information concerning average interest-earning assets and interest-bearing liabilities and the yields and rates thereon for the periods indicated. Interest income and resultant yield information in the table is on a fully tax-equivalent basis using marginal federal income tax rates of 34%. Averages are computed on the daily average balance for each month in the period divided by the number of days in the period. Yields and amounts earned include loan fees. Nonaccrual loans have been included in interest-earning assets for purposes of these calculations.

   
For the three months Ended June 30,
 
   
2013
   
2012
 
               
Average
               
Average
 
 
 
Average
         
Yield /
   
Average
         
Yield /
 
(Dollars in thousands)
 
Balance
   
Interest
   
Cost
   
Balance
   
Interest
   
Cost
 
Interest-earning assets:
 
 
               
 
             
Real estate loans residential
  $ 174,625     $ 1,978       4.53 %   $ 166,447     $ 2,046       4.92 %
Real estate loans commercial
    87,475       1,169       5.35 %     73,769       1,094       5.93 %
Commercial loans
    53,148       622       4.68 %     39,725       458       4.61 %
Consumer loans
    25,244       359       5.69 %     27,474       390       5.68 %
Taxable investment securities
    97,518       423       1.74 %     102,395       514       2.01 %
Tax-exempt investment securities
    25,653       284       4.43 %     23,273       275       4.73 %
Interest-earning time deposit
    1,821       5       1.10 %     2,000       6       1.20 %
Interest-earning deposits
    5,571       2       0.14 %     951       1       0.42 %
Total interest-earning assets
    471,055       4,842       4.11 %     436,034       4,784       4.39 %
Noninterest-earning assets:
                                               
Other assets
    33,811                       34,086                  
Allowance for loan losses
    (4,756 )                     (4,160 )                
Net unrealized gains
                                               
on available for sale securities
    2,235                       2,279                  
Total assets
  $ 502,345                     $ 468,239                  
Interest-bearing liabilities:
                                               
NOW accounts
  $ 40,441       20       0.20 %   $ 30,672       19       0.25 %
Money management accounts
    14,374       7       0.19 %     14,958       12       0.32 %
MMDA accounts
    81,106       87       0.43 %     81,257       109       0.54 %
Savings and club accounts
    69,595       13       0.07 %     64,179       13       0.08 %
Time deposits
    165,688       502       1.21 %     158,316       583       1.47 %
Junior subordinated debentures
    5,155       41       3.18 %     5,155       44       3.41 %
Borrowings
    31,344       163       2.08 %     30,780       217       2.81 %
Total interest-bearing liabilities
    407,703       833       0.82 %     385,317       997       1.03 %
Noninterest-bearing liabilities:
                                               
Demand deposits
    48,821                       40,079                  
Other liabilities
    4,286                       4,338                  
Total liabilities
    460,810                       429,734                  
Shareholders' equity
    41,535                       38,505                  
Total liabilities & shareholders' equity
  $ 502,345                     $ 468,239                  
Net interest income
          $ 4,009                     $ 3,787          
Net interest rate spread
                    3.29 %                     3.36 %
Net interest margin
                    3.40 %                     3.47 %
Ratio of average interest-earning assets
                                               
to average interest-bearing liabilities
                    115.54 %                     113.16 %
 
 
 
- 37 -


 
   
For the six months Ended June 30,
 
   
2013
   
2012
 
               
Average
               
Average
 
 
 
Average
         
Yield /
   
Average
         
Yield /
 
(Dollars in thousands)
 
Balance
   
Interest
   
Cost
   
Balance
   
Interest
   
Cost
 
Interest-earning assets:
 
 
               
 
             
Real estate loans residential
  $ 176,270     $ 4,037       4.58 %   $ 164,765     $ 4,117       5.00 %
Real estate loans commercial
    84,728       2,278       5.38 %     73,253       2,133       5.82 %
Commercial loans
    52,151       1,230       4.72 %     39,780       969       4.87 %
Consumer loans
    25,291       718       5.68 %     27,713       788       5.69 %
Taxable investment securities
    95,681       842       1.76 %     98,095       1,005       2.05 %
Tax-exempt investment securities
    25,815       573       4.44 %     21,807       521       4.78 %
Interest-earning time deposit
    1,910       11       1.15 %     2,000       12       1.20 %
Interest-earning deposits
    6,340       3       0.09 %     1,122       2       0.36 %
Total interest-earning assets
    468,186       9,692       4.14 %     428,535       9,547       4.46 %
Noninterest-earning assets:
                                               
Other assets
    33,329                       34,297                  
Allowance for loan losses
    (4,654 )                     (4,101 )                
Net unrealized gains
                                               
on available for sale securities
    2,379                       2,220                  
Total assets
  $ 499,240                     $ 460,951                  
Interest-bearing liabilities:
                                               
NOW accounts
  $ 39,901       38       0.19 %   $ 30,972       38       0.25 %
Money management accounts
    14,409       16       0.22 %     14,668       26       0.35 %
MMDA accounts
    81,156       183       0.45 %     79,233       223       0.56 %
Savings and club accounts
    68,737       27       0.08 %     63,228       28       0.09 %
Time deposits
    164,923       1,024       1.24 %     156,631       1,182       1.51 %
Junior subordinated debentures
    5,155       81       3.14 %     5,155       86       3.34 %
Borrowings
    31,887       361       2.26 %     29,178       429       2.94 %
Total interest-bearing liabilities
    406,168       1,730       0.85 %     379,065       2,012       1.06 %
Noninterest-bearing liabilities:
                                               
Demand deposits
    47,799                       39,520                  
Other liabilities
    3,960                       3,956                  
Total liabilities
    457,927                       422,541                  
Shareholders' equity
    41,313                       38,410                  
Total liabilities & shareholders' equity
  $ 499,240                     $ 460,951                  
Net interest income
          $ 7,962                     $ 7,535          
Net interest rate spread
                    3.29 %                     3.40 %
Net interest margin
                    3.40 %                     3.52 %
Ratio of average interest-earning assets
                                               
to average interest-bearing liabilities
                    115.27 %                     113.05 %










 
- 38 -


Net interest income, on a tax-equivalent basis, increased to $4.0 million for the three months ended June 30, 2013, from $3.8 million for the three months ended June 30, 2012.  This was principally due to a decrease in interest expense and, to a lesser extent, an increase in interest income reflecting increases in average balances of the loan portfolio. The largest increases in earning assets were within real estate residential loans and commercial loans as the Company continued to experience strong loan demand within its marketplace.  Net interest margin, however, contracted to 3.40% from 3.47% reflecting the lower yields obtained from our interest earning assets which recorded a greater decline than the rates paid on interest-bearing liabilities.

As indicated in the three month table above and in the rate/volume analysis below, total interest income on a tax-equivalent basis increased $59,000 due principally to an increase in average balances of both commercial loan products, partially offset by reductions in the yield for the real estate commercial and residential loan products.  The yield on most classes of interest earning asset products decreased, with the most significant yield decrease reported in commercial real estate loans and residential real estate loans. For both of these products, yields decreased due to maturing loans and payoffs being replaced with those of lower rates reflecting current market conditions.  Average balances of commercial loans reported the largest relative increase while also reporting a nominal increase in yield.  The average yield on tax-exempt investment securities continues to be significantly greater than taxable investment securities during the second quarter of 2013, but significantly declined in second quarter year over year yields as management elected to reduce the duration of securities within this portfolio.

Interest expense decreased $164,000 between year over year second quarter periods, as indicated in the above three month table.  The primary reason for the decline was lower rates paid on time deposits as higher cost maturing certificates of deposit were replaced with lower cost certificates of deposits at current market rates in addition to increased average balances of brokered deposits at shorter maturities which command lower market rates.  Secondly, interest expense on money market deposit accounts declined as the Company was able to gather an increase in average balances of these short term deposit accounts at lower rates and in support of consumers’ desire to invest in short term products.  Customers are largely opting to replace their higher rate maturing certificates of deposit with either one year certificates of deposit at the current lower market rate or money market deposit accounts at the current low market rate to preserve their liquidity in anticipation of potentially rising future market rates.  Lastly, interest expense on borrowings, largely composed of FHLBNY long term advances, declined as higher rate maturing advances were replaced with borrowings at current lower market rates.

Referencing the above six month table and the rate/volume analysis below for the six month period ended June 30, 2013 as compared to the same prior year period, net interest income improved $427,000 driven primarily by the reduction in reduced interest expense from lower rates paid on certificates of deposit, reduced borrowing costs on replaced FHLBNY long term advances, and lower rates paid on money market deposit accounts.  In addition, interest income increased due principally to an increase in average balances of commercial real estate and commercial loan products, despite lower yields recorded within each of these loan products.  The Company continues to expand its commercial portfolio in our effort to improve diversification within our earning assets.


 
- 39 -


Rate/Volume Analysis

Net interest income can also be analyzed in terms of the impact of changing interest rates on interest-earning assets and interest-bearing liabilities and changes in the volume or amount of these assets and liabilities. The following table represents the extent to which changes in interest rates and changes in the volume of interest-earning assets and interest-bearing liabilities have affected the Company’s interest income and interest expense during the periods indicated. Information is provided in each category with respect to: (i) changes attributable to changes in volume (change in volume multiplied by prior rate); (ii) changes attributable to changes in rate (changes in rate multiplied by prior volume); and (iii) total increase or decrease.  Changes attributable to both rate and volume have been allocated ratably.

   
Three Months Ended June 30
   
Six Months Ended June 30
 
   
2013 vs. 2012
   
2013 vs. 2012
 
   
Increase/(Decrease) Due to
   
Increase/(Decrease) Due to
 
               
Total
               
Total
 
               
Increase
               
Increase
 
(In thousands)
 
Volume
   
Rate
   
(Decrease)
   
Volume
   
Rate
   
(Decrease)
 
Interest Income:
 
 
               
 
             
Real estate loans residential
  $ 470     $ (538 )   $ (68 )   $ 591     $ (671 )   $ (80 )
Real estate loans commercial
    612       (537 )     75       534       (389 )     145  
Commercial loans
    156       7       163       347       (87 )     260  
Consumer loans
    (35 )     4       (31 )     (68 )     (2 )     (70 )
Taxable investment securities
    (23 )     (66 )     (89 )     (24 )     (139 )     (163 )
Tax-exempt investment securities
    92       (83 )     9       144       (92 )     52  
Interest-earning time deposits
    -       -       -       -       -       -  
Interest-earning deposits
    5       (5 )     -       6       (5 )     1  
Total interest income
    1,277       (1,218 )     59       1,530       (1,385 )     145  
Interest Expense:
                                               
NOW accounts
    19       (19 )     -       20       (20 )     -  
Money management accounts
    -       (5 )     (5 )     -       (9 )     (9 )
MMDA accounts
    -       (22 )     (22 )     15       (55 )     (40 )
Savings and club accounts
    4       (3 )     1       5       (6 )     (1 )
Time deposits
    154       (234 )     (80 )     156       (315 )     (159 )
Junior subordinated debentures
    -       (3 )     (3 )     -       (5 )     (5 )
Borrowings
    26       (80 )     (54 )     94       (162 )     (68 )
Total interest expense
    203       (366 )     (163 )     290       (572 )     (282 )
Net change in net interest income
  $ 1,074     $ (852 )   $ 222     $ 1,240     $ (813 )   $ 427  


Provision for Loan Losses

The provision for loan losses represents management’s estimate of the amount necessary to maintain the allowance for loan losses at an adequate level.  The Company recorded $276,000 in provision for loan losses for the three-month period ended June 30, 2013, as compared to $150,000 for the three-month period ended June 30, 2012.  This increase was due primarily to the specific reserve required from the addition of a large commercial relationship newly categorized as impaired in the first quarter of 2013 and net charge-offs of $98,000 recorded in the second quarter of 2013 as compared to $50,000 in net charge-offs recorded in the same prior year period. An additional reason for the increased provision is the higher level of recent historical loss rates that determined the need for the current level of the allowance. The provision for loan losses for the six month period ended June 30, 2013 was $600,000 as compared to $375,000 for the same prior year period.


 
- 40 -

Delinquency trends improved in total across all product segments between December 31, 2012 and June 30, 2013 with the most notable improvements reported within the residential loan and consumer loan portfolios.  Within the commercial loan product segment, however, there has been a significant shift to the 90 days and over category for the commercial real estate class and an increase in both the 30-59 days past due and the 60-89 days past due for the other commercial and industrial loan class.  Management reviews trends in historical loss rates and environmental factors on a quarterly basis, in addition to assessing the specific allowance needs on impaired loans, and judges the current level of allowance for loan losses to be adequate to absorb the estimable and probable losses inherent in the loan portfolio.

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 periods indicated:

   
Three Months Ended June 30,
   
Six Months Ended June 30,
 
(Dollars In thousands)
 
2013
   
2012
   
Change
   
2013
   
2012
   
Change
 
Service charges on deposit accounts
  $ 287     $ 280     $ 7       2.5 %   $ 542     $ 553     $ (11 )     -2.0 %
Earnings and gain on bank owned life insurance
    52       96       (44 )     -45.8 %     112       188       (76 )     -40.4 %
Loan servicing fees
    38       66       (28 )     -42.4 %     82       108       (26 )     -24.1 %
Debit card interchange fees
    122       106       16       15.1 %     228       203       25       12.3 %
Other charges, commissions and fees
    124       137       (13 )     -9.5 %     266       273       (7 )     -2.6 %
Noninterest income before gains
    623       685       (62 )     -9.1 %     1,230       1,325       (95 )     -7.2 %
Net gains on sales and redemptions of investment securities
    60       49       11       22.4 %     99       161       (62 )     -38.5 %
Net gains on sales of loans and foreclosed real estate
    421       49       372       759.2 %     451       25       426       1704.0 %
Total noninterest income
  $ 1,104     $ 783     $ 321       41.0 %   $ 1,780     $ 1,511     $ 269       17.8 %

As indicated above, noninterest income for the second quarter of 2013 increased when compared to the same prior year period due principally to $395,000 in net gains from the sale of residential loans as the company sold a portfolio of 30 year term and lower yielding residential loans in an interest rate risk management initiative to mitigate the risk of our liability-sensitive balance sheet.  When comparing the six months ended June 30, 2013 with the same prior year period, the improvement in noninterest income was principally due to the residential loan portfolio sale, offset partially by reduced levels of sales and redemptions of the Company’s available-for-sale investment securities and reduced levels of earnings and gain on bank owned life insurance.  The latter was due to the recognition of a death benefit in the second quarter of 2012 from the passing of a former Company director.

Noninterest Expense

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

   
Three Months Ended June 30,
   
Six Months Ended June 30,
 
(Dollars In thousands)
 
2013
   
2012
   
Change
   
2013
   
2012
   
Change
 
Salaries and employee benefits
  $ 1,941     $ 1,869     $ 72       3.9 %   $ 3,852     $ 3,844     $ 8       0.2 %
Building occupancy
    361       346       15       4.3 %     726       729       (3 )     -0.4 %
Data processing
    343       341       2       0.6 %     711       682       29       4.3 %
Professional and other services
    168       146       22       15.1 %     327       298       29       9.7 %
Advertising
    128       99       29       29.3 %     244       160       84       52.5 %
FDIC assessments
    84       78       6       7.7 %     167       155       12       7.7 %
Audits and exams
    63       56       7       12.5 %     123       111       12       10.8 %
Other expenses
    513       419       94       22.4 %     955       830       125       15.1 %
Total noninterest expenses
  $ 3,601     $ 3,354     $ 247       7.4 %   $ 7,105     $ 6,809     $ 296       4.3 %


 
- 41 -

As indicated above, noninterest expense for the year over year second quarter period increased due principally to an increase in salary expenses reflecting normal wage increases and other expenses inclusive of a write-down of a repossessed asset in the amount of $65,000, fraud losses, office supplies and travel and training. Additionally, advertising expenses for the second quarter of 2013 increased over the comparable prior year period due to the Company’s initiative to improve its market position and expand core deposits through expanded media exposure and direct mail marketing in the central New York marketplace.  When comparing the six month period ended June 30, 2013 with the same prior year period, noninterest expenses increased due principally to advertising expenses and other expenses.

Income Tax Expense

Income tax expense increased by $65,000 for the quarter ended June 30, 2013 as compared to the same period in 2012 primarily due to an increase in pretax income and an increase in the effective tax rate to 27.0% as compared to 25.0% for the same prior year period.  The effective tax rate increase principally reflects a smaller proportion of tax-exempt investments as a proportion of our taxable income in the second quarter of 2013 as compared to the second quarter of 2012.  The Company has reduced its effective tax rate from the combined federal and state statutory rate of 38.7% primarily through the ownership of tax-exempt investment securities, bank owned life insurance, and other tax saving strategies.  For the six months ended June 30, 2013, income tax expense increased by $75,000 over the same prior year period due to an increase in pretax income between these same two time periods and an increase in the effective tax rate to 27.0% as compared to 25.0% for the same prior year period.

Earnings per Share

Basic and diluted earnings per share were $0.33 in the second quarter of 2013 as compared to basic and diluted earnings per share of $0.24 in the second quarter of 2012.  This increase was due to net income available to common shareholders being greater in the second quarter of 2013 stemming from the lack of need for SBLF dividend payments through the second quarter of 2013 as positive updated lending information provided to the U.S. Treasury resulted in a credit against the dividend rate for this quarter.  Assuming our present lending activity continues, the amount of unused credit presently available would negate the need for any dividend payments in 2013.

Basic and diluted earnings per share for the six month period ended June 30, 2013 were $0.53 as compared to basic and diluted earnings per share of $0.40 for the same prior year period.  This increase was principally due to the above mentioned lack of need for SBLF dividend payments in addition to an increase in net income between the comparable six month periods.
 
 
Changes in Financial Condition

Assets

Total assets increased to $494.4 million at June 30, 2013, from $477.8 million at December 31, 2012.  The increase in total assets was primarily the result of an increase of $10.9 million in investment securities and a $3.9 million increase in gross loans.  The increase in investment securities was primarily in U.S. Treasury and Agency securities in addition to residential mortgage-backed securities issued or guaranteed by U.S. Agencies.  The growth in gross loans was due to the increase in commercial real estate and commercial and industrial loans as the total commercial loan segment recorded an increase of $12.3 million between these two time periods.  Residential loans decreased $7.9 million between these same two time periods, resulting primarily from the sale of $8.8 million in long term and lower yielding residential loans during the second quarter.

Liabilities

Total liabilities increased to $454.2 million at June 30, 2013, from $437.0 million at December 31, 2012.  Deposits increased $8.6 million, with over one-half of this increase in the form of demand deposit accounts, as the Company was able to take advantage of competitive changes in the marketplace to improve deposit gathering across all markets.  Net borrowings increased $9.9 million through short-term FHLBNY borrowings which increased by $18.9 million as long-term borrowings decreased $9.0 million.


 
- 42 -

Capital

Shareholders' equity decreased $604,000 to $40.1 million at June 30, 2013, as compared to December 31, 2012 due principally to the increase in accumulated other comprehensive loss as rising interest rates between the above two time periods caused a decrease in market value of the available-for-sale investment portfolio, after tax.  Partially offsetting this reduction was an increase in retained earnings of $1.2 million due to the combination of net income reduced by the dividends payable to common shareholders.

Capital adequacy is evaluated primarily by the use of ratios which measure capital against total assets, as well as against total assets that are weighted based on defined risk characteristics.  The Company’s goal is to maintain a strong capital position, consistent with the risk profile of its subsidiary banks that supports growth and expansion activities while at the same time exceeding regulatory standards.  At June 30, 2013, Pathfinder Bank exceeded all regulatory required minimum capital ratios and met the regulatory definition of a “well-capitalized” institution, i.e. a leverage capital ratio exceeding 5%, a Tier 1 risk-based capital ratio exceeding 6%, and a total risk-based capital ratio exceeding 10%.

The Bank’s actual capital amounts and ratios as of the indicated dates are presented in the following table.

                           
Minimum
 
                           
To Be "Well-
 
               
Minimum
   
Capitalized"
 
               
For Capital
   
Under Prompt
 
 
 
Actual
   
Adequacy Purposes
   
Corrective Provisions
 
(Dollars in thousands)
 
Amount
   
Ratio
   
Amount
   
Ratio
   
Amount
   
Ratio
 
As of June 30, 2013:
                                   
Total Core Capital (to Risk-Weighted Assets)
  $ 47,371       14.3 %   $ 26,522       8.0 %   $ 33,152       10.0 %
Tier 1 Capital (to Risk-Weighted Assets)
  $ 43,002       13.0 %   $ 13,261       4.0 %   $ 19,891       6.0 %
Tier 1 Capital (to Assets)
  $ 43,002       8.8 %   $ 19,504       4.0 %   $ 24,380       5.0 %
As of December 31, 2012:
                                               
Total Core Capital (to Risk-Weighted Assets)
  $ 45,763       14.2 %   $ 25,808       8.0 %   $ 32,259       10.0 %
Tier 1 Capital (to Risk-Weighted Assets)
  $ 41,574       12.9 %   $ 12,904       4.0 %   $ 19,356       6.0 %
Tier 1 Capital (to Assets)  (1)
  $ 41,574       8.8 %   $ 18,831       4.0 %   $ 23,539       5.0 %
As of December 31, 2011:
                                               
Total Core Capital (to Risk-Weighted Assets)
  $ 43,670       14.9 %   $ 23,386       8.0 %   $ 29,233       10.0 %
Tier 1 Capital (to Risk-Weighted Assets)
  $ 39,917       13.7 %   $ 11,693       4.0 %   $ 17,540       6.0 %
Tier 1 Capital (to Average Assets)
  $ 39,917       9.4 %   $ 17,041       4.0 %   $ 21,301       5.0 %

(1) As of June 30, 2012, the Federal Financial Institutions Examination Council changed the computation for the Tier 1 Capital ratio as it applies to the Bank’s designation as a savings association.  The denominator has changed from using the average assets over the prior three months to the assets on the statement of condition as of the end of the June 30, 2012 and subsequent reporting quarters.


 
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Loan and Asset Quality and Allowance for Loan Losses

The following table represents information concerning the aggregate amount of non-performing assets at the indicated dates:

   
June 30,
   
December 31,
   
June 30,
 
(Dollars In thousands)
 
2013
   
2012
   
2012
 
Nonaccrual loans:
                 
Commercial real estate and commercial
  $ 3,844     $ 2,726     $ 2,182  
Consumer
    205       776       809  
Residential real estate
    1,751       2,046       1,344  
Total nonaccrual loans
    5,800       5,548       4,335  
Total nonperforming loans
    5,800       5,548       4,335  
Foreclosed real estate
    429       426       419  
Total nonperforming assets
  $ 6,229     $ 5,974     $ 4,754  
                         
Troubled debt restructurings not included above
  $ 1,965     $ 1,937     $ 589  
                         
Nonperforming loans to total loans
    1.72 %     1.66 %     1.39 %
Nonperforming assets to total assets
    1.26 %     1.25 %     1.00 %


Nonperforming assets include nonaccrual loans, troubled debt restructurings (“TDR”), and foreclosed real estate. Loans are considered modified in a TDR when, due to a borrower’s financial difficulties, the Company makes a concession(s) to the borrower that it would not otherwise consider. These modifications may include, among others, an extension of the term of the loan, and granting a period when interest-only payments can be made, with the principal payments made over the remaining term of the loan or at maturity.  TDRs are included in the above table within the following categories of nonaccrual loans or TDRs not included above (the latter also known as accruing TDRs).

As indicated in the above table, total non-performing loans increased modestly at June 30, 2013, when compared to December 31, 2012.  While significant improvement was recorded in the consumer and residential loan segments through reductions in nonperforming loans in these two product segments, this was more than offset by the increase in the commercial real estate and commercial loan segments from the addition of one large commercial relationship to nonperforming status.  This event contributed to the additional provision for loan losses required in the first half of 2013.  Management continues to monitor and react to national and local economic trends as well as general portfolio conditions, which may impact the quality of the portfolio.  Management believes that the current level of the allowance for loan losses, at $4.9 million, adequately addresses the current level of risk within the loan portfolio.

Foreclosed real estate (“FRE”) balances increased to $429,000 at June 30, 2013, from $426,000 at December 31, 2012 as the Company successfully reduced FRE properties from eight to six, in addition to writing down an existing property as new fair value information became available.  Of the existing inventory of properties, two are commercial properties and the remaining four are 1-4 family residential properties.  Additionally, the Company is carrying a repossessed boat in other assets, which was written down by $65,000 in the second quarter, and is carried at $170,000 at June 30, 2013 as compared to $235,000 at December 31, 2012.  The repossessed boat was subsequently sold in the third quarter of 2013 for $170,000.

The Company generally places a loan on nonaccrual status and ceases accruing interest when loan payment performance is deemed unsatisfactory and the loan is past due 90 days or more.  There are no loans that are past due 90 days or more and still accruing interest.  The Company considers a loan impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal and interest when due according to the contractual terms of the loan.
 

 
 
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The measurement of impaired loans is generally based upon the fair value of the collateral, with a portion of the impaired loans measured based upon the present value of future cash flows discounted at the historical effective interest rate.  The Company used the fair value of collateral to measure impairment on commercial loans and commercial real estate loans.  At June 30, 2013 and December 31, 2012, the Company had $6.2 million and $6.7 million in loans, which were deemed to be impaired, having established specific reserves of $943,000 and $923,000, respectively on these loans.  Between these two time periods, the composition of impaired loans changed significantly as the decrease in the proportion of residential loans was partially offset by an increase in the proportion of commercial real estate loans.
 
 
Management has identified potential problem loans totaling $11.4 million as of June 30, 2013, compared to $11.7 million as of December 31, 2012.  These loans have been internally classified as special mention or substandard, yet are not currently considered impaired or in non-accrual status.  Management has identified potential credit problems which may result in the borrowers not being able to comply with the current loan repayment terms and which may result in it being included in future impaired loan reporting.  Management judges the current level of allowance for loan losses to be adequate to cover probable credit losses in the current loan portfolio.  As a result, the ratio of the allowance to loan and lease losses to period-end loans at June 30, 2013 was 1.44% as compared to 1.35% at December 31, 2012.  The increase reflects the recent historical charge-off experience, the allowance for impaired loans, and the modest increase in gross loans reported in the first half of 2013.

Appraisals are obtained at the time a real estate secured loan is originated.   For commercial real estate held as collateral, the property is inspected every two years.  When evaluating our ability to collect from secondary sources, appraised values are adjusted to reflect the age of appraisal, the condition of the property, the current local real estate market, and cost to sell.  Properties are re-appraised when our evaluation of the current property condition and the local real estate market suggests values may not be accurate.

In the normal course of business, Pathfinder Bank has sold residential mortgage loans and participation interests in commercial loans. As is typical in the industry, Pathfinder Bank makes certain representations and warranties to the buyer. Pathfinder Bank maintains a quality control program for closed loans and considers the risks and uncertainties associated with potential repurchase requirements to be minimal.

Liquidity

Liquidity management involves the Company’s ability to generate cash or otherwise obtain funds at reasonable rates to support asset growth, meet deposit withdrawals, maintain reserve requirements, and otherwise operate the Company on an ongoing basis.  The Company's primary sources of funds are deposits, borrowed funds, amortization and prepayment of loans and maturities of investment securities and other short-term investments, and earnings and funds provided from operations.  While scheduled principal repayments on loans are a relatively predictable source of funds, deposit flows and loan prepayments are greatly influenced by general interest rates, economic conditions and competition.  The Company manages the pricing of deposits to maintain a desired deposit composition and balance.  In addition, the Company invests excess funds in short-term interest-earning and other assets, which provide liquidity to meet lending requirements.

The Company's liquidity has been enhanced by its ability to borrow from the Federal Home Loan Bank of New York, whose competitive advance programs and lines of credit provide the Company with a safe, reliable, and convenient source of funds.  A significant decrease in deposits in the future could result in the Company having to seek other sources of funds for liquidity purposes.  Such sources could include, but are not limited to, additional borrowings, brokered deposits, negotiated time deposits, the sale of "available-for-sale" investment securities, the sale of securitized loans, or the sale of whole loans.  Such actions could result in higher interest expense costs and/or losses on the sale of securities or loans.

Through the first half of 2013, as indicated in the Consolidated Statement of Cash Flows, the Company reported net cash flows from financing activities of $18.1 million generated by increased balances of demand, savings and money market deposit accounts.  This was invested in available-for-sale investment securities of $14.6 million, net, and loan generation of $4.3 million.  As a recurring source of liquidity, the Company’s investment securities provided $13.5 million in proceeds from maturities and principal reductions through the first half of 2013.  Net cash provided by operating activities for this same period was $2.6 million.

 
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The Company has a number of existing credit facilities available to it.  At June 30, 2013, total credit available to the Company under the existing lines of credit is approximately $152.7 million.  At June 30, 2013, the Company has $42.1 million outstanding on its existing lines of credit with $110.6 million available.
 
 
The Asset Liability Management Committee of the Company is responsible for implementing the policies and guidelines for the maintenance of prudent levels of liquidity.  As of June 30, 2013, management reported to the Board of Directors that the Company is in compliance with its liquidity policy guidelines.

Item 3 - Quantitative and Qualitative Disclosures About Market Risk

A smaller reporting company is not required to provide the information relating to this item.

Item 4 - Controls and Procedures

Under the supervision and with the participation of the Company's management, including our Chief Executive Officer and Chief Financial Officer, the Company has evaluated the effectiveness of the design and operation of its disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this quarterly report.  Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that, as of the end of the period covered by this report, the Company's disclosure controls and procedures are effective to ensure that information required to be disclosed in the reports that the Company files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission's rules and forms.  There has been no change in the Company's internal control over financial reporting during the most recent fiscal quarter that has materially affected, or is reasonable likely to materially affect, the Company's internal control over financial reporting.

 
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PART II - OTHER INFORMATION

Item 1 - Legal Proceedings

The Company is not currently a named party in a legal proceeding, the outcome of which would have a material and adverse effect on the financial condition or results of operations of the Company.

Item 1A – Risk Factors

A smaller reporting company is not required to provide the information relating to this item.

Item 2 – Unregistered Sales of Equity Securities and Use of Proceeds

None

Item 3 - Defaults Upon Senior Securities

None

Item 4 – Mine Safety Disclosures

Not applicable

Item 5 - Other Information

None

Item 6 - Exhibits

Exhibit No.                                                           Description                                                                                                

31.1                      Rule 13a-14(a) / 15d-14(a) Certification of the Chief Executive Officer
31.2                      Rule 13a-14(a) / 15d-14(a) Certification of the Chief Financial Officer
32.1                      Section 1350 Certification of the Chief Executive Officer and Chief Financial
                             Officer








 
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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 PATHFINDER BANCORP, INC.


August 13, 2013                                                       /s/ Thomas W. Schneider
   Thomas W. Schneider
                   President and Chief Executive Officer

August 13, 2013                                                       /s/ James A. Dowd
   James A. Dowd
   Senior Vice President and Chief Financial Officer

 
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