SECURITIES
      AND EXCHANGE COMMISSION





Washington,
      D.C. 20549





**FORM
      10-Q**


**xQUARTERLY
              REPORT
              PURSUANT TO SECTION 13 OR 15(d) OF THE**
 **SECURITIES
              EXCHANGE ACT OF 1934**





For
      the
      quarterly period ended September 30, 2006





OR


**o   
            TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE**
 **SECURITIES
            EXCHANGE ACT OF 1934**
  Commission
        File Number 000-51318








NORTHERN
      EMPIRE BANCSHARES


(Exact
      name of registrant as specified in its charter)





California
            94-2830529(State
                or other jurisdiction of incorporation or organization)
            (I.R.S.
                Employer Identification No.)




801
                Fourth Street, Santa Rosa, California
            
            95404(Address
                of principal executive offices)
            
            (Zip
                code)





707-579-2265


(Registrant’s
      telephone number, including area code)





NONE


(Former
      name, former address and former fiscal year, if changed since last
      report)





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 x No £





Indicate
      by check mark whether the registrant is a large accelerated filer, an
      accelerated filer, or a non-accelerated filer. See definitions of “accelerated
      filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check
      one):





Large
                accelerated filer£
            Accelerated
                filer x
            Non-accelerated
                filer£





Indicate
      by check mark whether the registrant is a shell company (as defined in Rule
      12b-2 of the Exchange Act).





Yes £ No x





APPLICABLE
      ONLY TO CORPORATE ISSUERS





Indicate
      the number of shares outstanding of each of the issuer's classes of common
      stock, as of the latest practicable date.





Title
      of
      class: Common Stock, no par value. Outstanding shares as of October 31, 2006:
      10,960,374













**PART
      I - FINANCIAL INFORMATION**





**ITEM
      1. FINANCIAL STATEMENTS**




**NORTHERN
      EMPIRE BANCSHARES AND SUBSIDIARY**


**CONSOLIDATED
      BALANCE SHEETS (unaudited)**





(dollars
      in thousands)


**ASSETS**
            
            **September
                30, 2006**
            
            **December
                31, 2005**Cash
                and equivalents:Cash
                and due from banks
            
            $
            28,234
            
            $
            28,936Federal
                funds sold
            
            
            88,974
            
            
            30,188Total
                cash and equivalents
            
            
            117,208
            
            
            59,124Investment
                securities available-for-sale
            
            
            1,087
            
            
            50,488Federal
                Home Loan Bank (FHLB) stock, at cost
            
            
            15,036
            
            
            11,731Federal
                Reserve Bank stock, at cost
            
            
            166
            
            
            166Loans
                receivable, net
            
            
            1,210,855
            
            
            1,090,772Leasehold
                improvements and equipment, net
            
            
            2,923
            
            
            3,292Accrued
                interest receivable and other assets
            
            
            18,081
            
            
            16,161Total
                assets
            
            $
            1,365,356
            
            $
            1,231,734**LIABILITIES
                AND SHAREHOLDERS' EQUITY**Liabilities:Deposits
            
            $
            962,121
            
            $
            888,027FHLB
                Advances
            
            
            274,351
            
            
            230,379Accrued
                interest payable and other liabilities
            
            
            7,378
            
            
            6,021Total
                liabilities
            
            
            1,243,850
            
            
            1,124,427Shareholders'
                equity:Common
                stock, no par value; authorized, 40,000,000 shares; shares issued
                and
                outstanding, 10,950,697 at September 30, 2006 and 10,919,606 at December
                31, 2005
            
            
            73,855
            
            
            60,655Additional
                paid-in-capital
            
            
            7,895
            
            
            7,681Accumulated
                other comprehensive loss
            
            
            (7
            )
            
            (101
            )Retained
                earnings
            
            
            39,763
            
            
            39,072Total
                shareholders' equity
            
            
            121,506
            
            
            107,307Total
                liabilities and shareholders' equity
            
            $
            1,365,356
            
            $
            1,231,734




See
      Notes
      to Consolidated Financial Statements





2





**NORTHERN
      EMPIRE BANCSHARES AND SUBSIDIARY**


**CONSOLIDATED
      STATEMENTS OF INCOME (unaudited)**





**Three
                Months Ended**
              **September
                30,**
            
            **Nine
                Months Ended**
              **September
                30,**(dollars
                in thousands, except per share data)
            
            **2006**
            
            **2005**
            
            **2006**
            
            **2005**Interest
                income:Loans
            
            $
            23,532
            
            $
            18,203
            
            $
            65,743
            
            $
            51,381Federal
                funds sold and investment securities
            
            
            1,463
            
            
            1,093
            
            
            3,824
            
            
            2,720Total
                interest income
            
            
            24,995
            
            
            19,296
            
            
            69,567
            
            
            54,101Interest
                expense
            
            
            12,806
            
            
            7,772
            
            
            33,293
            
            
            20,120Net
                interest income before provision for loan losses
            
            
            12,189
            
            
            11,524
            
            
            36,274
            
            
            33,981Provision
                for loan losses
            
            
            450
            
            
            600
            
            
            1,400
            
            
            1,650Net
                interest income after provision for loan losses
            
            
            11,739
            
            
            10,924
            
            
            34,874
            
            
            32,331Other
                income:Service
                charges on deposits
            
            
            114
            
            
            115
            
            
            358
            
            
            368Gain
                on sale of loans
            
            
            756
            
            
            803
            
            
            2,416
            
            
            2,168Other
            
            
            288
            
            
            248
            
            
            776
            
            
            662Total
                other income
            
            
            1,158
            
            
            1,166
            
            
            3,550
            
            
            3,198Other
                expenses:Salaries
                and employee benefits
            
            
            3,273
            
            
            2,914
            
            
            9,505
            
            
            8,399Occupancy
            
            
            544
            
            
            501
            
            
            1,569
            
            
            1,403Equipment
            
            
            290
            
            
            287
            
            
            867
            
            
            855Advertising
                and business development
            
            
            198
            
            
            202
            
            
            590
            
            
            642Outside
                customer services
            
            
            85
            
            
            113
            
            
            259
            
            
            283Director
                and shareholder expenses
            
            
            83
            
            
            141
            
            
            314
            
            
            476Deposit
                and other insurance
            
            
            149
            
            
            130
            
            
            414
            
            
            392Professional
                fees
            
            
            436
            
            
            43
            
            
            764
            
            
            456Other
            
            
            338
            
            
            371
            
            
            1,114
            
            
            1,179Total
                other expenses
            
            
            5,396
            
            
            4,702
            
            
            15,396
            
            
            14,085Income
                before provision for income taxes
            
            
            7,501
            
            
            7,388
            
            
            23,027
            
            
            21,444Provision
                for income taxes
            
            
            3,080
            
            
            3,026
            
            
            9,346
            
            
            8,806Net
                income
            
            $
            4,421
            
            $
            4,362
            
            $
            13,681
            
            $
            12,638Basic
                earnings per common share
            
            $
            0.40
            
            $
            0.40
            
            $
            1.25
            
            $
            1.16Diluted
                earnings per common share
            
            $
            0.39
            
            $
            0.38
            
            $
            1.21
            
            $
            1.11




See
      notes
      to Consolidated Financial Statements





3





**NORTHERN
      EMPIRE BANCSHARES AND SUBSIDIARY**


**CONSOLIDATED
      STATEMENTS OF CASH FLOWS (Unaudited)**





**Nine
                months ended****September
                30,**(dollars
                in thousands)
            
            **2006**
            
            **2005**Cash
                flows from operating activities:Net
                income
            
            $
            13,681
            
            $
            12,638Adjustments
                to reconcile net income to net cash provided by operating
                activities:Provision
                for loan losses
            
            
            1,400
            
            
            1,650Depreciation
                and amortization
            
            
            708
            
            
            637Accretion
                of investment securities
            
            
            (443
            )
            
            (193
            )FHLB
                Stock dividends
            
            
            (451
            )
            
            (304
            )Compensation
                expense of stock options
            
            
            164
            
            
            0Gain
                on sale of loans
            
            
            (2,416
            )
            
            (2,168
            )Change
                in deferred income taxes
            
            
            287
            
            
            471Changes
                in operating assets and liabilities:Change
                in deferred loan fees and discounts
            
            
            404
            
            
            599Change
                in interest receivable and other assets
            
            
            (2,271
            )
            
            (2,309
            )Change
                in accrued interest payable and other liabilities
            
            
            1,357
            
            
            (2,847
            )Net
                cash provided by operating activities
            
            
            12,420
            
            
            8,174Cash
                flows from investing activities:Purchases
                of investment securities
            
            
            -
            
            
            (49,122
            )Proceeds
                from maturities of investment securities
            
            
            50,000
            
            
            0Purchase
                of restricted stock
            
            
            (2,854
            )
            
            (2,435
            )Redemption
                of restricted stock
            
            
            -
            
            
            88Net
                increase in loans receivable
            
            
            (119,471
            )
            
            (113,233
            )Purchase
                of leasehold improvements and equipment
            
            
            (339
            )
            
            (1,420
            )Net
                cash used by investing activities
            
            
            (72,664
            )
            
            (166,122
            )Cash
                flows from financing activities:Net
                change in deposits
            
            
            74,094
            
            
            107,529Net
                change in FHLB advances
            
            
            43,972
            
            
            18,477Payment
                of cash dividends
            
            
            (8
            )
            
            (9
            )Tax
                benefit of stock options
            
            
            51
            
            
            0Proceeds
                from exercise of stock options
            
            
            219
            
            
            245Net
                cash from financing activities
            
            
            118,328
            
            
            126,242Net
                change in cash and cash equivalents
            
            
            58,084
            
            
            (31,706
            )Cash
                and cash equivalents, at beginning of year
            
            
            59,124
            
            
            116,504Cash
                and cash equivalents, at end of period
            
            $
            117,208
            
            $
            84,798Supplemental
                cash-flow information:Interest
                paid
            
            $
            32,568
            
            $
            19,750Income
                taxes paid
            
            $
            9,340
            
            $
            11,720




See
      Notes
      to Consolidated Financial Statements





4





**Northern
      Empire Bancshares and Subsidiary**


**Notes
      to Consolidated Financial Statements**




**September
      30, 2006**





**Note
      1 - Basis of Presentation**





The
      unaudited financial information contained in this report reflects all
      adjustments which, in the opinion of Management, are necessary to present fairly
      the financial condition of Northern Empire Bancshares (the “Company”) and
      Subsidiary at September 30, 2006 and the results of operations for the three
      and
      nine months then ended. The results of operations reflect interim adjustments,
      all of which, except for expenses related to the proposed merger with Sterling
      Financial Corporation, are of a normal recurring nature and which, in the
      opinion of Management, are necessary for a fair presentation of the results
      for
      the interim periods presented. The results of operations for the three and
      nine
      months ended September 30, 2006, are not necessarily indicative of the operating
      results to be anticipated for the year ending December 31, 2006.





The
      preparation of the consolidated financial statements in conformity with
      accounting principles generally accepted in the United States requires
      management to make estimates and assumptions that affect amounts reported in
      the
      consolidated financial statements. Changes in these estimates and assumptions
      are considered reasonably possible and may have a material impact on the
      consolidated financial statements and thus actual results could differ from
      the
      amounts reported and disclosed herein. The Company considers the allowance
      for
      loan loss a critical accounting policy subject to estimate.





Certain
      information and footnote disclosures presented in the Company's annual
      consolidated financial statements are not included in these interim financial
      statements pursuant to SEC rules or regulations. Accordingly, the accompanying
      unaudited interim consolidated financial statements should be read in
      conjunction with the consolidated financial statements and notes thereto
      included in the Company's 2005 Annual Report on Form 10-K.





**Recently
      issued accounting pronouncements**




In
      September 2006, the FASB issued SFAS No. 158, "Employers' Accounting for Defined
      Benefit Pension and other Postretirement Plans - an amendment of FASB Statements
      No. 87, 88, 106, and 132(R)." This Statement improves financial reporting by
      requiring an employer to recognize the over funded or under funded status of
      a
      defined benefit postretirement plan as an asset or liability in its statement
      of
      financial position and to recognize changes in that funded status in the year
      in
      which the changes occur through comprehensive income of a business entity or
      changes in unrestricted net assets of a not-for-profit organization. This
      Statement also improves financial reporting by requiring an employer to measure
      the funded status of a plan as of the date of its year-end statement of
      financial position, with limited exceptions. An employer with publicly traded
      equity securities is required to initially recognize the funded status of a
      defined benefit postretirement plan and to provide the required disclosures
      as
      of the end of the fiscal year ending after December 15, 2006. The requirement
      to
      measure plan assets and benefit obligations as of the date of the employer's
      fiscal year-end statement of financial position is effective for fiscal years
      ending after December 15, 2008. SFAS No. 158 is not expected to have a material
      impact on the Company.





In
      September 2006, the FASB issued SFAS No. 157, "Fair Value Measurements." This
      Statement defines fair value, establishes a framework for measuring fair value
      in generally accepted accounting principles, and expands disclosures about
      fair
      value measurements. This Statement applies under other accounting pronouncements
      that require or permit fair value measurements. Accordingly, this Statement
      does
      not require any new fair value measurements. This Statement is effective for
      financial statements issued for fiscal years beginning after November 15, 2007,
      and interim periods within those fiscal years. SFAS No. 157 is not expected
      to
      have a material impact on the Company.





**Note
      2 - Net Income per Common and Common Equivalent Share**





Basic
      earnings per share (EPS) is computed by dividing income available to common
      shareholders by the weighted average number of common shares outstanding during
      the period. Diluted EPS is computed by dividing income available to shareholders
      by the weighted average number of common shares and common equivalent shares
      outstanding, which include dilutive stock options. The computation of common
      stock equivalent shares is based on the weighted average market price of the
      Company’s common stock throughout the period adjusted for the impact of the 5%
      stock dividends declared on March 28, 2006 and March 22, 2005. Earnings per
      share on a diluted basis are calculated based on the average number of shares
      outstanding including dilutive options at the time. The Company’s EPS data is as
      follows:





5








**For
                  the three months ended**
                **September
                  30, 2006**
              
              **For
                  the three months ended**
                **September,
                  2005****Income/**
                **Numerator**
              
              **Shares/**
                **Denominator**
              
              **Per
                  Share**
                **Amount**
              
              **Income/**
                **Numerator**
              
              **Shares/**
                **Denominator**
              
              **Per
                  Share**
                **Amount**Net
                  Income
              
              $
              4,421,000
              
              
              
              
              
              
              
              $
              4,362,000EPS
                  - Income available to common stockholders
              
              $
              4,421,000
              
              
              10,939,428
              
              $
              0.40
              
              $
              4,362,000
              
              
              10,907,839
              
              $
              0.40Effect
                  of Dilutive Securities - Stock Options
              
              
              
              
              
              376,017
              
              
              
              
              
              
              
              
              486,887EPS
                  assuming dilution - Income available to common stockholders plus
                  assumed
                  conversion
              
              $
              4,421,000
              
              
              11,315,445
              
              $
              0.39
              
              $
              4,362,000
              
              
              11,394,726
              
              $
              0.38




**For
                  the nine months ended**
                **September
                  30, 2006**
              
              **For
                  the nine months ended**
                **September
                  30, 2005****Income/**
                **Numerator**
              
              **Shares/**
                **Denominator**
              
              **Per
                  Share**
                **Amount**
              
              **Income/**
                **Numerator**
              
              **Shares/**
                **Denominator**
              
              **Per
                  Share**
                **Amount**Net
                  Income
              
              $
              13,681,000
              
              
              
              
              
              
              
              $
              12,638,000EPS
                  - Income available to common stockholders
              
              $
              13,681,000
              
              
              10,933,702
              
              $
              1.25
              
              $
              12,638,000
              
              
              10,890,334
              
              $
              1.16Effect
                  of Dilutive Securities - Stock Options
              
              
              
              
              
              377,074
              
              
              
              
              
              
              
              
              475,751EPS
                  assuming dilution - Income available to common stockholders plus
                  assumed
                  conversion
              
              $
              13,681,000
              
              
              11,310,776
              
              $
              1.21
              
              $
              12,638,000
              
              
              11,366,085
              
              $
              1.11





**Note
      3 - Stock Based Compensation**





Effective
      January 1, 2006, the Company adopted the Financial Accounting Standards No.
      123
      (revised 2004), “Share-Based Payment (SFAS 123R)”, using the modified
      prospective transition method and therefore has not restated results for the
      prior periods. The adoption of SFAS No. 123 (R) did not have a significant
      impact on our financial position or our results of operations. Prior to our
      adoption of SFAS No. 123 (R), benefits of tax deductions in excess of recognized
      compensation expense were reported as operating cash flows. SFAS No. 123 (R)
      requires excess tax benefits to be reported as a financing cash
      inflow.





The
      total
      compensation expense related to the Company’s stock plan was $128,000 for the
      three months ended September 30, 2006 and $164,000 for the nine months ended
      September 30, 2006. Prior to January 1, 2006, the Company accounted for the
      plan
      under the recognition and measurement provision of APB 25. Accordingly, the
      Company generally had not recognized compensation expense since all stock option
      grants were made at the fair market value on the date of grant. Prior to January
      1, 2006, pro forma disclosure amounts had been applied to its stock-based
      compensation in accordance with SFAS No 148 “Accounting for Stock-Based
      Compensation-Transition and Disclosure” (SFAS 148), as the fair value method
      defined by SFAS 123 prior to revision.





The
      pro
      forma table below reflects net earnings and basic and diluted net earnings
      per
      share for the three and nine months ended September 30, 2005, had the Company
      applied the fair value recognition provisions of SFAS 123 prior to revision.
      The
      information in the following table has been adjusted for the impact of the
      5%
      stock dividend declared on March 28, 2006.





6




(In
                  thousands)
              
              **For
                  the three months**
                **ended**
                **September
                  30, 2005**
              
              **For
                  the nine months**
                **Ended**
                **September
                  30, 2005**Net
                  Income for the period
              
              $
              4,362
              
              $
              12,638Compensation
                  expense, net of tax effect
              
              
              281
              
              
              349Pro
                  forma net income
              
              $
              4,081
              
              $
              12,289Pro
                  forma earnings per common share
              
              $
              0.37
              
              $
              1.13Pro
                  forma earnings per common share, assuming dilution
              
              $
              0.36
              
              $
              1.08





Nonqualified
      and incentive stock options have been granted to our directors, officers and
      employees under our stock option plan. Options vest either on the date of
      grant or over a period of 3 to 5 years from the grant date and have a term
      of up
      to 10 years.





No
      options were granted in the first nine months of 2006. During the third quarter
      of 2005, a total of 37,000 were granted to seven outside directors of the Bank.
      These options vested on the date of the grant and were issued at the fair market
      value at the date of grant.









A
      summary
      of option activity under the stock option plan for the nine months ended
      September 30, 2006 was as follows:




Shares
              
              Weighted
                  Average
                Exercise
                  price
              
              Weighted
                  Average
                remaining
                Contractual
                  Term
                (in
                  years)
              
              Aggregate
                  Intrinsic
                ValueOutstanding
                  at December 31, 2005
              
              
              763,566
              
              $
              11.24Options
                  granted attributable to the stock dividend
              
              
              37,385
              
              
              10.79Exercised
              
              
              30,690
              
              $
              7.13Forfeited
              
              
              510
              
              $
              7.79Outstanding
                  at September 30, 2006
              
              
              769,751
              
              $
              10.86
              
              
              4.0
              
              $
              13,213,000Vested
                  and expected to vest at September 30, 2006
              
              
              769,751
              
              $
              10.86
              
              
              4.0
              
              $
              13,213,000Vested
                  and exercisable at September 30, 2006
              
              
              761,778
              
              $
              10.77
              
              
              4.0
              
              $
              13,141,000





The
      aggregate intrinsic value in the table above represents the total pretax
      intrinsic value (the difference between the Company’s closing stock price and
      the exercise price, multiplied by the number of in-the-money options) that
      would
      have been received by the option holders had all options holders exercised
      their
      options on September 30, 2006. Total intrinsic value of options exercised for
      the nine months ended September 30, 2006 was $435,000.





Cash
      received from option exercises for the three months and nine months ended
      September 30, 2006 was $119,000 and $219,000 respectively. The actual tax
      benefit realized from option exercises for the nine months ended September
      30,
      2006 was $51,000.





As
      of
      September 30, 2006, the total of unrecognized stock-based compensation expense
      related to non-vested stock options was $17,000. That cost is expected to be
      recognized over a weighted-average period of 6 months. The non-vested stock
      options totaled 4,784 at September 30, 2006.




7





**Note
      4 - Comprehensive Income**





The
      Company’s total comprehensive income presentation is as follows:




**For
                  the three months ended**
              
              **For
                  the nine months ended**(In
                  thousands)
              
              **September
                  30,**
                **2006**
              
              **September
                  30,**
                **2005**
              
              **September
                  30,**
                **2006**
              
              **September30,**
                **2005**Net
                  Income
              
              $
              4,421
              
              $
              4,362
              
              $
              13,681
              
              $
              12,638Other
                  Comprehensive income (loss):Change
                  in unrealized holding gain (losses) arising during the
                  period
              
              
              21
              
              
              (127
              )
              
              156
              
              
              (128
              )Income
                  tax benefit (expense)
              
              
              (8
              )
              
              52
              
              
              (63
              )
              
              52Comprehensive
                  income
              
              $
              4,434
              
              $
              4,287
              
              $
              13,774
              
              $
              12,562




**Note
      5 - Business Combination**





On
      September 17, 2006, the Company announced that it had entered into an Agreement
      and Plan of Merger with Sterling Financial Corporation (Sterling), Spokane,
      Washington. **** Under
      the terms of the Agreement, the Company will be merged with and into Sterling
      with Sterling being the surviving corporation in the merger. Also under the
      terms of the Agreement, which has been unanimously approved by the Board of
      Directors of both companies, each share of the Company’s common stock will be
      converted into 0.805 shares of Sterling common stock and $2.71 in cash. The
      transaction is expected to close in the second quarter of 2007, subject to
      Northern Empire and Sterling shareholder and regulatory approval and the
      satisfaction of other customary closing conditions.





**ITEM
      2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
      OF
      OPERATIONS**





Northern
      Empire Bancshares (the "Company") is the financial holding company of Sonoma
      National Bank (the "Bank"). Since the principal business of the Company is
      the
      Bank, the following discussion pertains mainly to the Bank.





**Critical
      Accounting Policies**





The
      Company and Bank’s accounting policies are fundamental to understanding
      management’s discussion and analysis of financial condition and results of
      operations. One policy, Allowance for Loan Losses, has been identified as being
      critical because it requires management to make difficult and subjective
      judgments about matters that are inherently uncertain and because of the
      likelihood that materially different amounts would be reported under different
      conditions or using different assumptions. This policy is reviewed by Loan
      Committee and approved by the Board of Directors.





The
      Allowance for Loan Losses represents management’s estimate of probable losses
      inherent in the loan portfolio at the balance sheet date. The allowance for
      loan
      losses is reviewed monthly and is based on allocations for each loan category
      (e.g. Real Estate, Commercial) plus an allocation for any outstanding loans
      which have been classified and are on the "Watch List." Each loan that has
      been
      classified is individually analyzed for the risk involved and an allowance
      provided according to the risk assessment. In addition to the allocated
      component, there is an unallocated component. The unallocated component
      incorporates management’s judgment of the inherent risks in the portfolio based
      on: historical loan loss experience, loan concentrations, evaluations made
      by
      regulatory agencies and our outside consultants, and an assessment of economic
      conditions. The allocated and unallocated components represent the total
      allowance for loan losses that management estimates is adequate to cover losses
      inherent in the loan portfolio.





Changes
      in the estimate related to the allowance for loan losses can materially affect
      net income. The process of determining the allowance requires us to make
      assumptions regarding the inherent losses which are highly uncertain, requires
      a
      high degree of judgment; and is impacted by regional, national and global
      economic trends. Different assumptions regarding possible future economic
      conditions could have been used and may have had a material impact on the
      provision for loan losses and on the consolidated results of
      operations.





8





**Forward-looking
      statements**





The
      discussion of certain matters in this report may constitute “forward-looking
      statements” as defined in section 27A of the Securities Act of 1933, and section
      21E of the Securities Exchange Act of 1934, which include statements such as
      projections, plans, objectives and assumptions about the future, and such
      forward looking statements are subject to the safe harbor created by these
      sections. Although the Company and the Bank have based their plans and
      projections on certain assumptions, there can be no assurances that such
      assumptions will be correct, or that their plans and projections can be
      achieved. Actual results, amounts and events may differ significantly from
      those
      expected to occur, and many factors, risks and uncertainties might cause such
      a
      difference, including economic conditions, changes in interest rates,
      competition from other financial institutions and other factors discussed in
      this report. Such factors, risks and uncertainties include, but are not limited
      to the following:





—
            Proposed
                merger with Sterling Financial Corporation.
                As stated herein and announced on September 18, 2006, the Company
                entered
                into an Agreement and Plan of Merger on September 17, 2006 by which,
                if
                completed, the Company will merge into Sterling Financial Corporation,
                Spokane, Washington. While the Board of Directors of the Company
                believes
                that the proposed merger is in the best interests of the Company’s
                shareholders, there are risks associated with the proposed merger,
                including the following: (1) the businesses of the Company and Sterling
                may not be combined successfully, or such combination may take longer,
                be
                more difficult, time-consuming or costly to accomplish than expected;
                (2)
                the expected growth opportunities and cost savings from the merger
                may not
                be fully realized or may take longer to realize than expected; (3)
                operating costs, customer losses and business disruption following
                the
                merger, including adverse effects on relationships with employees,
                may be
                greater than expected; (4) governmental approvals of the merger may
                not be
                obtained, or adverse regulatory conditions may be imposed in connection
                with governmental approvals of the merger; (5) the shareholders of
                the
                Company or Sterling may fail to approve the merger; (6) adverse
                governmental or regulatory policies may be enacted; (7) the interest
                rate
                environment may further compress margins and adversely affect net
                interest
                income; (8) results may be adversely affected by continued diversification
                of assets and adverse changes to credit quality; (9) competition
                from
                other financial services companies in the Company's and Sterling's
                markets
                could adversely affect operations; and (10) an economic slowdown
                could
                adversely affect credit quality and loan originations.





If
      the
      proposed merger is not completed due to failure to obtain the required
      shareholder and/or regulatory approvals, or for other reasons, the expected
      benefits of the merger will not take place, and the Company will have incurred
      substantial expenses related to the merger. In addition, in the event that
      the
      merger is not completed due to certain actions by the Company, the Company
      may
      be required to pay substantial termination fees or damages to Sterling.




**Further
      information regarding the proposed merger is contained in the Company's Current
      Report on Form 8-K filed on September 18, 2006.**





—
            Changes
                in economic conditions and declines in the value of real estate
                collateral.At
                September 30, 2006, $1,202.9 million or 98.2% of the Bank’s loans,
                including real estate loans and a majority of the Bank’s SBA loans, were
                secured by real estate as the principal source of collateral. A worsening
                of economic conditions, a decline in real estate values and/or rising
                interest rates would have an adverse effect on the value of real
                estate
                securing these loans and would have an adverse effect on the financial
                condition of the Bank.





The
      banking authorities have recently proposed Guidance, entitled Concentrations
      in
      Commercial Real Estate Lending, Sound Risk Management Practices, which if
      adopted, will apply to institutions like the Bank that have a high concentration
      of real estate and related loans in their portfolio. The proposed Guidance
      provides that such institutions may be required in the future to maintain higher
      capital ratios than other institutions with lower such concentrations. If the
      proposed Guidance is adopted, the Bank may be subject to increased regulatory
      oversight and guidance. While the Company and the Bank are well capitalized
      under current policies of the banking authorities, they could become subject
      to
      higher capital requirements under the proposed Guidance.





—
            Changes
                in Federal Home Loan Bank (FHLB) borrowing policies.The Bank relies upon advances from the FHLB for a large portion of
                the
                funding for the Bank’s loans. FHLB advances are collateralized by loan
                assets. Based upon the current policies of the FHLB we believe the
                advances are renewable. Changes in the requirements of the FHLB could
                materially affect the Bank’s business and financial statements, and
                changes in the rates or duration of advances could make them less
                advantageous to the Bank.





9





—
            Changes
                in the U.S. Small Business Administration (SBA) program.The Bank makes a significant portion of its commercial loans through
                the
                U.S. Small Business Administration program, which guarantees a portion
                of
                such loans, and the Bank generates income through the sale of such
                loans.
                Changes in the Small Business Administration program could have an
                adverse
                effect on the Bank’s business and specifically on its ability to generate
                income through the sale of SBA
                loans.





—
            Changes
                in market interest rates and the volatility of rate sensitive loans
                and
                deposits.Changes in interest rates impact: (1) the demand for new loans, (2)
                the
                volume of loan prepayments, (3) the rates received on loans and
                securities, (4) the debt service burden on the Bank’s loan customers and
                (5) the rates paid on deposits and borrowings. Significant fluctuations
                in
                interest rates may have an adverse effect on the business, financial
                condition and results of operations of the Company and the
                Bank.





—
            Competitive
                pressures in the banking industry.The banking business is highly competitive, and competition among
                financial institutions for all types of financial products and services
                is
                expected to increase. The ability of the Bank to compete in the future
                will depend on the nature and level of future
                competition.





—
            Declines
                in the national or regional economy.A
                worsening of economic conditions could reduce the demand for loans,
                cause
                credit quality deterioration and/or result in a decline in the value
                of
                real estate that collateralizes substantially all of the Bank’s loans. Any
                of these factors could have an adverse impact on the Bank’s financial
                condition.





—
            Changes
                in accounting standards by the Financial Accounting Standards Board,
                the
                Securities and Exchange Commission (SEC) or other standard-setting
                bodies.Such changes could affect the manner in which the Company and the
                Bank are
                required to account for, and report income, expenses, reserves, or
                a
                merger or acquisition, if any, and could materially affect the Company’s
                business and financial statements.





—
            Changes
                in the legislative and regulatory environment.Banks and bank holding companies are subject to extensive supervision
                and
                regulation. The banking business is also affected by the monetary
                and
                fiscal policies of the United States government and the Federal Reserve
                Board. The future regulatory environment may significantly affect
                the
                Bank’s business.





—
            Operational
                risks including data processing system failures or fraud.Banks are dependent upon technology in the conduct of business. The
                Banking industry and the Bank have developed business continuity
                plans to
                address the various operational risks such as system failures. Depending
                upon the operational failure or fraud situation, the Bank could be
                adversely impacted by such an event.





—
            Terrorism
                and foreign hostilities.Uncertainty regarding the economic outlook resulting from the continuing
                war on terrorism and foreign hostilities, as well as actions taken,
                or to
                be taken, by the U.S. or other governments as a result of further
                acts or
                threats of terrorism could adversely impact the Bank’s business and
                financial statements.





Investors
      are cautioned to consider these and other risks and uncertainties.





The
      Company specifically disclaims any obligation to update any such factors or
      to
      publicly announce the results of any revisions to any forward-looking statements
      in this report to reflect future events or developments.





**Summary
      of Financial Results**





Total
      consolidated assets of $1,365,356,000 at September 30, 2006, grew $133.6 million
      during the first nine months of 2006, compared to $1,231,734,000 at December
      31,
      2005. Net loans increased $37.8 million in the third quarter of 2006. Cash
      and
      equivalents increased $11.7 million during the third quarter. Deposits increased
      by $51.0 million during the third quarter.





Net
      income after income taxes for the first nine months of 2006 equaled $13,681,000
      compared to $12,638,000 for the comparable period in 2005, an increase of 8.3%.
      Net income for the third quarter of 2006 equaled $4,421,000, an increase of
      1.4%
      when compared to net income of $4,362,000 for the third quarter of 2005.
      Increased profit resulted primarily from growth in net interest income due
      to
      loan growth. **T** he
      Company has incurred $645,000 in expenses related to the proposed merger with
      Sterling ($629,000 was expensed in the third quarter). This had an after tax
      impact of $383,000 for the year to date and $374,000 for the third quarter.
      Income excluding these expenses would have increased 11.3% for the year to
      date
      and 9.9% for the third quarter in comparison to the same periods of
      2005.





10





**Net
      Interest Income**





Net
      interest income (before the provision for loan losses) of $12,189,000 for the
      third quarter of 2006 increased 5.8% from $11,524,000 for the comparable period
      last year. This increase in net interest income resulted primarily from volume
      increases of $154.4 million in average earning assets for the current quarter
      compared to the third quarter of 2005. Average loans outstanding increased
      $161.0 million for the current quarter compared to the third quarter of 2005.
      Average interest bearing deposits for the third quarter increased $38.8 million
      over the same period last year and average borrowings with the Federal Home
      Loan
      Bank increased $85.0 million.





The
      net
      interest margin equaled 3.64% during the third quarter of 2006, compared to
      net
      interest margin for the third quarter of 2005 of 3.89% and 3.99% for the year
      ended December 31, 2005. The yield on average loans equaled 7.67% in the third
      quarter compared to 6.84% for the same period last year, while the Bank’s cost
      of funds increased to 4.50% for the third quarter of 2006 from 3.07% for the
      third quarter of 2005.





Several
      factors affected the Bank’s net interest margin. These factors include changes
      in market interest rates, the level of loans relative to deposits, the mix
      of
      loan and earning assets, non-accrual loan balances and mix of deposits and
      other
      funding sources.





—
            Changes
                in Market Interest Rates





Changes
      in economic conditions and the actions of the Federal Reserve Board to increase
      or decrease the Fed Funds and Discount rates have a direct impact on the Bank’s
      net interest margin since loan pricing is tied to various indices (prime rate,
      CMT, Eleventh District Cost of Funds, etc), which generally move in response
      to
      the Federal Reserve Board’s actions.





The
      full
      impact of rate changes on the Bank's earnings is not realized for several
      months, since not all loans, deposits, or wholesale borrowings reprice
      immediately. The majority of SBA loans is tied to the prime rate and reprice
      on
      a calendar quarter basis. During the third quarter of 2006 the prime rate
      equaled 8.25%, compared to 6.75% on September 30, 2005. During 2005 the prime
      rate increased 200 basis points to 7.25% at December 31, 2005 and has increased
      100 basis points during 2006 to its current level of 8.25%. There are no
      assurances that earnings will not be adversely impacted by future actions of
      the
      Federal Reserve Board and changes in market interest rates.





The
      Bank
      also has adjustable rate loans, mainly commercial real estate loans, which
      are
      tied to a variety of indices including the prime rate, the Eleventh District
      Cost of Funds Index (COFI), LIBOR, the six-month constant maturity treasury
      (CMT) and the five-year CMT. Each of these indices reacts to changes in market
      interest rates at different speeds and magnitudes. The Bank also has a fixed
      rate loan portfolio which generally reduces net interest margin as interest
      rates rise as a result of increasing funding costs, and benefits net interest
      margin as rates decline as a result of decreasing funding costs.




Of
      the
      Bank's loan portfolio totaling $1,224.9 million at September 30, 2006, $748.9
      million or 61.1% of total loans were adjustable rate loans which had not reached
      a floor or ceiling rate. Of that total, approximately $274.9 million were
      prime-based loans, of which $66.3 million reprice when prime changes and $199.2
      million reprice on a quarterly basis.





Changing
      market rates also impact borrower behavior. The Bank has experienced an
      increasing rate of loan payoffs as borrowers have refinanced their existing
      loans with loans at more attractive rates and terms.





Market
      rates also impact the Bank’s ability to attract deposits and grow the loan
      portfolio. In a rising rate environment, it is necessary to remain competitively
      priced in order to retain existing and acquire new deposit balances. Even though
      deposit rates have been increasing, they remain at historically relatively
      low
      levels making them less attractive to depositors. The Bank has responded to
      the
      highly competitive rate environment by adding new deposit products such as
      the
      high yield money market account and initiating marketing campaigns designed
      to
      attract additional certificate of deposit balances.





The
      Bank
      had $667.3 million in time deposits at September 30, 2006. These accounts
      reprice at the time the certificate matures, which delays the impact of rising
      interest rates. The Bank has offered competitive market rates for deposits
      when
      compared to other financial institutions in its area. The cost of time deposits
      equaled 4.80% for the third quarter of 2006, compared to 3.37% for the third
      quarter of last year.




11




—
              Level
                  of Loans Relative to Deposits


The
      Bank’s ratio of loans-to-deposits increased to an average of 131.1% in the third
      quarter of 2006, compared to 119.3.0% for the same period last year. An increase
      in the loan-to-deposit ratio generally has a positive impact on net interest
      margin; however, other factors explained in this section have offset this
      benefit.





—
            Mix
                of Loans and Earning Assets





Changes
      in the mix of loans also impact the Bank’s net interest margin. Real estate
      mortgage loans grew to $971.5 million at the end of this quarter from $825.2
      million at December 31, 2005. The yield on this category was 7.32%, while the
      yield on the entire loan portfolio for the quarter was 7.67%. The Bank has
      developed loan products tied to the US Treasury yield curve and LIBOR indices,
      with other favorable terms to attract new loan volume. Management continues
      to
      focus on loan growth. The Bank’s competitive environment and rate structure,
      along with several other factors discussed in this section, have resulted in
      downward pressure on net interest margin.





Construction
      loans continued to grow, totaling $49.1 million at the end of this quarter,
      compared to $37.2 million at December 31, 2005. Construction loans typically
      have short maturity dates (approximately one year). During the third quarter
      construction lending activity remained strong. The Bank’s construction loans
      yielded 8.47% in the third quarter of 2006, compared to 7.32% for the third
      quarter of last year. Construction loans generally have higher yields than
      other
      real estate loans. General economic conditions greatly influence the demand
      for
      construction loans, and there are no guarantees that the current level of
      construction lending will continue.





Commercial
      loan yields (the majority of the Bank’s commercial loans are SBA loans)
      increased to 8.89% in the third quarter of 2006 from 7.35% for the same period
      last year. The majority of these loans reprice on a quarterly schedule based
      upon the current prime rate. Average commercial loan yields were positively
      impacted by the quarterly repricing of SBA loans to reflect the 150 basis point
      increase in prime rate since September 30, 2005. SBA loans have prepayment
      penalties (remitted to the SBA) during the first three years of the loan. Even
      with the prepayment penalties the Bank has experienced higher prepayment rates
      on SBA loans as a result of the increase in the prime rate. SBA borrowers have
      been refinancing to loans with more favorable terms.





Economic
      conditions and competition have impacted the mix of loans. The rising short
      term
      interest rate environment has contributed to an increasing yield on many of
      the
      Bank’s variable rate loans. The underlying index and structure of the variable
      interest rate loan determines the frequency of rate changes and how responsive
      loan yields are to changes in market rates. With rising shorter term interest
      rates, the yield curve has flattened, which narrows the difference between
      short
      term rates and long term rates. As the difference between short and long term
      interest rates diminishes, it becomes more attractive for borrowers to seek
      longer term, fixed rate loans, which has resulted in increased refinancing
      activity. The Bank offers loan products tied to prime rate, U.S. Treasury rates
      or LIBOR, which may have lower interest rates at the time of funding but reprice
      at a faster rate than loans tied to COFI. The Bank continues to experience
      strong competition for loans, which has resulted in lower loan pricing in the
      market place, impacting the Bank’s offering rates on new loans and negatively
      impacting the Bank’s net interest margin.





—
            Non-Accrual
                Loan Balances





Loans
      which have been placed on non-accrual status also impact the net interest
      margin. At the time a loan is placed on non-accrual, the unpaid interest is
      reversed and interest accruals are discontinued until the credit quality of
      the
      loan justifies returning it to accrual status. As of September 30, 2006, the
      Bank had $600,000 in non-accrual loans or 0.05% of total loans compared to
      $618,000 at December 31, 2005. When a non-accrual loan pays off, or is
      reinstated to accrual status, the interest income is reinstated to income which
      has a positive effect on loan yields. The current level of non-accrual loans
      is
      considered by management to be a low level of non-accrual loans based upon
      comparisons to our peer group (other banks of comparable asset size). See
      Allowance for Loan Losses for additional information.





—
            Mix
                of Deposits and Other Funding
                Sources





In
      the
      third quarter of 2006, interest expense increased to $12.8 million from $7.8
      million for the same period last year. The increase in interest expense,
      resulted from an increase in the amount of interest bearing deposits, an
      increase in the average interest rate paid for deposits, an increase in the
      amount of borrowings from the FHLB and an increase in their interest cost.
      Average interest bearing deposits equaled $834.2 million for the third quarter
      of 2006 compared to $795.4 million in the same quarter last year. The average
      cost of interest bearing deposits equaled 4.22% this quarter compared to 2.93%
      in the same quarter of 2005.





Certificates
      of deposit reprice at the time the certificate matures, which delays the impact
      to the Bank’s cost of funds in an upward interest rate market. Money market and
      other interest bearing transactions accounts reprice weekly at the discretion
      of
      the Bank. The impact of repricing money market and other interest bearing
      transactions accounts is more immediate since all balances will earn at the
      new
      rates at the time of a rate change. Competition also is a factor in the
      repricing of certain deposit products. In an increasing rate environment,
      deposit rates are monitored to be competitive in the market place to retain
      existing deposits, and when liquidity is needed, higher rates are offered to
      attract new deposits to fund growth.





12





The
      Bank
      also has a borrowing line with the Federal Home Loan Bank (FHLB) which has
      been
      used as a source of funding balance sheet growth and liquidity. Borrowings
      with
      the FHLB are generally for a term of one to three years and are at fixed rates
      or variable prime based rates. The average cost of FHLB advances was 5.30%
      for
      this quarter compared to 3.58% for the same period last year. The increase
      is
      the result of the increase in prime rate (150 basis points since September
      30,
      2005). Average borrowings increased to $294.5 million for the current quarter
      compared to $209.5 million for the same period last year.





The
      following is an analysis of the net interest margin:




**Three
                  months ended September 30, 2006**
              
              **Three
                  months ended September 30, 2005**(dollars
                  in thousands)
              
              **Average**
                **Balance**
              
              **Interest**
              
              **Yield/**
                **Cost**
              
              **Average**
                **Balance**
              
              **Interest**
              
              **Yield/**
                **Cost**Earning
                  assets (1)
              
              $
              1,328,629
              
              $
              24,995
              
              
              7.46
              %
              $
              1,174,180
              
              $
              19,296
              
              
              6.52
              %Interest
                  bearing liabilities
              
              
              1,128,714
              
              
              12,806
              
              
              4.50
              %
              
              1,004,839
              
              
              7,772
              
              
              3.07
              %Net
                  interest income
              
              
              
              
              $
              12,189
              
              
              
              
              
              
              
              $
              11,524Net
                  Interest income to earning assets
              
              
              
              
              
              
              
              
              3.64
              %
              
              
              
              
              
              
              
              3.89
              %


(1)
      Non-accrual loans are included in the calculation of average balance of earning
      assets, and interest not accrued is excluded.





13




**Nine
                  months ended September 30, 2006**
              
              **Nine
                  months ended September 30, 2005**(dollars
                  in thousands)
              
              **Average**
                **Balance**
              
              **Interest**
              
              **Yield/**
                **Cost**
              
              **Average**
                **Balance**
              
              **Interest**
              
              **Yield/**
                **Cost**Earning
                  assets (1)
              
              $
              1,279,669
              
              $
              69,567
              
              
              7.27
              %
              $
              1,133,503
              
              $
              54,101
              
              
              6.38
              %Interest
                  bearing liabilities
              
              
              1,090,000
              
              
              33,293
              
              
              4.08
              %
              
              973,873
              
              
              20,120
              
              
              2.76
              %Net
                  interest income
              
              
              
              
              $
              36,274
              
              
              
              
              
              
              
              $
              33,981Net
                  Interest income to earning assets
              
              
              
              
              
              
              
              
              3.79
              %
              
              
              
              
              
              
              
              4.01
              %


(1)  Non-accrual
      loans are included in the calculation of average balance of earning assets,
      and
      interest not accrued is excluded.





The
      following table sets forth changes in interest income and interest expense
      for
      each major category of interest-earning asset and interest-bearing liability,
      and the amount of change attributable to volume and rate changes for the three
      and nine months ended September 30, 2006 and 2005. Changes not solely
      attributable to rate or volume have been allocated to rate.




**For
                  the three months ended September 30, 2006**
                **over
                  September 30, 2005**(dollars
                  in thousands)
              
              **Volume**
              
              **Rate**
              
              **Total**Increase
                  (decrease) in interest income:Loans
              
              $
              2,682
              
              $
              2,647
              
              $
              5,329Investment
                  securities and other interest bearing investments
              
              
              (227
              )
              
              92
              
              
              (135
              )Federal
                  funds sold
              
              
              123
              
              
              382
              
              
              505Total
                  increase
              
              
              2,578
              
              
              3,121
              
              
              5,699Increase
                  in interest expense:Interest-bearing
                  transaction accounts
              
              
              (50
              )
              
              354
              
              
              304Time
                  deposits
              
              
              423
              
              
              2,266
              
              
              2,689Other
                  borrowings
              
              
              768
              
              
              1,273
              
              
              2,041Total
                  increase
              
              
              1,141
              
              
              3,893
              
              
              5,034Increase
                  (decrease) in net interest income
              
              $
              1,437
              
              $
              (772
              )
              $
              665




14





**For
                the nine months ended September 30, 2006**
              **over
                September 30, 2005**(dollars
                in thousands)
            
            **Volume**
            
            **Rate**
            
            **Total**Increase
                (decrease) in interest income:Loans
            
            $
            7,608
            
            $
            6,754
            
            $
            14,362Investment
                securities and other interest bearing investments
            
            
            793
            
            
            116
            
            
            909Federal
                funds sold
            
            
            (692
            )
            
            887
            
            
            195Total
                increase
            
            
            7,709
            
            
            7,757
            
            
            15,466Increase
                in interest expense:Interest-bearing
                transaction accounts
            
            
            (11
            )
            
            842
            
            
            831Time
                deposits
            
            
            152
            
            
            7,308
            
            
            7,460Other
                borrowings
            
            
            1,127
            
            
            3,755
            
            
            4,882Total
                increase
            
            
            1,268
            
            
            11,905
            
            
            13,173Increase
                (decrease) in net interest income
            
            $
            6,441
            
            $
            (4,148
            )
            $
            2,293




**Provision
      for Loan Losses**





The
      provision for loan losses for the three and nine months ended September 30,
      2006, amounted to $450,000 and $1,400,000,respectively, compared to $600,000
      and
      $1,650,000 for the same time periods last year. The provision was based upon
      the
      overall growth in loans and nonperforming loans at the end of the current
      quarter. For further discussion see Allowance for Loan Losses.





**Non-Interest
      Income**





Other
      income is derived primarily from service charges, SBA loan sales and SBA loan
      servicing. Other income decreased 0.7% to $1,158,000 from $1,166,000 when
      comparing the third quarter of 2006 to the same period last year. The majority
      of the decrease results from decreased income from gains on sale of SBA loans
      during the third quarter of 2006 as compared to the third quarter of
      2005.





The
      following table sets forth non-interest income by category for the periods
      indicated.


(in
                  thousands)
              
              Three
                  months ended September 30,
              
              Nine
                  months ended September 30,2006
              
              2005
              
              2006
              
              2005Gains
                  on loan sales
              
              $
              756
              
              $
              803
              
              $
              2,416
              
              $
              2,168Service
                  charges on deposits
              
              
              114
              
              
              115
              
              
              358
              
              
              368Other
                  Service charges
              
              
              84
              
              
              52
              
              
              230
              
              
              176Loan
                  servicing fees
              
              
              130
              
              
              113
              
              
              372
              
              
              308Income
                  on insurance policies
              
              
              30
              
              
              24
              
              
              86
              
              
              72Other
              
              
              44
              
              
              59
              
              
              88
              
              
              106Total
                  Other Income
              
              $
              1,158
              
              $
              1,166
              
              $
              3,550
              
              $
              3,198




The
      change in gains on the sale of the guaranteed portion of SBA loans results
      primarily from the lower premiums received on SBA loan sales. The average
      percent gain on sales in the third quarter of 2006 equaled 7.5% compared to
      9.5%
      for the third quarter of 2005. The decline in the average percent gain was
      adversely impacted by the sale of more seasoned loans. In addition, market
      premiums have been adversely affected by the increase in the SBA loan prepayment
      speed. Premiums on loan sales are market driven based upon factors such as
      rate
      of prepayments of SBA loans experienced throughout the country, age of the
      loan,
      term of the loan, loan amount, and loan interest rate. The Bank sold $10.1
      million and $29.2 million during the three and nine month periods in 2006
      compared to $8.5 million and $21.0 million during the same periods in 2005.
      The
      Bank continues to retain a portion of the SBA loans it originates, in order
      to
      realize the interest yield, rather than selling the guaranteed portion for
      a one
      time gain and servicing fees. Management considers the Bank's liquidity needs
      and anticipates loan and deposit growth as a part of the decision to hold SBA
      guaranteed loans versus selling them. There is no guarantee that premiums will
      continue at the current level.





15





SBA
      servicing fees, which increased 15.0% in the third quarter of 2006 compared
      to
      the third quarter of 2005, are based on loan payments and payoffs received
      on
      the sold potion of SBA loans, and therefore vary from quarter to quarter. The
      Bank’s average SBA loan portfolio serviced was $87.0 million in the third
      quarter of 2006 compared to $59.4 million for the same period last year. The
      serviced portfolio reflects SBA loan payoffs and volume of new sales during
      the
      period.





There
      can
      be no assurances that the SBA program will continue to generate significant
      amounts of other non-interest income in the future. Governmental actions may
      alter the SBA program at any time, which could have a negative impact on the
      Bank’s profits.





**Non-Interest
      Expenses**





For
      the
      third quarter of 2006, total non-interest expense of $5,396,000 increased 14.8%
      from $4,702,000 for the third quarter last year. The operating expenses in
      the
      third quarter were impacted by $629,000 of expenses which were associated with
      the Company’s proposed merger with Sterling Financial Corporation. The Company
      expects additional expenses to be incurred related to the proposed merger.
      The
      following table outlines the components of non-interest expense for the periods
      indicated:


***(In
                  thousands)***
              
              **Three
                  months Ended September 30,**
              
              **Percentage****Expense
                  Item**
              
              **2006**
              
              **2005**
              
              **Change****Salaries
                  & Employee Benefits**
              
              $
              3,273
              
              $
              2,914
              
              
              12.3
              %**Occupancy**
              
              
              544
              
              
              501
              
              
              8.6**Equipment**
              
              
              290
              
              
              287
              
              
              1.0**Advertising/Business
                  Development/Donations**
              
              
              198
              
              
              202
              
              
              (2.0
              )**Outside
                  Customer Services**
              
              
              85
              
              
              113
              
              
              (24.8
              )**Director
                  & Shareholder expenses**
              
              
              83
              
              
              141
              
              
              (41.1
              )**Deposit
                  and Other Insurance**
              
              
              149
              
              
              130
              
              
              14.6**Postage
                  & courier expenses**
              
              
              82
              
              
              96
              
              
              (14.6
              )**Professional
                  Fees**
              
              
              436
              
              
              43
              
              
              914.0**Stationery
                  & Supplies**
              
              
              79
              
              
              92
              
              
              (14.1
              )**Telephone
                  expense**
              
              
              53
              
              
              62
              
              
              (14.5
              )**Loan
                  expenses**
              
              
              37
              
              
              26
              
              
              42.3**Other**
              
              
              87
              
              
              95
              
              
              (8.4
              )**TOTAL**
              
              $
              5,396
              
              $
              4,702
              
              
              14.8
              %





16





***(In
                thousands)***
            
            **Nine
                months Ended September 30,**
            
            **Percentage****Expense
                Item**
            
            **2006**
            
            **2005**
            
            **Change****Salaries
                & Employee Benefits**
            
            $
            9,505
            
            $
            8,399
            
            
            13.2
            %**Occupancy**
            
            
            1,569
            
            
            1,403
            
            
            11.8**Equipment**
            
            
            867
            
            
            855
            
            
            1.4**Advertising/Business
                Development/Donations**
            
            
            590
            
            
            642
            
            
            (8.1
            )**Outside
                Customer Services**
            
            
            259
            
            
            283
            
            
            (8.5
            )**Director
                & Shareholder expenses**
            
            
            314
            
            
            476
            
            
            (34.0
            )**Deposit
                and Other Insurance**
            
            
            414
            
            
            392
            
            
            5.6**Postage
                & courier expenses**
            
            
            292
            
            
            299
            
            
            (2.3
            )**Professional
                Fees**
            
            
            764
            
            
            456
            
            
            67.5**Stationery
                & Supplies**
            
            
            228
            
            
            256
            
            
            (10.9
            )**Telephone
                expense**
            
            
            160
            
            
            173
            
            
            (7.5
            )**Loan
                expenses**
            
            
            100
            
            
            112
            
            
            (10.7
            )**Other**
            
            
            334
            
            
            339
            
            
            (1.5
            )**TOTAL**
            
            $
            15,396
            
            $
            14,085
            
            
            9.3
            %




Certain
      categories of Bank expenses have increased as a result of Bank expansion and
      loan origination volumes. In May 2006, the Healdsburg branch opened and the
      Bank
      is currently working on a new branch in Novato, California.





The
      increase in salaries and employee benefits was impacted by an agreement to
      compensate Mr. Larry Sorensen, a former executive officer, $240,000 as severance
      upon his termination and to modify his stock option agreement to accelerate
      the
      vesting of his options, which resulted in an additional charge of
      $120,000. In the fourth quarter of 2005 the Bank implemented new cost
      recovery allocations based upon an updated study. This increased allocation
      reduced salaries when comparing to the third quarter of 2005. This benefit
      was
      offset by increased staff level, with the Bank’s full time equivalent employees
      (FTE) increasing to 184 at September 30, 2006, from 166 at September 30, 2005.
      New staff was hired for the new Healdsburg branch, and the Bank has also
      deployed additional staff to loan review and appraisal functions. The balance
      of
      the growth in staff occurred in IT and branch operations support staff.
      Personnel costs are also impacted by annual salary increases, incentives based
      upon production goals and changes in insurance and benefit costs. The salary
      continuation agreement between the Bank and Mr. David Titus, the Bank’s Senior
      Loan Officer, was modified in February 2006. The impact of the modification,
      which totaled $365,000, was recorded in the first and second quarters of 2006.
      In addition, the adoption of FASB 123(R) added $9,000 to compensation expense
      during this quarter for the cost of stock-based compensation to directors,
      officers and employees under the Company’s stock option plan.





Occupancy
      expenses increased due to the branch office expansion with the new office in
      Healdsburg. Occupancy expenses will continue to increase as and if the Bank
      continues to expand. Equipment costs were relatively unchanged when comparing
      this quarter to the third quarter of 2005.





Advertising,
      business development and donations decreased 2.0% as a result of changes
      implemented in an effort to control costs. Advertising activity varies depending
      upon the need to attract new deposits or the promotion of new branch locations.
      In 2005, the Bank opened two branches in Contra Costa County, a new geographic
      market for the Bank, which required additional promotional and business
      development activities. The new branch in Healdsburg which opened in May 2006
      is
      in an existing market and benefits from existing marketing
      promotions.





Professional
      fees increased significantly to $436,000 for the quarter and $764,000 for the
      first nine months of 2006 compared to $43,000 and $456,000 for the same periods
      of 2005. This quarter the Company paid $269,000 in professional fees related
      to
      the proposed merger with Sterling Financial Corporation, including $204,000
      to
      Sandler O”Neil & partners, L.P (Sandler) for financial advisory services
      rendered in connection with the proposed merger. Under the terms of its
      engagement letter with Sandler, the Company has also agreed to pay Sandler
      a fee
      equal to 1% of the aggregate consideration to be paid by Sterling upon
      consummation of the proposed merger. Audit or review services are contracted
      by
      the Audit Committee and are performed on a varying schedule, with most of the
      audit fees occurring during the first half of the year. The Company expects
      that
      audit, legal and consulting fees will continue to increase as we comply with
      SEC
      regulations and incur expenses related to the proposed merger.





17





Outside
      customer services vary depending upon the costs incurred by analysis account
      customers. The Bank pays for certain direct costs (i.e.: payroll services,
      escrow fees, etc.), which are included in non-interest expense. These costs
      are
      based upon the depositor using the analysis system. The analysis customer
      receives earnings credits based upon their deposit account balances, which
      can
      be used to offset these charges. The customer is charged a bank service fee
      if
      their earnings credits do not cover the costs. These expenses vary depending
      upon the cost of services incurred by the analysis customers and the average
      account balances they keep with the Bank.





Included
      in shareholder and director expenses are directors’ fees for attending Board,
      Loan Committee, ALCO, Executive Committee and Audit Committee meetings. The
      cost
      of the Company’s annual report, transfer agent fees and other costs of
      communicating with shareholders are also included in this expense category.
      During the third quarter there was a one time adjustment to reduce an accrual
      for director expenses to agree with updated estimates.





Loan
      expenses include the adjustment to the allowance for unfunded loan commitments.
      In the third quarter, the allowance was increased by $3,000 since the level
      of
      unfunded commitments was higher than previous periods. This allowance can vary
      rather significantly from period to period. Also included in this category
      are
      costs associated with problem loans and the use of contracted loan services
      to
      assist staff during periods of high loan production. During the third quarter
      of
      2006, the Bank experienced higher loan origination and appraisal expenses than
      in the third quarter of 2005.





Other
      expenses decreased during the third quarter of 2006 to $87,000, compared to
      $95,000 for the same period last year. The decrease in other expenses during
      the
      third quarter of 2006 is primarily due to the reduction of the reserve for
      operating losses, since the Bank’s has historically had very few operating
      losses. Costs related to publications and subscriptions, business travel and
      operational losses are also included in this category.




**Income
      Taxes**





The
      effective tax rate was 41.1% for the third quarter of 2006, and 40.6% for the
      nine months ended September 30, 2006, compared to 41.0% and 41.1%, for
      comparable periods of 2005. This decrease in the effective tax rate largely
      results from the increased tax benefit associated with the “California
      enterprise zones” deduction. California’s taxable income is reduced by the net
      interest received on loans made to businesses located in designated enterprise
      zones. The enterprise zone deduction has benefited from the increasing interest
      rate environment, which has resulted in higher loan rates. The higher rate
      during the third quarter includes adjustments resulting from the true-up
      calculation of the 2005 estimated tax provision to the final numbers used in
      the
      2005 tax returns which were filed in September 2006.




**Liquidity
      and Investment Portfolio**





Liquidity
      is a bank's ability to meet possible deposit withdrawals, to meet loan
      commitments and increased loan demand, and to take advantage of other investment
      opportunities as they arise. The Bank's liquidity practices are defined in
      both
      the Asset and Liability Policy and the Investment Policy. These policies define
      acceptable liquidity measures in terms of ratios to total assets, deposits,
      liabilities and capital.





Cash
      and
      due from banks, federal funds sold and interest bearing deposits totaled $117.2
      million or 8.6% of total assets at September 30, 2006, compared to $59.1 million
      or 4.8% of total assets at December 31, 2005. From December 31, 2005 to
      September 30, 2006 there was a substantial decrease in investment securities
      held for sale and a corresponding increase in federal funds sold. This reflects
      Asset and Liability Committee’s (ALCO) decision to invest the maturing
      investments in federal funds sold overnight. During the third quarter of 2006,
      the net cash provided by operating activities was $13.2 million. Net cash flows
      devoted to investing activities totaled $73.4 million (mainly in loans) and
      net
      cash flows received from financing activities totaled $118.3 million, which
      included borrowing from the FHLB and increased Bank deposits.





The
      Bank
      sold $10.1 million in SBA loans during the third quarter of 2006. The Bank
      also
      reduced borrowings from the Federal Home Loan Bank by $20.0 million. During
      the
      third quarter Bank deposits increased $51.0 million as a result of deposit
      campaigns. As a result of the inflow of deposits the Bank was able to fund
      the
      current loan growth and reduce its dependency on borrowings from the FHLB during
      this quarter.





18





The
      Bank
      considers the unsold guaranteed portion of 7(a) SBA loans as a secondary source
      of liquidity. Although we are not holding these for sale, there is an
      established market for these loans and a sale transaction can typically be
      completed within 30 days. As of September 30, 2006, the Bank held $105.9 million
      in SBA guaranteed loans, which could be sold for additional liquidity.





At
      September 30, 2006, the Bank had unused federal funds lines of credit totaling
      $26,000,000. The Bank also has a credit line with the Federal Home Loan Bank
      which is based upon the value of pledged collateral (investments and loans).
      At
      September 30, 2006, the Bank had collateral pledged that would allow the Bank
      to
      borrow up to $402.0 million. The FHLB will permit the Bank to borrow up to
      35%
      of the Bank’s total assets provided that adequate collateral has been pledged to
      the FHLB. At September 30, 2006, the Bank had borrowed $274.4 million, which
      left $127.6 million available to borrow. Management believes this amount of
      secondary liquidity provides an important supplemental cushion for cash demands
      that may arise.





At
      present, the Company's primary sources of liquidity are from cash balances,
      interest on deposits, exercise of stock options and dividends from the Bank.
      The
      Bank's ability to pay dividends to the Company is subject to the restrictions
      of
      the national banking laws and, under certain circumstances, the approval of
      the
      Comptroller of the Currency. At September 30, 2006, the Company had non-interest
      and interest bearing cash balances of $11.0 million, which management believes
      are adequate to meet the Company's foreseeable operational
      expenses.





The
      Company and the Bank do not engage in hedging transactions or trading activities
      (interest rate futures, caps, swap agreements, etc.).





**Deposits**





During
      the third quarter of 2006, deposits increased $51.1 million to $962.1 million
      at
      September 30, 2006. The majority of this change occurred in time deposits.
      During the first nine months of 2006, deposit totals increased $74.1 million
      to
      $962.1 million, an increase of 8.3% over $888.0 million at December 31, 2005.
      The deposit growth generated by the new branches located in Walnut Creek, West
      Petaluma, Concord and Healdsburg in the third quarter provided $10.7 million
      in
      additional deposits. As the cost of wholesale deposits became competitive with
      local pricing the Bank also brought in $18.0 million in deposits.





The
      following table outlines the components of the Bank’s deposit portfolio on the
      dates indicated:


(in
                  thousands)
              
              September
                  30, 2006
              
              December
                  31, 2005Non-interest
                  bearing demand deposits
              
              $
              27,129
              
              $
              80,808Non-interest
                  bearing savings deposits
              
              
              67,175
              
              
              0Interest
                  bearing transaction accounts
              
              
              200,548
              
              
              214,488Time
                  certificates, $100,000 and over
              
              
              318,763
              
              
              278,681Other
                  time certificates
              
              
              348,506
              
              
              314,050Total
              
              $
              962,121
              
              $
              888,027





During
      the first quarter, the Bank began reclassifying interest and non-interest
      bearing demand deposits with certain transaction characteristics to a savings
      classification. This reclassification explains the significant differences
      shown
      above in non-interest bearing demand deposits and non-interest bearing savings
      deposits, when comparing December 31, 2005 to September 30, 2006. This
      reclassification of deposits was implemented to reduce the required reserves
      held at the Federal Reserve Bank on a daily basis. This change reduced our
      reserve requirement by approximately $6 million dollars and allowed the Bank
      to
      invest those funds that had previously been restricted due to the reserve
      requirement.





Demand
      deposits and interest bearing transaction account balances vary depending upon
      the activity of customers. Approximately 57.2% of these accounts are business
      accounts, the balances of which tend to be more volatile than consumer deposits
      balances. Money market accounts, which are included in interest bearing
      transaction accounts, are a limited transaction account with a discretionary
      rate set by management. The Bank has tried to remain competitive without
      offering the highest rates, which has made retention of these accounts more
      challenging as market rates increased. Many depositors continue to retain funds
      in transaction accounts rather than locking in time certificate rates even
      though rates on time certificates have improved. These funds are also more
      volatile and fluctuate during various business cycles.





19





Certificates
      of deposit totaled $667.3 million at September 30, 2006, an increase of 12.6%
      over $592.7 million at December 31, 2005. During the third quarter of 2006,
      certificate of deposit balances increased 10.9% from the $601.8 million reported
      at June 30, 2006. In an effort to control the increasing cost of deposits,
      time
      deposit pricing was targeted at retaining the majority of maturities during
      the
      second quarter, a period when 46.5% of the Bank’s time deposits matured. During
      the third quarter the Bank was more competitive in pricing time certificates.
      The Bank increased deposits by $18.0 million from an internet listing service
      during the third quarter when the cost of these deposit dropped to levels equal
      to or below rates offered in our current market area.





Competition
      continues to increase as more community banks establish branches in the Sonoma
      County market and other financial service companies offer similar rates and
      products. The current increasing interest rate environment and competition
      have
      made it more difficult to attract new deposits at favorable rates. The Bank
      continually monitors competitors' rates, strives to be competitive in pricing
      deposits, and offers attractive time deposit rates to raise funds during periods
      of high loan growth.





**Loans**





Loans,
      net of discounts and reserves, equaled $1,210.9 million at September 30, 2006
      compared to $1,090.8 million at December 31, 2005, increasing 11.0% since
      December 31, 2005.





The
      following is an analysis of the loan portfolio.


**Type
                  of Loan**
                **(in
                  thousands)**
              
              **September
                  30,**
                **2006**
              
              **December
                  31,**
                **2005****Real
                  estate - mortgage**
              
              $
              971,505
              
              $
              825,151**Real
                  estate - construction**
              
              
              49,136
              
              
              37,219**Commercial
                  loans**
              
              
              203,181
              
              
              234,841**Consumer
                  installment loans**
              
              
              1,106
              
              
              5,8311,224,928
              
              
              1,103,042**Deferred
                  loan fees and discount**
              
              
              (1,924
              )
              
              (1,521
              )**Allowance
                  for loan losses**
              
              
              (12,149
              )
              
              (10,749
              )**TOTAL**
              
              $
              1,210,855
              
              $
              1,090,772





The
      table
      above illustrates the Bank’s emphasis on commercial and real estate lending. At
      September 30, 2006, and December 31, 2005, commercial loans comprised 16.6%
      and
      21.3%, respectively, of the Bank’s total loan portfolio. Construction and other
      real estate loans (combined) comprised 83.4% and 78.2% on those same dates.
      Management is aware of the risk factors in making commercial and real estate
      loans and is continuously monitoring the local marketplace as well as performing
      annual reviews of this portfolio.





Commercial
      real estate mortgage and construction lending contains potential risks that
      are
      not inherent in other types of portfolio loans. With respect to construction
      lending, the potential risks include declines in market values of underlying
      real property collateral and delays or cost overruns, which could expose the
      Bank to loss. Risks in commercial real estate lending include declines in
      commercial real estate values, increasing interest rates for variable rate
      loan
      customers, general economic conditions surrounding the commercial real estate
      properties and vacancy rates. Management attempts to mitigate lending risks
      through established underwriting procedures, periodic reviews of the underlying
      collateral and monitoring of real estate values and vacancy rates in our market
      areas.




The
      Bank
      makes commercial loans primarily to small and medium sized businesses and to
      professionals located within Northern California and Arizona. While the Bank
      emphasizes commercial lending, management does not believe that there is any
      significant concentration of commercial loans to any specific type of business
      or industry.





The
      Bank
      has continued to grow its commercial and commercial real estate portfolio
      through its reputation as an experienced business and real estate lender, which
      facilitates the successful negotiation of complex commercial loans. The Bank
      maintains high credit qualifications with most real estate loans having 60-75%
      loan to value ratios. Management is aware of the risk factors in making
      commercial and real estate loans and is continually monitoring the local market
      place. A decline in real estate values and/or demand, a worsening of economic
      conditions or a natural disaster could potentially have an adverse impact on
      the
      value of collateral, on the loan portfolio, and on the financial condition
      of
      the Bank.





20





At
      September 30, 2006, 98.2% or $1,202.9 million of the Bank’s loans, including
      real estate, commercial and a majority of the Bank’s SBA loans were secured by
      real estate as the principal source of collateral. The majority of commercial
      real estate term loans are amortized over 30 years with higher quality loans
      amortized for up to 40 years. Both 30 and 40 year amortizing loans typically
      reflect a 15 year maturity. Worsening of economic conditions, increasing vacancy
      rates, excessive new construction, and/or rising interest rates could have
      an
      adverse effect on the value of real estate securing these loans and could have
      an adverse impact on the financial condition of the Bank.





The
      SBA
      loan program has been a less popular loan product in the current competitive
      market. Most SBA loans are floating rate loans tied to the prime rate which
      has
      been increasing. In an effort to remain competitive with SBA loans, the Bank
      has
      offered prime based fixed rate SBA loans for a fixed period, which moves to
      a
      variable loan at a stated date. This has made SBA loans more competitive, but
      also less attractive for purchase in the secondary market until they move to
      a
      floating rate. At September 30, 2006 total SBA (7a) guaranteed loans equaled
      $172.8 million, of which $105.9 million was guaranteed by the SBA. The majority
      of the Bank’s SBA loans are secured by real estate; however, they are reported
      as commercial loans. SBA loans have the same underwriting requirements as the
      Bank’s other loans, except they are sometimes for longer terms (7 to 25 years)
      and have higher loan-to-value ratios than the Bank typically accepts. If a
      default on a SBA loan occurs the Bank shares proportionally in the collateral
      supporting the loan with the SBA, which guarantees the loan. The 7(a) program
      is
      now operating at a zero subsidy which should resolve the budget considerations
      at the Federal government level that previously disrupted the program. With
      a
      $16.5 billion dollar authorization level, the program is not expected to be
      disrupted by governmental limitations on funding. Major changes to the default
      rates and subsequent subsidy calculation could affect the Bank’s profitability
      and future SBA loan growth.





Construction
      loans totaled $49.1 million at September 30, 2006, up from $37.2 million at
      December 31, 2005. Construction loans are made to owner/occupied and owner/users
      of the properties and occasionally to developers with a successful history
      of
      developing projects in the Bank’s market areas. The construction lending
      business is subject to, among other things, the volatility of interest rates,
      real estate prices in the area and the market availability of conventional
      real
      estate financing to repay such construction loans. A decline in real estate
      values and/or demand could potentially have an adverse impact on this portion
      of
      the loan portfolio and on the earnings and financial condition of the Bank.





The
      Bank
      offers residential equity lines of credit on a limited basis. The Bank has
      a
      small portfolio of consumer loans which equaled 0.1% of the total loan portfolio
      at September 30, 2006 and 0.5% of the total loan portfolio at December 31,
      2005.





**Allowance
      for Loan Losses**





The
      allowance for loan losses equaled $12,149,000 at September 30, 2006, compared
      to
      $10,749,000 at December 31, 2005. At September 30, 2006, the allowance for
      loan
      losses equaled 1.09% of loans (net of the guaranteed portion of SBA loans).
      The
      allowance for loan losses is reviewed on a monthly basis, based upon an
      allocation for each loan category, plus an allocation for any outstanding loans
      which have been classified by regulators or internally for the "Watch List".
      Each loan that has been classified is individually analyzed for the risk
      involved with a specific reserve allocation assigned according to the risk
      assessment.




At
      September 30, 2006, there was one borrower on non-accrual totaling $600,000
      which are collateralized by real estate and $450,000 of the total guaranteed
      by
      the SBA. There were no loans past due 90 days or more which were still on
      accrual status. Loans past due 30 to 89 days totaled $4,224,000, all of which
      are collateralized by real estate. At December 31, 2005, the Bank had $618,000
      in non-accrual loans and no loans past due 90 or more days and still accruing
      interest. Loans past due 30 to 89 days totaled $5,172,000 at December 31,
      2005.





During
      the third quarter of 2006, there were no loans charged off and there were no
      recoveries on loans previously charged off. The Bank continues to have a low
      charge off experience compared to industry standards but there can be no
      assurances that this will continue or that the Bank will not experience loan
      losses. The following is an analysis of the activity in the allowance for loan
      losses during the quarter and nine months ended September 30, 2006:





21





(In
                thousands)
            
            Three
                months ended
              September
                30, 2006
            
            Nine
                months ended
              September
                30, 2006Balance
                - Beginning of period
            
            $
            11,699
            
            $
            10,749Provision
                for loan losses
            
            
            450
            
            
            1,400Charge
                offs
            
            
            -
            
            
            -Recoveries
            
            
            -
            
            
            -Balance
                - End of period
            
            $
            12,149
            
            $
            12,149




**Capital
      Resources**





Pursuant
      to regulations under the FDIC Improvement Act of 1991 (FDICIA), five capital
      levels were prescribed as applicable for banks, ranging from well-capitalized
      to
      critically under-capitalized. At September 30, 2006, the Bank was considered
      "well capitalized."





The
      capital ratios for the Bank and the Company are presented in the following
      table.


Sonoma
                  National Bank
              
              Northern
                  Empire BancsharesSeptember
                  30, 2006
              
              December
                  31, 2005
              
              September
                  30, 2006
              
              December
                  31, 2005Tier
                  1 leverage ratio
              
              8.2%
              
              7.9%
              
              9.0%
              
              8.8%Tier
                  1 risk-based capital ratio
              
              9.8%
              
              9.9%
              
              10.8%
              
              11.0%Total
                  risk based capital ratio
              
              10.9%
              
              11.1%
              
              11.9%
              
              12.2%




The
      Company declared a 5% stock dividend on March 28, 2006, with a record date
      of
      May 1, 2006.








**ITEM
      3. Quantitative and Qualitative Disclosures about Market
      Risk**





The
      Bank’s financial performance is impacted by, among other factors, interest rate
      risk and credit risk. The Bank does not use derivatives to mitigate its credit
      risk, relying instead on underwriting standards, loan review and adequate loan
      loss reserves. See Allowance for Loan Losses. The Bank does not use derivatives
      to mitigate its interest rate risk. Interest rate risk is managed at the product
      level by structuring loan and deposit product offerings and pricing and
      structuring wholesale borrowings, such as Federal Home Loan Bank Advances,
      in a
      way that minimizes interest rate risk.





Interest
      rate risk is the risk of loss in value due to changes in interest rates. Since
      virtually all of the Company’s interest rate risk exposure lies at the Bank
      level, this risk is addressed by the Bank’s Asset Liability Committee (“ALCO”),
      which includes members of the Board of Directors and senior officers of the
      Bank. ALCO attempts to manage the various components of the Company’s balance
      sheet to minimize the impact of sudden and sustained changes in interest rates
      on portfolio values and net interest income.





A
      fundamental objective is to manage its assets and liabilities to maximize the
      economic value of the Bank while maintaining adequate liquidity and minimizing
      exposure to interest rate risk. Management believes an acceptable degree of
      exposure to interest rate risk results from the management of assets and
      liabilities through maturity, pricing and mix with the goal of limiting its
      exposure to interest rate risk. The Bank’s profitability is dependent to a large
      extent upon its net interest income. The Bank is subject to interest rate risk
      to the degree that its interest-earning assets reprice at different speeds
      and
      different magnitudes than its interest-bearing liabilities, impacting the
      quantity of interest income earned and interest expense incurred.





Interest
      rate sensitivity analysis is used to measure the Bank’s interest rate risk by
      computing estimated changes in the net present value (NPV) of its cash flows
      from assets, liabilities and off-balance sheet items in the event of a range
      of
      assumed changes in market interest rates. NPV represents the market value of
      portfolio equity and is equal to the present value of asset cash flows minus
      the
      present value of liability cash flows, with adjustments made for off-balance
      sheet items. This analysis assesses the risk of loss in interest rate sensitive
      assets, liabilities and instruments in the event of sudden and sustained
      increases and decreases in market interest rates of 100 and 200 basis points.
      The Bank has no trading securities.





22





On
      a
      monthly basis, management prepares an analysis of interest rate exposure. Such
      analysis calculates the change in net interest income given a change in general
      interest rates of 100 and 200 basis points up or down. All changes are measured
      in dollars and are compared to projected net interest income assuming a stable
      rate environment. Additionally, the analysis calculates the change in the value
      of the Bank’s equity by discounting cash flows associated with the Bank’s assets
      and liabilities. The following table summarizes the simulated change in net
      interest income based on the next twelve months given a change in general
      interest rates of 100 and 200 basis points up or down.


**Change
                  in**
                **Interest
                  Rate**
                **(basis
                  points)**
              **Estimated**
                **Net
                  Interest Income**
                **(in
                  thousands)**
              **Estimated
                  Change in**
                **Net
                  Interest Income**
                **(in
                  thousands)**+200
              $44,618
              ($1,461)+100
              45,637
              (443)Base
                  Scenario
              46,080
              --100
              46,481
              401-200
              46,948
              868





The
      model
      used by management to create the report presented above makes numerous
      assumptions, including relative levels of market interest rates, loan
      prepayments and deposit runoff, and should not be relied upon as indicative
      of
      actual future results. Computations do not contemplate any actions that ALCO
      could undertake in response to changes in interest rates, nor does the model
      consider the impact of growth. Actual results could differ significantly from
      those estimates, which would result in significant differences in the calculated
      projected change.





Interest
      rate risk management is a function of the repricing characteristics of the
      portfolio of assets and liabilities. Interest rate risk management focuses
      on
      the maturity structure of assets and liabilities and their repricing
      characteristics during periods of changes in market interest rates. Effective
      interest rate risk management seeks to ensure that both assets and liabilities
      respond to changes in interest rates within an acceptable time frame, thereby
      minimizing the effect of interest rate movements on net interest income.
      Interest rate sensitivity is measured as the difference between the volume
      of
      assets and liabilities in the current portfolio that is subject to repricing
      at
      various time horizons. The differences are known as interest rate sensitivity
      gaps.





The
      following schedule represents interest rate sensitivity profile as of September
      30, 2006, of assets, liabilities and shareholders' equity classified by earliest
      possible repricing opportunity or maturity date.





23





**Balance
                Sheet**
              **(in
                thousands)**
            
            **Through
                3**
              **months**
            
            **Over
                3 months**
              **through**
              **1
                year**
            
            **Over
                1 year**
              **through
                5**
              **years**
            
            **Non-rate**
              **Sensitive
                or**
              **Over
                5 years**
            
            **Total****Assets****Fed
                funds sold & certificates of deposit**
            
            $
            95,008
            
            $
            1,773
            
            $
            297
            
            
            
            
            $
            97,078**Investment
                securities**
            
            
            
            
            
            1,087
            
            
            
            
            $
            15,202
            
            
            16,289**Loans
                (net of discounts)**
            
            
            471,256
            
            
            252,034
            
            
            103,187
            
            
            396,527
            
            
            1,223,004**Non-interest-earning
                assets (net of allowance for loan losses)**
            
            
            
            
            
            
            
            
            
            
            
            28,985
            
            
            28,985$
            566,264
            
            $
            254,894
            
            $
            103,484
            
            $
            440,714
            
            $
            1,365,356**Liabilities
                & Shareholders’ Equity****Time
                Deposits $100,000 and over**
            
            $
            63,709
            
            $
            226,176
            
            $
            28,878
            
            
            
            
            $
            318,763**All
                other interest-bearing liabilities**
            
            
            499,203
            
            
            325,853
            
            
            65,391
            
            $
            190
            
            
            890,637**Non-interest
                bearing liabilities**
            
            
            
            
            
            
            
            
            
            
            
            34,450
            
            
            34,450**Shareholders'
                Equity**
            
            
            
            
            
            
            
            
            
            
            
            121,506
            
            
            121,506$
            562,912
            
            $
            552,029
            
            $
            94,269
            
            $
            156,146
            
            $
            1,365,356**Interest
                Rate Sensitivity (1)**
            
            $
            3,352
            
            
            ($297,135
            )
            $
            9,215
            
            $
            284,568**Cumulative
                Interest Rate Sensitivity**
            
            $
            3,352
            
            
            ($293,783
            )
            
            ($284,568
            )
            $
            0




(1)
            Interest
                rate sensitivity is the difference between interest rate sensitive
                assets
                and interest rate sensitive liabilities within the above time
                frames.








**ITEM
      4. Controls and Procedures**





As
      of the
      end of the period covered by this report, the Company carried out an evaluation,
      under the supervision and with the participation of the Company's management,
      including its Chief Executive Officer and Chief Accounting Officer, of the
      effectiveness of the design and operation of the Company's disclosure controls
      and procedures, as defined in Securities Exchange Act Rule 13a-15(e). Based
      on
      that evaluation, the Chief Executive Officer and Chief Accounting Officer
      concluded that the Company's disclosure controls and procedures are effective
      in
      a timely manner to alert them to material information relating to the Company,
      which is required to be included in the Company's periodic Securities and
      Exchange Commission filings. No change in internal control over financial
      reporting, as defined in Securities and Exchange Act Rule 13a-15(f), occurred
      during the fiscal quarter ended September 30, 2006, that has materially affected
      or is reasonably likely to materially affect, the Company’s internal control
      over financial reporting.




24





PART
      II -
      OTHER INFORMATION





Item
      1.
      Legal Proceedings





None
      other than in the ordinary course of business.





Item
      1A.
      Risk Factors





Management
      has reviewed the risk factors disclosed in its 2005 Form 10K filed on March
      16,
      2006. We do not believe that there have been any material changes in the risk
      factors previously disclosed in our 2005 Form 10-K. Please refer to the risk
      factors included under the section “Forward-looking statements” in Part 1, Item
      2 above.





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





None





Item
      3.
      Defaults Upon Senior Securities





None





Item
      4.
      Submission of Matters to a Vote of Security Holders





None





Item
      5.
      Other Information





None





Item
      6.
      Exhibits





a.
      Exhibits:





(3)
                (i)
            Restated
                Articles of Incorporation, as amended through December 1, 2003 (filed
                as
                Exhibit (3)(d) to the Corporation’s Annual Report on Form 10-K for the
                Fiscal Year Ended December 31, 2003, file number 2-9116, and incorporated
                herein by this reference).





(ii)
            Secretary’s
                Certificate of Amendment to the Bylaws of the Corporation and revised
                Bylaws (filed as Exhibit (3)(b) to the Corporation's Annual Report
                on Form
                10-K for the Fiscal Year Ended December 31, 2004 and incorporated
                herein
                by this reference).





(10)
                (a)
            Severance
                Agreement between Northern Empire Bancshares and Larry V. Sorensen
                dated
                September 29, 2006.





(10)
                (b)
            Amended
                Executive Salary Continuation Agreement between Sonoma National Bank
                and
                Deborah A. Meekins dated February 14,
                2006.




(10)
                  (c)
              Amended
                  Executive Salary Continuation Agreement between Sonoma National
                  Bank and
                  David Titus dated February 14,
                  2006.




(10)
                (d)
            Engagement
                Letter between Sandler O’Neill and Northern Empire Bancshares dated
                January 6, 2006.





(31)
            Rule
                13a-14(a)/15d-14(a) Certifications





(32)
            Section
                1350 Certification




25





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.








NORTHERN
      EMPIRE BANCSHARES


Date:
              November
                  7, 2006/s/
                  Deborah A. Meekins
              
              /s/
                  Jane M. BakerDeborah
                  A. Meekins
              
              Jane
                  M. BakerPresident
                  and Chief Executive Officer
              
              Chief
                  Accounting Officer