UNITED STATES SECURITIES AND EXCHANGE COMMISSIONWASHINGTON, D.C. 20549FORM 10-Q(Mark One)[X] Quarterly report pursuant to Section 13 or l5(d) of the Securities Exchange Act of 1934For the quarterly period ended September 30, 2010[ ] Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934For the transition period from ________ to ________ Commission File Number 000-24503WASHINGTON BANKING COMPANY(Exact name of registrant as specified in its charter) Washington
     
     91-1725825(State or other jurisdiction of
     
     (I.R.S. Employerincorporation or organization)
     
     Identification Number)
  450 SW Bayshore DriveOak Harbor, Washington 98277(Address of principal executive offices) (Zip Code)(360) 679-3121(Registrants telephone number, including area code) (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 has submitted electronically and posted on its corporate web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 229.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).Yes [ ] No [ ] Indicate by check mark if the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of large accelerated filer, accelerated filer and smaller reporting company in Rule 12b-2 of the Exchange Act. Large accelerated filer[  ]Accelerated filer [X]Non-Accelerated filer[  ]Smaller reporting company [  ] Indicate by check mark if the registrant is a shell company as defined in Rule 12b-2 under the Securities Exchange Act of 1934, as amended. Yes[]No[X] The number of shares of the issuers Common Stock outstanding at November 5, 2010 was 15,315,789.


---



PART I - FINANCIAL INFORMATIONPageItem 1.
     Financial StatementsCondensed Consolidated Statements of Financial Condition (unaudited)September 30, 2010 and December 31, 2009
     1Condensed Consolidated Statements of Income (unaudited)Three and Nine Months Ended September 30, 2010 and 2009
     2Condensed Consolidated Statements of Shareholders' Equity and ComprehensiveIncome (unaudited) Nine Months Ended September 30, 2010 and 2009
     3Condensed Consolidated Statements of Cash Flows (unaudited)Nine Months Ended September 30, 2010 and 2009
     4Notes to Condensed Consolidated Financial Statements
     6Item 2.
     Management's Discussion and Analysis of Financial Condition and Results of Operations
     31Item 3.
     Quantitative and Qualitative Disclosures about Market Risk
     51Item 4.
     Controls and Procedures
     51PART II - OTHER INFORMATIONItem 1.
     Legal Proceedings
     52Item 1A.
     Risk Factors
     52Item 2.
     Unregistered Sales of Equity Securities and Use of Proceeds
     53Item 3.
     Defaults Upon Senior Securities
     53Item 4.
     (Removed and Reserved)
     53Item 5.
     Other Information
     53Item 6.
     Exhibits
     54Signatures
     55
  i


---



PART I  FINANCIAL INFORMATIONItem 1. Financial StatementsWASHINGTON BANKING COMPANYAND SUBSIDIARIESCondensed Consolidated Statements of Financial Condition (unaudited)(Dollars in thousands, except per share data)September 30,
     
     
     December 31,2010
     
     
     2009AssetsCash and due from banks
     $
     24,572
     
     $
     14,950($4,627 and $1,635, respectively, are restricted)Interest-bearing deposits
     
     141,630
     
     
     86,891Federal funds sold
     
     4,963
     
     
     -Total cash, restricted cash and cash equivalents
     
     171,165
     
     
     101,841Investment securities available for sale, at fair value
     
     200,448
     
     
     80,833Federal Home Loan Bank stock
     
     7,576
     
     
     2,430Loans held for sale
     
     7,785
     
     
     3,232Non-covered loans, net of allowance for loan losses
     
     819,081
     
     
     797,640Covered loans
     
     393,347
     
     
     -Total loans
     
     1,212,428
     
     
     797,640Premises and equipment, net
     
     37,462
     
     
     25,495Bank owned life insurance
     
     17,217
     
     
     16,976Other intangible assets, net
     
     2,919
     
     
     -Non-covered other real estate owned
     
     4,095
     
     
     4,549Covered other real estate owned
     
     27,250
     
     
     -FDIC indemnification asset
     
     124,709
     
     
     -Other assets
     
     17,130
     
     
     12,875Total assets
     $
     1,830,184
     
     $
     1,045,871Liabilities and Shareholders' EquityLiabilities:DepositsNoninterest-bearing demand
     $
     187,009
     
     $
     104,070NOW accounts
     
     194,370
     
     
     141,121Money market
     
     336,329
     
     
     202,144Savings
     
     88,085
     
     
     49,003Time deposits
     
     805,471
     
     
     350,333Total deposits
     
     1,611,264
     
     
     846,671Other borrowed funds
     
     -
     
     
     10,000Junior subordinated debentures
     
     25,774
     
     
     25,774Other liabilities
     
     13,404
     
     
     3,905Total liabilities
     
     1,650,442
     
     
     886,350Commitments and contingencies (See Note 13)Shareholders' Equity:Preferred stock, no par value; 26,380 shares authorizedSeries A (liquidiation preference $1,000 per share); 26,380 shares issuedand outstanding at September 30, 2010 and December 31, 2009
     
     25,249
     
     
     24,995Common stock, no par value; 35,000,000 shares authorized; 15,310,893 and15,297,801 shares issued and outstanding at September 30, 2010 andDecember 31, 2009, respectively
     
     85,123
     
     
     84,814Retained earnings
     
     67,181
     
     
     49,463Accumulated other comprehensive income
     
     2,189
     
     
     249Total shareholders' equity
     
     179,742
     
     
     159,521Total liabilities and shareholders' equity
     $
     1,830,184
     
     $
     1,045,871
  1


---



WASHINGTON BANKING COMPANYAND SUBSIDIARYCondensed Consolidated Statements of Income (unaudited)(Dollars in thousands, except per share data)Three Months Ended
     
     
     Nine Months EndedSeptember 30,
     
     
     September 30,2010
     
     
     
     2009
     
     
     2010
     
     
     2009Interest income:Interest and fees on non-covered loans
     $
     13,536
     
     
     $
     13,538
     
     $
     39,962
     
     $
     39,782Interest and fees on covered loans
     
     5,479
     
     
     
     -
     
     
     10,406
     
     
     -Interest on taxable investment securities
     
     699
     
     
     
     191
     
     
     1,620
     
     
     468Interest on tax-exempt investment securities
     
     187
     
     
     
     130
     
     
     514
     
     
     292Other
     
     99
     
     
     
     18
     
     
     231
     
     
     28Total interest income
     
     20,000
     
     
     
     13,877
     
     
     52,733
     
     
     40,570Interest expense:Interest on deposits
     
     3,075
     
     
     
     3,201
     
     
     8,383
     
     
     10,106Interest on other borrowed funds
     
     59
     
     
     
     94
     
     
     243
     
     
     341Interest on junior subordinated debentures
     
     135
     
     
     
     139
     
     
     374
     
     
     543Total interest expense
     
     3,269
     
     
     
     3,434
     
     
     9,000
     
     
     10,990Net interest income
     
     16,731
     
     
     
     10,443
     
     
     43,733
     
     
     29,580Provision for loan losses
     
     3,950
     
     
     
     2,500
     
     
     8,650
     
     
     7,950Net interest income after provision for loan losses
     
     12,781
     
     
     
     7,943
     
     
     35,083
     
     
     21,630Noninterest income:Service charges and fees
     
     907
     
     
     
     909
     
     
     2,498
     
     
     2,620Electronic banking income
     
     511
     
     
     
     376
     
     
     1,325
     
     
     1,034Investment products
     
     120
     
     
     
     38
     
     
     348
     
     
     368Bank owned life insurance income
     
     61
     
     
     
     106
     
     
     241
     
     
     312Income from the sale of mortgage loans
     
     352
     
     
     
     138
     
     
     697
     
     
     708SBA premium income
     
     126
     
     
     
     49
     
     
     378
     
     
     83Bargain purchase gain on acquisitions
     
     17,511
     
     
     
     -
     
     
     19,268
     
     
     -Change in FDIC indemnification asset
     
     812
     
     
     
     -
     
     
     1,596
     
     
     -Other
     
     448
     
     
     
     232
     
     
     1,310
     
     
     800Total noninterest income
     
     20,848
     
     
     
     1,848
     
     
     27,661
     
     
     5,925Noninterest expense:Salaries and benefits
     
     6,615
     
     
     
     3,638
     
     
     17,471
     
     
     10,499Occupancy and equipment
     
     1,677
     
     
     
     1,099
     
     
     4,042
     
     
     3,203Office supplies and printing
     
     299
     
     
     
     198
     
     
     820
     
     
     577Data processing
     
     403
     
     
     
     141
     
     
     1,011
     
     
     418Consulting and professional fees
     
     92
     
     
     
     184
     
     
     490
     
     
     564Intangible amortization
     
     234
     
     
     
     -
     
     
     425
     
     
     -Merger related expenses
     
     978
     
     
     
     -
     
     
     1,654
     
     
     -FDIC premiums
     
     562
     
     
     
     283
     
     
     1,068
     
     
     1,106OREO and repossession expenses
     
     (23
     )
     
     
     389
     
     
     641
     
     
     982Other
     
     2,007
     
     
     
     1,446
     
     
     4,924
     
     
     3,763Total noninterest expense
     
     12,844
     
     
     
     7,378
     
     
     32,546
     
     
     21,112Income before provision for income taxes
     
     20,785
     
     
     
     2,413
     
     
     30,198
     
     
     6,443Provision for income taxes
     
     7,085
     
     
     
     740
     
     
     9,937
     
     
     1,965Net income before preferred dividends
     
     13,700
     
     
     
     1,673
     
     
     20,261
     
     
     4,478Preferred stock dividends and discount accretion
     
     415
     
     
     
     414
     
     
     1,244
     
     
     1,186Net income available to common shareholders
     $
     13,285
     
     
     $
     1,259
     
     $
     19,017
     
     $
     3,292Net income available per common share, basis
     $
     0.87
     
     
     $
     0.13
     
     $
     1.24
     
     $
     0.35Net income available per common share, diluted
     $
     0.86
     
     
     $
     0.13
     
     $
     1.23
     
     $
     0.35Average number of common shares outstanding, basis
     
     15,309,000
     
     
     
     9,532,000
     
     
     15,303,000
     
     
     9,519,000Average number of common shares outstanding, diluted
     
     15,473,000
     
     
     
     9,554,000
     
     
     15,452,000
     
     
     9,541,000
  2


---



WASHINGTON BANKING COMPANYAND SUBSIDIARYCondensed Consolidated Statements of Shareholders' Equity andComprehensive Income (unaudited)(Dollars in thousands, except per share data)AccumulatedPreferred
     
     
     
     
     
     
     
     
     
     
     
     
     other
     
     
     Totalstock
     
     Common stock
     
     
     Retained
     
     
     
     comprehensive
     
     
     shareholders'amount
     
     Shares
     
     
     
     Amount
     
     
     earnings
     
     
     
     income
     
     
     equityBalance at December 31, 2008
     $
     -
     
     9,510
     
     
     $
     33,701
     
     $
     46,567
     
     
     $
     
     292
     
     $
     80,560Comprehensive income:Net income
     
     -
     
     -
     
     
     
     -
     
     
     4,478
     
     
     
     
     -
     
     
     4,478Net change in unrealized gain(net of tax expense of $94)
     
     -
     
     -
     
     
     
     -
     
     
     -
     
     
     
     
     255
     
     
     255Total comprehensive income
     
     
     
     
     
     
     
     
     
     
     
     
     
     
     
     
     
     
     4,733Issuance of preferred stock to U. S. Treasury
     
     24,660
     
     -
     
     
     
     -
     
     
     -
     
     
     
     
     -
     
     
     24,660Issuance of warrants to U.S. Treasury
     
     -
     
     -
     
     
     
     1,720
     
     
     -
     
     
     
     
     -
     
     
     1,720Preferred stock dividends and accretion
     
     251
     
     -
     
     
     
     -
     
     
     (1,186
     )
     
     
     
     -
     
     
     (935
     )Cash dividends on common stock,$0.155 per share
     
     -
     
     -
     
     
     
     -
     
     
     (1,478
     )
     
     
     
     -
     
     
     (1,478
     )Stock-based compensation expense
     
     -
     
     -
     
     
     
     239
     
     
     -
     
     
     
     
     -
     
     
     239Issuance of common stock under stock plans
     
     -
     
     20
     
     
     
     90
     
     
     -
     
     
     
     
     -
     
     
     90Tax benefit associated with stock awards
     
     -
     
     -
     
     
     
     3
     
     
     -
     
     
     
     
     -
     
     
     3Cancellation of restricted stock
     
     -
     
     (1
     )
     
     
     -
     
     
     -
     
     
     
     
     -
     
     
     -Balance at September 30, 2009
     $
     24,911
     
     9,529
     
     
     $
     35,753
     
     $
     48,381
     
     
     $
     547
     
     $
     109,592Balance at December 31, 2009
     $
     24,995
     
     15,298
     
     
     $
     84,814
     
     $
     49,463
     
     
     $
     
     249
     
     $
     159,521Comprehensive income:Net income
     
     -
     
     -
     
     
     
     -
     
     
     20,261
     
     
     
     
     -
     
     
     20,261Net change in unrealized gain
     
     
     
     
     
     
     
     
     
     
     
     
     
     
     
     
     
     
     -(net of tax expense of $1,047)
     
     -
     
     -
     
     
     
     -
     
     
     -
     
     
     
     1,940
     
     
     1,940Total comprehensive income
     
     
     
     
     
     
     
     
     
     
     
     
     
     
     
     
     
     
     22,201Preferred stock dividends and accretion
     
     254
     
     -
     
     
     
     -
     
     
     (1,244
     )
     
     
     
     -
     
     
     (990
     )Cash dividends on common stock,
     
     
     
     
     
     
     
     
     
     
     
     
     
     
     
     
     
     
     -$0.085 per share
     
     -
     
     -
     
     
     
     -
     
     
     (1,299
     )
     
     
     
     -
     
     
     (1,299
     )Stock-based compensation expense
     
     -
     
     -
     
     
     
     281
     
     
     -
     
     
     
     
     -
     
     
     281Issuance of common stock under stock plans
     
     -
     
     13
     
     
     
     20
     
     
     -
     
     
     
     
     -
     
     
     20Tax benefit associated with stock awards
     
     -
     
     -
     
     
     
     8
     
     
     -
     
     
     
     
     -
     
     
     8Balance at September 30, 2010
     $
     25,249
     
     15,311
     
     
     $
     85,123
     
     $
     67,181
     
     
     $
     2,189
     
     $
     179,742
  3


---



WASHINGTON BANKING COMPANYAND SUBSIDIARYCondensed Consolidated Statements of Cash Flows (continued) (unaudited)(Dollars in thousands)Nine Months EndedSeptember 30,2010
     
     
     2009Cash flows from operating activities:Net income
     $
     20,261
     
     
     $
     4,478Adjustments to reconcile net income to net cash provided by operating acitivities:Accretion of investment security discounts, net
     
     369
     
     
     
     20Depreciation
     
     1,208
     
     
     
     1,327Intangible amortization
     
     425
     
     
     
     -Provision for loan losses
     
     8,650
     
     
     
     7,950Earnings on bank owned life insurance
     
     (241
     )
     
     
     (312
     )Net (gain) loss on sale of premises and equipment
     
     5
     
     
     
     (57
     )Net gain on sale of non-covered other real estate owned
     
     (20
     )
     
     
     (51
     )Origination of loans held for sale
     
     (79,967
     )
     
     
     (91,337
     )Proceeds from sales of loans held for sale
     
     75,414
     
     
     
     91,282Valuation adjustment on non-covered other real estate owned
     
     -
     
     
     
     382Bargain purchase gain on acquisitions
     
     (19,268
     )
     
     
     -Change in FDIC indemnification asset
     
     (1,596
     )
     
     
     -Stock-based compensation
     
     281
     
     
     
     239Excess tax benefit from stock-based compensation
     
     (8
     )
     
     
     (3
     )Net change in assets and liabilities:Net (increase) decrease in other assets
     
     183
     
     
     
     (6
     )Net decrease in other liabilities
     
     (7,540
     )
     
     
     (2,215
     )Net cash provided by (used in) operating activities
     
     (1,844
     )
     
     
     11,697Cash flows from investing activities:Purchases of investment securities, available for sale
     
     (127,453
     )
     
     
     (44,537
     )Maturities/calls/principal payments of investment and mortgage-backed securities,available for sale
     
     40,860
     
     
     
     6,503Net decrease (increase) in loans and covered loans
     
     18,006
     
     
     
     (2,848
     )Purchases of premises and equipment
     
     (13,147
     )
     
     
     (2,012
     )Proceeds from the sale of premises and equipment
     
     101
     
     
     
     -Proceeds from sale of non-covered other real estate owned
     
     1,682
     
     
     
     2,125Proceeds from sale of covered other real estate owned
     
     5,719
     
     
     
     -Capitalization of non-covered other real estate owned improvements
     
     (118
     )
     
     
     -Cash acquired in merger, net of cash consideration paid
     
     351,287
     
     
     
     -Net cash provided by (used in) investing activities
     $
     276,937
     
     
     $
     (40,769
     )
  4


---



WASHINGTON BANKING COMPANYAND SUBSIDIARYCondensed Consolidated Statements of Cash Flows (continued) (unaudited)(Dollars in thousands)Nine Months EndedSeptember 30,2010
     
     
     
     
     2009Cash flows from financing activities:Net increase (decrease) in deposits
     $
     (143,356
     )
     
     $
     64,858Gross payments on other borrowed funds
     
     (10,000
     )
     
     
     (20,000
     )Net decrease in FHLB overnight borrowings
     
     (50,152
     )
     
     
     (11,640
     )Proceeds from issuance of preferred stock
     
     -
     
     
     
     
     26,380Proceeds from exercise of stock options
     
     20
     
     
     
     
     90Excess tax benefits from stock-based compensation
     
     8
     
     
     
     
     3Dividends paid on preferred stock
     
     (990
     )
     
     
     
     (935
     )Dividends paid on common stock
     
     (1,299
     )
     
     
     
     (1,478
     )Net cash provided by (used in) financing activities
     
     (205,769
     )
     
     
     
     57,278Net change in cash and cash equivalents
     
     69,324
     
     
     
     
     28,206Cash and cash equivalents at beginning of period
     
     101,841
     
     
     
     
     13,990Cash and cash equivalents at end of period
     $
     171,165
     
     
     $
     42,196Supplemental disclosures of cash flow information:Cash paid during the period for:Interest
     $
     8,697
     
     
     $
     11,188Income taxes
     $
     5,000
     
     
     $
     
     1,965Supplemental disclosures about noncash investing and financing activities:Change in fair value of investment securities available for sale, net of taxes
     $
     1,940
     
     
     $
     
     255Transfer of loans to non-covered other real estate owned
     $
     1,090
     
     
     $
     
     5,282Transfer of loans to covered other real estate owned
     $
     14,444
     
     
     $
     
     -Acquisitions:
     
     
     
     
     $Assets acquired
     $
     994,407
     
     
     $
     
     -Liabilities assumed
     $
     981,883
     
     
     $
     
     -
  5


---



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(1) Description of Business and Summary of Significant Accounting Policies


(a) Description of Business:Washington Banking Company (the Company or WBCO) is a registered bank holding company formed on April 30, 1996. At September 30, 2010, WBCO had two wholly-owned subsidiaries Whidbey Island Bank (WIB or the Bank), the Companys principal subsidiary, and Washington Banking Master Trust (the Trust). The business of the Bank, which is focused in the northern area of Western Washington, consists primarily of attracting deposits from the general public and originating loans. The regions economy has evolved from one that was once heavily dependent upon forestry, fishing and farming to an economy with a much more diverse blend of industries including retail trade, services, manufacturing, tourism and a large military base presence. Although the Bank has a diversified loan portfolio, a substantial portion of its borrowers ability to repay their loans is dependent upon the economic conditions affecting this area.

(b) Basis of Presentation:The accompanying interim condensed consolidated financial statements include the accounts of WBCO and its subsidiaries described above. The accompanying interim condensed consolidated financial statements have been prepared, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (SEC). Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles in the United States of America for complete financial statements. These condensed consolidated financial statements should be read in conjunction with the December 31, 2009 audited consolidated financial statements and notes thereto included in the Companys Annual Report on Form 10-K filed with the SEC.

In preparing these financial statements, the Company has evaluated events and transactions subsequent to September 30, 2010 for potential recognition or disclosure.In managements opinion, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the nine months ended September 30, 2010, are not necessarily indicative of the results that may be expected for the year ending December 31, 2010. In preparing the condensed consolidated financial statements, estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses are required. Actual results could differ from those estimates.

(c) Reclassifications:Certain amounts in prior years financial statements may have been reclassified to conform to the 2010 presentation. These reclassifications had no significant impact on the Companys financial position or results of operations.

(d) Significant Accounting Policies: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 and the accompanying notes. 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 following significant accounting policies are in addition to the significant accounting policies described in Note (1) of the Notes to Consolidated Financial Statements for the year ended December 31, 2009, as filed on Form 10-K.

Acquired Loans:Acquired loans are valued as of acquisition date in accordance with Financial Accounting Standards Board Accounting Standards Codification (FASB ASC) 805,Business Combinations. Loans purchased with evidence of credit deterioration since origination for which it is probable that all contractually required payments will not be collected are accounted for under FASB ASC 310-30,Loans and Debt Securities Acquired with Deteriorated Credit Quality. In addition, because of the significant discounts associated with the acquired portfolios, the Company elected to account for all acquired loans under ASC 310-30.

6

---



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (1) Description of Business and Summary of Significant Accounting Policies (continued) In accordance with FASB ASC 310-30, acquired loans are aggregated into pools, based on individually evaluated common risk characteristics, and aggregate expected cash flows were estimated for each pool. A pool is accounted for as a single asset with a single interest rate, cumulative loss rate and cash flow expectation. The Bank aggregated all of the loans acquired in the FDIC-assisted acquisitions of City Bank and North County Bank into 18 and 14 pools, respectively. A loan will be removed from a pool of loans only if the loan is sold, foreclosed, assets are received in satisfaction of the loan, or the loan is written off, and will be removed from the pool at the carrying value. If an individual loan is removed from a pool of loans, the difference between its relative carrying amount and the cash, fair value of the collateral, or other assets received will be recognized in income immediately and would not affect the effective yield used to recognize the accretable difference on the remaining pool. Loans originally placed into a performing pool will not be reported individually as 30-89 days past due, non-performing (90+ days past due or nonaccrual) or accounted for as a troubled debt restructuring as the pool is the unit of accounting. Rather, these metrics related to the underlying loans within a performing pool will be considered in our ongoing assessment and estimates of future cash flows. If, at acquisition, the loans are collateral dependent and acquired primarily for the rewards of ownership of the underlying collateral, or if cash flows expected to be collected cannot be reasonably estimated, accrual of income is inappropriate. Such loans will be placed into nonperforming (nonaccrual) loan pools. The cash flows expected to be received over the life of the pool were estimated by management with the assistance of a third party valuation specialist. These cash flows were input into a ASC 310-30 compliant accounting loan system which calculates the carrying values of the pools and underlying loans, book yields, effective interest income and impairment, if any, based on actual and projected events. Default rates, loss severity and prepayment speed assumptions will be periodically reassessed and updated within the accounting model to update the expectation of future cash flows. The excess of the cash flows expected to be collected over the pools carrying value is considered to be the accretable yield and is recognized as interest income over the estimated life of the loan or pool using the effective yield method. The accretable yield will change due to changes in the timing and amounts of expected cash flows. For the performing loan pools, a prepayment assumption, as documented by the valuation specialist, is initially applied. Changes in the accretable yield will be disclosed quarterly. The excess of the contractual balances due over the cash flows expected to be collected is considered to be the nonaccretable difference. The nonaccretable difference represents the estimate of the credit losses expected to occur and was considered in determining the fair value of the loans as of the acquisition date. Subsequent to the acquisition date, any increases in expected cash flows over those expected at purchase date in excess of fair value are adjusted through the accretable difference on a prospective basis. Any subsequent decreases in expected cash flows over those expected at purchase date are recognized by recording a provision for loan losses. Any disposals of loans, including sales of loans, payments in full or foreclosures, result in the removal of the loan from the pool at its carrying amount. FDIC Indemnification Asset:The Company has elected to account for amounts receivable under the loss share agreement as an indemnification asset in accordance with FASB ASC 805. The FDIC indemnification asset is initially recorded at fair value, based on the discounted value of expected future cash flows under the loss share agreement. The difference between the present value and the undiscounted cash flows the Company expects to collect from the FDIC will be accreted into noninterest income over the life of the FDIC indemnification asset. The FDIC indemnification asset is reviewed quarterly and adjusted for any changes in expected cash flows based on recent performance and expectations for future performance of the covered portfolio. These adjustments are measured on the same basis as the related covered loans and covered other real estate owned. Any increases in cash flow of the covered assets over those expected will reduce the FDIC indemnification asset and any decreases in cash flow of the covered assets under those expected will increase the FDIC indemnification asset. Increases and decreases to the FDIC indemnification asset are recorded as adjustments to noninterest income over the life of the loss share agreements. 7


---



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (2) Recent Financial Accounting Pronouncements In July 2010, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2010-20,Receivables (Topic 310): Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses.This ASU provides enhanced disclosures related to the credit quality of financing receivables and the allowance for credit losses, and provides that new and existing disclosures should be disaggregated based on how an entity develops its allowance for credit losses and how it manages credit exposures. Under the provisions of ASU 2010-20, additional disclosures required for financing receivables include information regarding the aging of past due receivables, credit quality indicators and modifications of financing receivables. ASU 2010-20 is effective for interim and annual reporting periods ending on or after December 15, 2010, for end of period disclosures. Activity related disclosures are required for interim and annual reporting periods beginning on or after December 15, 2010. The Company does not expect this ASU to have an impact on the consolidated financial statements. In April 2010, the FASB issued ASU No. 2010-18,Receivables (Topic 310): Effect of a Loan Modification When the Loan Is Part of a Pool That Is Accounted for as a Single Asset.This ASU codifies the consensus reached in Emerging Issues Task Force (EITF) Issue No. 09-I, Effect of a Loan Modification When the Loan Is Part of a Pool That Is Accounted for as a Single Asset. The amendments to theFASB Accounting Standards Codification (the Codification or ASC) provide that modifications of loans that are accounted for within a pool under Subtopic 310-30 do not result in the removal of those loans from the pool even if the modification of those loans would otherwise be considered a troubled debt restructuring. An entity will continue to be required to consider whether the pool of assets in which the loan is included is impaired if expected cash flows for the pool change. ASU 2010-18 does not affect the accounting for loans under the scope of Subtopic 310-30 that are not accounted for within pools. Loans accounted for individually under Subtopic 310-30 continue to be subject to the troubled debt restructuring accounting provisions within Subtopic 310-40. ASU 2010-18 is effective prospectively for modifications of loans accounted for within pools under Subtopic 310-30 occurring in the first interim or annual period ending on or after July 15, 2010. Early application is permitted. Upon initial adoption of ASU 2010-18, an entity may make a one-time election to terminate accounting for loans as a pool under Subtopic 310-30. This election may be applied on a pool-by-pool basis and does not preclude an entity from applying pool accounting to subsequent acquisitions of loans with credit deterioration. The Company does not expect this ASU to have an impact on the consolidated financial statements. On April 16, 2010, the FASB issued ASU No. 2010-13,CompensationStock Compensation(Topic 718): Effect of Denominating the Exercise Price of a Share-Based Payment Award in the Currency of the Market in Which the Underlying Equity Security Trades. The ASU codifies the consensus reached in EITF Issue No. 09-J.The amendments to the Codification clarify that an employee share-based payment award with an exercise price denominated in the currency of a market in which a substantial portion of the entitys equity shares trades should not be considered to contain a condition that is not a market, performance or service condition. Therefore, an entity would not classify such an award as a liability if it otherwise qualifies as equity. As the Companys current share-based payment awards are equity awards (exercise price is denominated in dollars in the U.S. where the Companys stock is traded), this ASU does not have an impact on the Companys consolidated financial statements. On February 24, 2010, the FASB issued ASU No. 2010-09,Subsequent Events (Topic 855): Amendments to Certain Recognition and Disclosure Requirements. The amendments in this ASU remove the requirement for an SEC filer to disclose a date through which subsequent events have been evaluated in both issued and revised financial statements. Revised financial statements include financial statements revised as a result of either correction of an error or retrospective application of U.S. generally accepted accounting principles. The FASB believes these amendments remove potential conflicts with the SECs literature. All of the amendments in the ASU were effective upon issuance. 8


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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (2) Recent Financial Accounting Pronouncements (continued) In January 2010, the FASB issued ASU No. 2010-06,Fair Value Measurements and Disclosures (Topic 820): Improving Disclosures about Fair Value Measurements.This ASU requires: (1) disclosure of the amounts of significant transfers in and out of Level 1 and Level 2 fair value measurement categories and the reasons for the transfers; and (2) separate presentation of purchases, sales, issuances and settlements in the reconciliation for fair value measurements using significant unobservable inputs (Level 3). In addition, ASU 2010-06 clarifies the requirements of the following existing disclosures set forth in the Codification Subtopic 820-10: (1) For purposes of reporting fair value measurement for each class of assets and liabilities, a reporting entity needs to use judgment in determining the appropriate classes of assets and liabilities; and (2) a reporting entity should provide disclosures about the valuation techniques and inputs used to measure fair value for both recurring and non-recurring fair value measurements. ASU 2010-06 is effective for interim and annual reporting periods beginning January 1, 2010, except for the disclosures about purchases, sales, issuances and settlements in the roll forward of activity in Level 3 fair value measurements, which are effective for fiscal years beginning January 1, 2011, and for interim periods within those fiscal years. As ASU 2010-06 is disclosure-related only, the Companys adoption of this ASU in the first quarter of 2010 did not impact the Companys consolidated financial statements. (3) Business Combinations On April 16, 2010, the Bank acquired certain assets and assumed certain liabilities of City Bank from the Federal Deposit Insurance Corporation (FDIC) in an FDIC assisted transaction. As part of the Purchase and Assumption Agreement, the Bank and the FDIC entered into loss share agreements (each, a loss share agreement and collectively, the loss share agreements). The Bank will share in the losses, which begins with the Bank incurring the first 2% of losses, on the covered assets. After the first 2% of losses on covered assets, the FDIC will absorb 80% of losses and share in 80% of loss recoveries on 100% of the covered loan portfolio. The loss share agreement for commercial and single family residential mortgage loans are in effect for five years and ten years, respectively, from the April 16, 2010 acquisition date and the loss recovery provisions for such loans are in effect for eight years and ten years, respectively, from the acquisition date. In April 2020, approximately ten years following the acquisition date, the Bank is required to make a payment to the FDIC in the event that losses on covered assets under the loss share agreements have been less than the stated threshold level. The payment amount will be 50% of the excess, if any, of (i) 20% of the intrinsic loss estimate ($111.0 million) minus (ii) the sum of (a) 25% of the asset discount (or 25% of the asset discount of ($50.7 million)), plus (b) 25% of cumulative loss share payments (as defined in the Agreement), plus (c) the cumulative servicing amount received by the Bank from the FDIC on covered assets. At September 30, 2010, the Bank estimates that there will be no liability under this provision. The Bank purchased certain assets of City Bank from the FDIC including (at fair value) approximately $323.8 million in loans, $280.0 million of cash and cash equivalents and $9.1 million in investment securities. The Bank also assumed liabilities with fair value of approximately $650.1 million in deposits, $50.1 million in FHLB advances and $13.7 million in other liabilities. The expected net reimbursements under the loss share agreements were recorded at estimated fair value of $84.1 million on the acquisition date. In addition to assuming certain liabilities in the transaction, the Company issued an equity appreciation instrument to the FDIC as part of the consideration. This instrument was valued at $2.1 million when issued. On April 27, 2010, the FDIC exercised its equity appreciation instrument. The application of the acquisition method of accounting resulted in a net after-tax gain of $1.1 million, which has been reported as a component of noninterest income. The operations of City Bank are included in the Companys operating results from April 17, 2010, and added revenue of $6.9 million and $12.8, noninterest expense of $1.4 million and $2.8 million and net earnings of $2.6 million and $4.4 million for the three and nine months ended September 30, 2010, respectively. Such operating results do not include any covered loan or covered other real estate owned losses because of the FDIC loss share agreement and are not necessarily indicative of future operating results. City Banks results of operations prior to the acquisition are not included in the Companys operating results. 9


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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (3) Business Combinations (continued) On September 24, 2010, the Bank assumed certain deposit liabilities and acquired certain assets of North County Bank, Arlington, Washington from the FDIC as receiver for North County Bank and entered into a Purchase and Assumption Agreement with the FDIC. As part of the Agreement, the Bank and the FDIC entered into a loss sharing arrangement covering future losses incurred on acquired or covered loans and other real estate owned (OREO). On single family loans and OREO, the FDIC will absorb: (i) 80% of losses on the first $7.8 million of losses incurred; (ii) 0% of losses on $7.8 million to $12.3 million of losses incurred; and (iii) 80% of losses above $12.3 million of losses incurred. On commercial and non-single family loans and OREO, the FDIC will absorb: (i) 80% of losses on the first $33.9 million of losses incurred; (ii) 0% of losses on $33.9 million to $47.9 million of losses incurred; and (iii) 80% of losses above $47.9 million of losses incurred. The FDIC will share in loss recoveries on the covered loan and OREO portfolio. In September 2020, approximately ten years following the acquisition date, the Bank is required to make a payment to the FDIC in the event that losses on covered assets under the loss share agreements have been less than the stated threshold level. The payment amount will be 50% of the excess, if any, of (i) 20% of the intrinsic loss estimate ($46.9 million) minus (ii) the sum of (a) 20% of the net loss amount, plus (b) 25% of the asset discount bid ($62.5 million), plus (c) 3.5% of total loss share assets at acquisition. At September 30, 2010, the Bank estimated a liability of $3.4 million under this provision. The Bank purchased certain assets of North County Bank from the FDIC including (at fair value) approximately $133.1 million in loans, $71.3 million of cash and cash equivalents, $21.3 million in investment securities and $12.7 million in OREO. The Bank also assumed liabilities with fair values of approximately $257.8 million in deposits and $10.1 million in other liabilities. The expected reimbursements under the loss share agreements were recorded at estimated fair value of $39.0 million on the acquisition date. The application of the acquisition method of accounting resulted in a net after-tax gain of $11.4 million, which has been reported as a component of noninterest income. The operations of North County Bank are included in the Companys operating results from September 25, 2010, and were immaterial to the BanksConsolidated Statement of Incomefor the three months ended September 30, 2010. North County Banks results of operations prior to the acquisition are not included in the Companys operating results. Operations subsequent to acquisition were deemed immaterial for the period presented. Merger-related expenses of $978 thousand and $1.7 million have been incurred in connection with the acquisitions of City Bank and North County Bank for the three and nine months ended September 30, 2010, respectively, and have been recognized as a separate line item on theCondensed Consolidated Statements of Income. The Company refers to the acquired loan portfolios and other real estate owned as covered loans and covered other real estate owned, respectively, and these are presented as separate line items in theCondensed Consolidated Statement of Condition.Collectively, these balances are referred to as covered assets. The assets acquired and liabilities assumed from the City Bank and North County Bank acquisitions have been accounted for under the acquisition method of accounting (formerly the purchase method). The assets and liabilities, both tangible and intangible, were recorded at estimated fair values as of the acquisition date. The fair values of the assets acquired and liabilities assumed were determined based on the requirements of FASB ASC 805. The foregoing fair value amounts are subject to change for up to one year after the closing date of the acquisitions as additional information relating to closing date fair values becomes available. The amounts are also subject to adjustments based upon final settlement with the FDIC. In addition, the tax treatment of FDIC assisted acquisitions is complex and subject to interpretations that may result in future adjustments of deferred taxes as of the acquisition date. The terms of the agreements provide for the FDIC to indemnify the Bank against claims with respect to liabilities of City Bank and North County Bank not assumed by the Bank and certain other types of claims identified in the agreements. The application of the acquisition method of accounting resulted in the recognition of pre-tax bargain purchase gains of $1.8 million and $17.5 million in the City Bank and North County Bank acquisitions, respectively. 10


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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (3) Business Combinations (continued) A summary of the net assets (liabilities) received from the FDIC and the estimated fair value adjustments are presented below: (dollars in thousands)
     
     City Bank
     
     
     
     North County BankApril 16, 2010
     
     
     
     September 24, 2010Cost basis net assets (liabilities)
     $
     (54,943
     )
     
     $
     11,217Cash payment received from the FDIC
     
     99,445
     
     
     
     46,860Net assets acquired before fair value adjustments
     
     44,502
     
     
     
     58,077Fair value adjustments:Covered loans
     
     (122,742
     )
     
     
     (67,360
     )Covered other real estate owned
     
     (551
     )
     
     
     (7,847
     )Core deposit intangible
     
     3,293
     
     
     
     50FDIC indemnification asset
     
     84,113
     
     
     
     39,000Visa Class B common stock
     
     2,025
     
     
     
     -Other assets
     
     (649
     )
     
     
     (89
     )Deposits
     
     (6,000
     )
     
     
     (956
     )FHLB advances
     
     (103
     )
     
     
     -Other liabilities
     
     -
     
     
     
     (3,364
     )FDIC equity appreciation instrument
     
     (2,131
     )
     
     
     -Pre-tax bargain purchase gain on acquisition
     
     1,757
     
     
     
     17,511Deferred income tax liability
     
     (615
     )
     
     
     (6,129
     )Bargain purchase gain on acquisition
     $
     1,142
     
     
     $
     11,382
  In FDIC-assisted transactions, only certain assets and liabilities are transferred to the acquirer and, depending on the nature and amount of the acquirers bid, the FDIC may be required to make a cash payment to the acquirer. In the City Bank acquisition, cost basis net liabilities of $54.9 million and a cash payment received from the FDIC of $99.4 million were transferred to the Company. The bargain purchase gain represents the excess of the estimated fair value of the assets acquired over the estimated fair value of the liabilities assumed. In the North County Bank acquisition, cost basis net assets of $11.2 million and a cash payment received from the FDIC of $46.9 million were transferred to the Company. The bargain purchase gain represents the excess of the estimated fair value of the assets acquired over the estimated fair value of the liabilities assumed. The Bank did not immediately acquire all the real estate, banking facilities, furniture or equipment of City Bank or North County Bank as part of the purchase and assumption agreements. However, the Bank had the option to purchase or lease the real estate and furniture and equipment from the FDIC. The term of this option expires 90 days from the acquisition dates. Acquisition costs of the real estate and furniture and equipment are based on current mutually agreed upon appraisals. Prior to the expiration of option terms, the Bank exercised its option and acquired the facilities and furnishings of the eight City Bank locations for $11.1 million. The option remains outstanding for North County Bank. 11


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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (3) Business Combinations (continued) The statement of assets acquired and liabilities assumed at their estimated fair values of City Bank and North County Bank are presented below: (dollars in thousands)
     
     City Bank
     
     
     North County BankApril 16, 2010
     
     
     September 24, 2010AssetsCash and due from banks
     $
     277,907
     
     $
     66,770Interest-bearing deposits
     
     2,078
     
     
     4,532Total cash and cash equivalents
     
     279,985
     
     
     71,302Investment securities, available for sale
     
     9,120
     
     
     21,286Covered loans
     
     323,842
     
     
     133,136FHLB stock
     
     4,744
     
     
     402Core deposit intangible
     
     3,293
     
     
     50Covered other real estate owned
     
     5,798
     
     
     12,727FDIC indemnification asset
     
     84,113
     
     
     39,000Other assets
     
     4,235
     
     
     1,374Total assets acquired
     $
     715,130
     
     $
     279,277LiabilitiesDeposits
     $
     650,104
     
     $
     257,845FHLB advances
     
     50,152
     
     
     -Other liabilities
     
     13,732
     
     
     10,050Total liabilities assumed
     
     713,988
     
     
     267,895Net assets acquired/bargain purchase gain on acquisition
     
     1,142
     
     
     11,382Total liabilities assumed and net assets acquired
     $
     715,130
     
     $
     279,277
  The acquisition of assets and liabilities of City Bank and North County Bank were significant at a level to require disclosure of one year of historical financial statements and related pro forma financial disclosure. However, given the pervasive nature of the loss sharing agreement entered into with the FDIC, the historical information of City Bank and North County Bank are much less relevant for purposes of assessing the future operations of the combined entity. In addition, prior to closure, City Bank had not completed an audit of their financial statements, and the Company determined that audited financial statements are not and will not be reasonably available for the year ended December 31, 2009. Given these considerations, the Company requested, and received, relief from the Securities and Exchange Commission from submitting certain financial information of City Bank and North County Bank. 12


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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (4) Investment Securities The Companys investment portfolio at September 30, 2010 and December 31, 2009 are reflected in the tables below: (dollars in thousands)
     September 30, 2010Amortized
     
     
     Unrealized
     
     Unrealizedcost
     
     
     gains
     
     
     losses
     
     
     
     Fair valueU.S. government agencies
     $
     105,270
     
     $
     1,227
     
     $
     (68
     )
     
     $
     106,429U. S. Treasuries
     
     54,199
     
     
     752
     
     
     -
     
     
     
     54,951Pass-through securities
     
     1,364
     
     
     34
     
     
     (2
     )
     
     
     1,396Taxable state and political subdivisions
     
     5,565
     
     
     158
     
     
     (11
     )
     
     
     5,712Tax exempt state and political subdivisions
     
     22,628
     
     
     1,332
     
     
     (67
     )
     
     
     23,893Corporate obligations
     
     4,002
     
     
     31
     
     
     (15
     )
     
     
     4,018Investments in mutual funds and other equities
     
     4,043
     
     
     6
     
     
     -
     
     
     
     4,049Total investment securities available for sale
     $
     197,071
     
     $
     3,540
     
     $
     (163
     )
     
     $
     200,448(dollars in thousands)
     December 31, 2009Amortized
     
     
     Unrealized
     
     Unrealizedcost
     
     
     gains
     
     
     losses
     
     
     
     Fair valueU.S. government agencies
     $
     37,183
     
     $
     211
     
     $
     (201
     )
     
     $
     37,193U. S. Treasuries
     
     24,090
     
     
     37
     
     
     (144
     )
     
     
     23,983Pass-through securities
     
     661
     
     
     5
     
     
     -
     
     
     
     666Taxable state and political subdivisions
     
     1,515
     
     
     -
     
     
     (24
     )
     
     
     1,491Tax exempt state and political subdivisions
     
     15,991
     
     
     519
     
     
     (47
     )
     
     
     16,463Corporate obligations
     
     1,003
     
     
     34
     
     
     -
     
     
     
     1,037Total investment securities available for sale
     $
     80,443
     
     $
     806
     
     $
     (416
     )
     
     $
     80,833
  The amortized cost and fair value of investment securities, by contractual maturity at September 30, 2010, are shown in the table below. Expected maturities may differ from contractual maturities because issuers of the securities may have the right to call or prepay obligations with or without call or prepayment penalties. (dollars in thousands)
     
     September 30, 2010Amortizedcost
     
     Fair valueThree months or less
     $
     556
     
     $
     558Over three months to one year
     
     6,381
     
     
     6,417After one year through three years
     
     75,295
     
     
     76,404After three years through five years
     
     78,094
     
     
     79,128After five years through ten years
     
     17,398
     
     
     17,802After ten years
     
     19,347
     
     
     20,139Total investment securities
     $
     197,071
     
     $
     200,448
  13


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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (4) Investment Securities (continued) The following table presents investment securities which were pledged to secure borrowings and public deposits as permitted or required by law: (dollars in thousands)
     
     September 30, 2010Amortizedcost
     
     Fair valueTo state and local governments to secure public deposits
     $
     44,291
     
     $
     45,646To Federal Reserve Bank to secure borrowings
     
     7,271
     
     
     7,395To U.S. Treasury and Federal Reserve to secure customer tax payments
     
     1,037
     
     
     1,075Other securities pledged, principally to secure deposits
     
     9,072
     
     
     9,620Total pledged investment securities
     $
     61,671
     
     $
     63,736
  (a) Other-Than-Temporary Impaired Debt Securities: For each security in an unrealized loss position, the Company assesses whether it intends to sell the security, or it is more likely than not that it will be required to sell the security before recovery of its amortized cost basis. For debt securities that are considered other-than-temporarily impaired and that the Company does not intend to sell and will not be required to sell prior to recovery of its amortized cost basis, the Company will separate the amount of the impairment into the amount that is credit related (credit loss component) and the amount due to all other factors. The credit loss component is recognized in earnings and is calculated as the difference between the securitys amortized cost basis and the present value of its expected future cash flows. The remaining difference between the securitys fair value and the present value of future expected cash flows is deemed to be due to factors that are not credit related and is recognized in other comprehensive income. The Company does not intend to sell the securities that are temporarily impaired, and it is more likely than not that the Company will not have to sell those securities before recovery of the cost basis. Additionally, the Company has evaluated the credit ratings of its investment securities and their issuers and/or insurers, as applicable. Based on the Companys evaluation, management has determined that no investment security in the Companys investment portfolio is other-than-temporarily impaired at September 30, 2010. 14


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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (4) Investment Securities (continued) At September 30, 2010 and December 31, 2009, there were 36 and 30 investment securities in unrealized loss positions, respectively. They are summarized and classified according to the duration of the loss period as follows: (dollars in thousands)
     
     September 30, 2010Less than 12 Months
     
     
     
     12 Months or Longer
     
     
     TotalFair
     
     Unrealized
     
     
     
     Fair
     
     Unrealized
     
     
     Fair
     
     Unrealizedvalue
     
     losses
     
     
     
     value
     
     losses
     
     
     value
     
     lossesU.S. government agencies
     $
     22,015
     
     $
     (68
     )
     
     $
     -
     
     $
     -
     
     $
     22,015
     
     $
     (68
     )Pass-through securities
     
     344
     
     
     (2
     )
     
     
     -
     
     
     -
     
     
     344
     
     
     (2
     )Taxable state and political subdivisions
     
     1,307
     
     
     (11
     )
     
     
     -
     
     
     -
     
     
     1,307
     
     
     (11
     )Tax exempt state and political subdivisions
     
     2,422
     
     
     (67
     )
     
     
     -
     
     
     -
     
     
     2,422
     
     
     (67
     )Corporate obligations
     
     2,985
     
     
     (15
     )
     
     
     -
     
     
     -
     
     
     2,985
     
     
     (15
     )Total investment securities available for sale
     $
     29,073
     
     $
     (163
     )
     
     $
     -
     
     $
     -
     
     $
     29,073
     
     $
     (163
     )(dollars in thousands)
     
     December 31, 2009Less than 12 Months
     
     
     
     12 Months or Longer
     
     
     TotalFair
     
     Unrealized
     
     
     
     Fair
     
     Unrealized
     
     
     Fair
     
     Unrealizedvalue
     
     losses
     
     
     
     value
     
     losses
     
     
     
     value
     
     lossesU.S. government agencies
     $
     28,018
     
     $
     (201
     )
     
     $
     -
     
     $
     -
     
     $
     28,018
     
     $
     (201
     )U.S. Treasuries
     
     19,956
     
     
     (144
     )
     
     
     -
     
     
     -
     
     
     19,956
     
     
     (144
     )Taxable state and political subdivisions
     
     1,491
     
     
     (24
     )
     
     
     -
     
     
     -
     
     
     1,491
     
     
     (24
     )Tax exempt state and political subdivisions
     
     2,587
     
     
     (47
     )
     
     
     -
     
     
     -
     
     
     2,587
     
     
     (47
     )Total investment securities available for sale
     $
     52,052
     
     $
     (416
     )
     
     $
     -
     
     $
     -
     
     $
     52,052
     
     $
     (416
     )
  The unrealized losses associated with U.S. government agency and treasury debt securities are primarily driven by changes in interest rates and not due to the credit quality of the securities. Further, the pass-through securities backed by GNMA, FNMA or FHLMC have the guarantee of the full faith and credit of the U.S. Federal Government. Obligations of U.S. states and political subdivisions in our portfolio are all investment grade without delinquency history. 15


---



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (5) Non-covered Loans and Allowance for Loan Losses Non-covered loans refer to loans not covered by FDIC loss sharing agreements. Covered loans are discussed in Note (6). The following table presents the major types of non-covered loans at September 30, 2010 and December 31, 2009. The classification of non-covered loan balances presented is reported in accordance with the regulatory reporting requirements. (dollars in thousands)
     
     September 30, 2010
     
     
     
     December 31, 2009Commercial
     $
     146,997
     
     
     $
     93,295Real estate mortgage
     
     399,283
     
     
     
     414,058Real estate construction
     
     108,284
     
     
     
     110,277Consumer
     
     180,200
     
     
     
     193,748834,764
     
     
     
     811,378Deferred loan costs, net
     
     2,253
     
     
     
     2,474Allowance for loan losses
     
     (17,936
     )
     
     
     (16,212
     )Total non-covered loans, net
     $
     819,081
     
     
     $
     797,640
  The following table summarizes activity related to the allowance for loan losses (ALLL) on non-covered loans for the three and nine months ended September 30, 2010 and 2009: (dollars in thousands)
     
     Three Months Ended
     
     
     
     Nine Months EndedSeptember 30,
     
     
     
     September 30,2010
     
     
     
     2009
     
     
     
     2010
     
     
     
     2009Beginning balance
     $
     16,975
     
     
     $
     14,770
     
     
     $
     16,212
     
     
     $
     12,250Provision for loan losses
     
     3,950
     
     
     
     2,500
     
     
     
     8,650
     
     
     
     7,950Charge-offs
     
     (3,215
     )
     
     
     (2,191
     )
     
     
     (7,853
     )
     
     
     (5,962
     )Recoveries
     
     226
     
     
     
     803
     
     
     
     927
     
     
     
     1,644Ending balance
     $
     17,936
     
     
     $
     15,882
     
     
     $
     17,936
     
     
     $
     15,882
  16


---



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (5) Non-covered Loans and Allowance for Loan Losses (continued) The following table summarizes nonperforming non-covered assets at September 30, 2010 and December 31, 2009: (dollars in thousands)
     
     September 30,
     
     
     
     December 31,2010
     
     
     
     2009Non-covered nonaccrual loans
     $
     16,420
     
     
     $
     3,395Non-covered restructured loans
     
     5,098
     
     
     
     -Total non-covered nonperforming loans
     
     21,518
     
     
     
     3,395Non-covered other real estate owned
     
     4,095
     
     
     
     4,549Total non-covered nonperforming assets
     $
     25,613
     
     
     $
     7,944Total non-covered impaired loans
     $
     21,518
     
     
     $
     3,395Non-covered accruing loans past due 90days or more
     
     -
     
     
     
     -Non-covered potential problem loans (1)
     
     12,497
     
     
     
     4,586Allowance for loan losses
     
     17,936
     
     
     
     16,212Non-covered nonperforming loans to totalnon-covered loans
     
     2.57
     %
     
     
     0.42
     %Allowance for loan losses to total non-covered loans
     
     2.14
     %
     
     
     1.99
     %Allowance for loan losses to non-coverednonperfoming loans
     
     83.35
     %
     
     
     477.53
     %Non-covered nonperforming assets to total assets
     
     1.40
     %
     
     
     0.76
     %
  (1) Non-covered potential problem loans represent loans where known information about possible credit problems of borrowers causes management to have serious doubts about the ability of such borrowers to comply with the present loan repayment terms. Loans are placed on nonaccrual status when collection of principal or interest is considered doubtful (generally, loans are 90 days or more past due). Loans are reported as restructured when the Bank grants a concession(s) to a borrower experiencing financial difficulties that it would not otherwise consider. Examples of such concessions include forgiveness of principal or accrued interest, extending the maturity date(s) or providing a lower interest rate than would be normally available for a transaction of similar risk. As a result of these concessions, restructured loans are impaired as the Bank will not collect all amounts due, both principal and interest, in accordance with the terms of the original loan agreement. A loan is considered impaired when, based upon currently known information, it is deemed probable that the Company will be unable to collect all amounts due as scheduled according to the original terms of the agreement. Impaired loans are measured based on the present value of expected future cash flows discounted at the loans effective interest rate or, as a practical expedient, based on the loans observable market price or the fair value of collateral, if the loan is collateral dependent. Interest income previously accrued on nonaccrual loans, but not yet received, is reversed in the period the loan is placed on nonaccrual status. Payments received are generally applied to principal. However, based on managements assessment of the ultimate collectability of an impaired or nonaccrual loan, interest income may be recognized on a cash basis. Nonaccrual loans are returned to an accrual status when management determines the circumstances have improved to the extent that there has been a sustained period of repayment performance and both principal and interest are deemed collectible. 17


---



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (5) Non-covered Loans and Allowance for Loan Losses (continued) At September 30, 2010 and December 31, 2009, non-covered impaired loans totaling $12.1 million and $3.4 million had related specific reserves in the allowance for loan losses of $2.1 million and $1.2 million, respectively. Non-covered impaired loans without related specific reserves in the allowance for loan losses at September 30, 2010, totaled $9.4 million. At December 31, 2009, all non-covered impaired loans had related specific reserves in the allowance for loan losses. The average recorded investment in non-covered impaired loans was approximately $6.9 million during the nine months ended September 30, 2010, and $5.7 million for the year ended December 31, 2009. At September 30, 2010, non-covered impaired loans of $5.1 million were classified as nonaccruing restructured loans. There were no restructured loans at December 31, 2009. The restructurings were granted in response to borrower financial difficulty, and generally provide for a temporary modification of loan repayment terms. The Company has no obligations to lend additional funds on the non-covered restructured loans at September 30, 2010. (6) Covered Assets and FDIC Indemnification Asset (a) Covered Loans:Loans acquired in an FDIC assisted acquisition that are subject to a loss share agreement are referred to as covered loans and reported separately in theCondensed Consolidated Statements of Financial Condition. Covered loans are reported exclusive of the expected cash flow reimbursements from the FDIC. The following table reflects the estimated fair value of the acquired loans at the acquisition dates: (dollars in thousands)
     
     City Bank
     
     
     
     North County BankApril 16, 2010
     
     
     
     September 24, 2010Gross loans acquired
     $
     446,584
     
     
     $
     200,496Fair value discount
     
     (122,742
     )
     
     
     (67,360
     )Covered loans, net
     $
     323,842
     
     
     $
     133,136
  The following table presents the major types of covered loans at September 30, 2010. The classification of covered loan balances presented is reported in accordance with the regulatory reporting requirements. (dollars in thousands)
     
     September 30, 2010Commercial
     $
     37,250Real estate mortgages:One-to-four family residential
     
     19,217Multi-family residential and commercial
     
     309,346Total real estate mortgages
     
     328,563Real estate construction:One-to-four family residential
     
     78,411Multi-family and commercial
     
     92,906Total real estate construction
     
     171,317Consumer - direct
     
     23,159Subtotal
     
     560,289Fair value discount
     
     (166,942
     )Total covered loans
     $
     393,347
  18


---



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (6) Covered Assets and FDIC Indemnification Asset (continued) In estimating the fair value of the covered loans at the acquisition date, we (a) calculated the contractual amount and timing of undiscounted principal and interest payments and (b) estimated the amount and timing of undiscounted expected principal and interest payments. The difference between these two amounts represents the nonaccretable difference. On the acquisition date, the amount by which the undiscounted expected cash flows exceed the estimated fair value of the acquired loans is the accretable yield. The accretable yield is then measured at each financial reporting date and represents the difference between the remaining undiscounted expected cash flows and the current carrying value of the loans. The following table presents a reconciliation of the undiscounted contractual cash flows, nonaccretable difference, accretable yield and fair value of covered loans for each respective acquired loan portfolio at the acquisition dates: (dollars in thousands)
     
     City Bank
     
     
     
     North County BankApril 16, 2010
     
     
     
     September 24, 2010Undiscounted contractual cash flows
     $
     477,159
     
     
     $
     225,937Undiscounted cash flows not expected to be collected(nonaccretable difference)
     
     (129,353
     )
     
     
     (61,906
     )Undiscounted cash flows expected to be collected
     
     347,806
     
     
     
     164,031Accretable yield at acquisition
     
     (23,964
     )
     
     
     (30,895
     )Estimated fair value of loans acquired at acquisition
     $
     323,842
     
     
     $
     133,136
  The following table presents the changes in the accretable yield for the three and nine months ended September 30, 2010, for each respective acquired loan portfolio: (dollars in thousands)
     
     Three Months EndedSeptember 30, 2010City Bank
     
     
     North County BankBalance, beginning of period
     $
     19,037
     
     
     $
     -Additions resulting from acquisition
     
     -
     
     
     
     30,895Accretion to interest income
     
     (5,369
     )
     
     
     (110
     )Disposals
     
     (1,087
     )
     
     
     -Reclassification (to)/from nonaccretable difference
     
     -
     
     
     
     -Balance, end of period
     $
     12,581
     
     
     $
     30,785(dollars in thousands)
     
     Nine Months EndedSeptember 30, 2010City Bank
     
     
     North County BankBalance, beginning of period
     $
     -
     
     
     $
     -Additions resulting from acquisition
     
     23,964
     
     
     
     30,895Accretion to interest income
     
     (10,296
     )
     
     
     (110
     )Disposals
     
     (1,087
     )
     
     
     -Reclassification (to)/from nonaccretable difference
     
     -
     
     
     
     -Balance, end of period
     $
     12,581
     
     
     $
     30,785
  19


---



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (6) Covered Assets and FDIC Indemnification Asset (continued) The following table summarizes nonperforming covered assets at September 30, 2010: (dollars in thousands)
     
     September 30, 2010Covered nonaccrual loans
     $
     102,917Covered restructured loans
     
     14,762Total covered nonperforming loans
     
     117,679Covered other real estate owned
     
     27,250Total covered nonperforming assets
     $
     144,929Total covered impaired loans
     $
     117,679Covered accruing loans past due 90days or more
     
     -Covered nonperforming loans to total covered loans
     
     29.92
     %Covered nonperforming assets to total assets
     
     7.92
     %
  There were no specific reserves in the allowance for loan losses related to covered impaired loans at September 30, 2010. (b) Covered Other Real Estate Owned:All OREO acquired in FDIC-assisted acquisitions that are subject to an FDIC loss share agreement are referred to as covered OREO and reported separately in theCondensed Consolidated Statements of Financial Condition. Covered OREO is reported exclusive of expected reimbursement cash flows from the FDIC. Foreclosed covered loan collateral is transferred into covered OREO at the loans carrying value, inclusive of the acquisition date fair value discount. The following table summarizes the activity related to covered OREO for the three and nine months ended September 30, 2010: (dollars in thousands)
     
     Three Months EndedSeptember 30, 2010City Bank
     
     
     North County Bank
     
     
     TotalBalance, beginning of period
     $
     
     14,178
     
     
     $
     -
     
     $
     14,178Acquisition
     
     
     -
     
     
     
     12,727
     
     
     12,727Additions to covered OREO
     
     
     5,682
     
     
     
     -
     
     
     5,682Dispositions of covered OREO
     
     
     (5,337
     )
     
     
     -
     
     
     (5,337
     )Valuation adjustments
     
     
     -
     
     
     
     -
     
     
     -Balance, end of period
     $
     
     14,523
     
     
     $
     12,727
     
     $
     27,250(dollars in thousands)
     
     Nine Months EndedSeptember 30, 2010City Bank
     
     
     North County Bank
     
     
     TotalBalance, beginning of period
     $
     
     -
     
     
     $
     -
     
     $
     -Acquisition
     
     
     5,798
     
     
     
     12,727
     
     
     18,525Additions to covered OREO
     
     
     14,444
     
     
     
     -
     
     
     14,444Dispositions of covered OREO
     
     
     (5,719
     )
     
     
     -
     
     
     (5,719
     )Valuation adjustments
     
     
     -
     
     
     
     -
     
     
     -Balance, end of period
     $
     
     14,523
     
     
     $
     12,727
     
     $
     27,250
  20


---



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (6)
     Covered Assets and FDIC Indemnification Asset (continued) (c)FDIC Indemnification Asset:The following table summarizes the activity related to the FDIC indemnificationasset for the three and nine months ended September 30, 2010: (dollars in thousands)
     
     Three Months EndedSeptember 30, 2010City Bank
     
     North County Bank
     
     
     TotalBalance, beginning of period
     $
     84,897
     
     $
     -
     
     $
     84,897Acquisition
     
     -
     
     
     39,000
     
     
     39,000Accretion
     
     812
     
     
     -
     
     
     812Payments from the FDIC
     
     -
     
     
     -
     
     
     -Balance, end of period
     $
     85,709
     
     $
     39,000
     
     $
     124,709(dollars in thousands)
     
     Nine Months EndedSeptember 30, 2010City Bank
     
     North County Bank
     
     
     TotalBalance, beginning of period
     $
     -
     
     $
     -
     
     $
     -Acquisition
     
     84,113
     
     
     39,000
     
     
     123,113Accretion
     
     1,596
     
     
     -
     
     
     1,596Payments from the FDIC
     
     -
     
     
     -
     
     
     -Balance, end of period
     $
     85,709
     
     $
     39,000
     
     $
     124,709
  (7) Other Real Estate Owned The following table presents the changes in non-covered other real estate owned for the three and nine months ended September 30, 2010 and 2009: (dollars in thousands)
     
     Three Months Ended
     
     
     
     Nine Months EndedSeptember 30,
     
     
     
     September 30,2010
     
     
     
     2009
     
     
     
     2010
     
     
     
     2009Balance, beginning of period
     $
     4,984
     
     
     $
     2,599
     
     
     $
     4,549
     
     
     $
     2,226Additions to OREO
     
     284
     
     
     
     3,403
     
     
     
     1,090
     
     
     
     5,282Capitalized improvements
     
     -
     
     
     
     -
     
     
     
     118
     
     
     
     -Dispositions of OREO
     
     (1,173
     )
     
     
     (808
     )
     
     
     (1,662
     )
     
     
     (2,114
     )Valuation adjustments
     
     -
     
     
     
     (182
     )
     
     
     -
     
     
     
     (382
     )Balance, end of period
     $
     4,095
     
     
     $
     5,012
     
     
     $
     4,095
     
     
     $
     5,012
  (8) Earnings per Common Share Basic earnings per share is computed by dividing net income available to common shareholders by the weighted average number shares of common stock outstanding during the period. Diluted earnings per share is computed in the same manner as basic earnings per share except that the denominator is increased to include the number of additional common shares that would have been outstanding if certain shares issuable upon exercise of options and non-vested restricted stock were included. 21


---



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (8) Earnings per Common Share (continued) The following table reconciles the denominator of the basic and diluted earnings per common share computation: Three Months Ended
     
     Nine Months EndedSeptember 30,
     
     September 30,2010
     
     2009
     
     2010
     
     2009Weighted average shares, basic
     15,309,000
     
     9,532,000
     
     15,303,000
     
     9,519,000Effect of dilutive stock awards
     164,000
     
     22,000
     
     149,000
     
     22,000Weighted average shares, diluted
     15,473,000
     
     9,554,000
     
     15,452,000
     
     9,541,000
  At September 30, 2010 and 2009, the following stock equivalents were antidilutive and therefore not included in the computation of diluted net income per share available to common shareholders. Three Months Ended
     
     Nine Months EndedSeptember 30,
     
     September 30,2010
     
     2009
     
     2010
     
     2009Antidilutive TARP CPP stock warrants
     -
     
     492,164
     
     -
     
     492,164Antidilutive stock awards
     54,725
     
     199,713
     
     63,492
     
     204,713Total antidilutive stock equivalents
     54,725
     
     691,877
     
     63,492
     
     696,877
  (9)
     Stock-Based Compensation (a)Stock Options:The Company measures the fair value of each stock option grant at the date of the grant, usingthe Black-Scholes option pricing model. There were no options granted during the nine months ended September 30, 2010 and 2009. The Company recognizes compensation expense for stock option grants on a straight-line basis over the requisite service period of the grant. For the three and nine months ended September 30, 2010, the Company recognized $42 thousand and $126 thousand in stock-based compensation expense, as a component of salaries and benefits, compared to $47 thousand and $137 thousand for the three and nine months ended September 30, 2009, respectively. As of September 30, 2010, there was approximately $147 thousand of total unrecognized compensation cost related to nonvested stock option grants. The following table summarizes information on stock option activity during 2010: Weighted average
     
     
     AverageWeighted average
     
     remaining
     
     
     intrinsicexercise price per
     
     contractual terms
     
     
     value (inShares
     
     
     
     share
     
     (in years)
     
     
     thousands)Outstanding, January 1, 2010
     221,339
     
     
     $
     9.99Granted
     -
     
     
     
     -Exercised
     (3,456
     )
     
     
     6.54Forfeited, expired or cancelled
     (3,004
     )
     
     
     14.32Outstanding, September 30, 2010
     214,879
     
     
     
     9.99
     
     6.23
     
     $
     924Exercisable at September 30, 2010
     157,800
     
     
     $
     9.66
     
     5.82
     
     $
     726
  22


---



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (9) Stock-Based Compensation (continued) The aggregate intrinsic value in the table above represents the total pre-tax intrinsic value (i.e., the difference between the Companys closing stock price on September 30, 2010, and the exercise price, times the number of shares) that would have been received by the option holders had all the option holders exercised their options on September 30, 2010. This amount changes based upon the fair market value of the Companys stock. (b)Restricted Stock Awards:The Company grants restricted stock awards (RSA) periodically for the benefit of employees and directors. Recipients of RSAs do not pay any cash consideration to the Company for the shares and receive all dividends with respect to such shares, whether or not the shares have vested. Restrictions are based on continuous service requirements with the Company. The following table summarizes information RSA activity during 2010: Weighted averageWeighted average
     
     remainingexercise price per
     
     contractual termsShares
     
     
     
     share
     
     (in years)Outstanding, January 1, 2010
     4,741
     
     
     $
     13.32Granted
     -
     
     
     
     -Exercised
     (3,356
     )
     
     
     12.60Forfeited, expired or cancelled
     -
     
     
     
     -Outstanding, September 30, 2010
     1,385
     
     
     $
     15.05
     
     0.62
  For the three and nine months ended September 30, 2010, the Company recognized $5 thousand and $21 thousand in RSA compensation expense, as a component of salaries and benefits, compared to $11 thousand and $34 thousand for the same periods of 2009, respectively. As of September 30, 2010, there was $13 thousand of total unrecognized compensation costs related to nonvested RSAs. (c)Restricted Stock Units:The Company grants restricted stock units (RSU) periodically for the benefit of employees and directors. Recipients of RSUs receive shares of the Companys stock upon the lapse of their related restrictions and do not pay any cash consideration to the Company for the shares. Restrictions are based on continuous service. The following table summarizes information on RSU activity during 2010: Weighted averageWeighted average
     
     remainingexercise price per
     
     contractual termsShares
     
     
     
     share
     
     (in years)Outstanding, January 1, 2010
     30,238
     
     
     $
     12.29Granted
     36,257
     
     
     
     8.29Vested
     (10,385
     )
     
     
     10.68Forfeited, expired or cancelled
     -
     
     
     
     -Outstanding, September 30, 2010
     56,110
     
     
     $
     10.00
     
     3.64
  For the three and nine months ended September 30, 2010, the Company recognized $96 thousand and $134 thousand in RSU compensation expense, as a component of salaries and benefits, compared to $24 thousand and $68 thousand for the three and nine months ended September 30, 2009, respectively. As of September 30, 2010, there was $462 thousand of total unrecognized compensation costs related to nonvested RSUs. 23


---



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (10)
     Shareholders Equity (a)Preferred Stock:On January 16, 2009, in exchange for an aggregate purchase price of $26.4 million, theCompany issued and sold to the United States Department of the Treasury pursuant to the Trouble Asset Relief Program Capital Purchase Program (TARP) the following: (i) 26,380 shares of the Companys newly designated Fixed Rate Cumulative Perpetual Preferred Stock, Series A, no par value per share, and liquidation preference of $1,000 per share ($26.4 million liquidation preference in the aggregate) and (ii) a warrant to purchase up to 492,164 shares of the Companys common stock, no par value per share, at an exercise price of $8.04 per share, subject to certain anti-dilution and other adjustments. As described below, the number of shares of common stock subject to the Warrant has been reduced pursuant to the terms of the Warrant. The Warrant may be exercised for up to ten years after it is issued. In connection with the issuance and sale of the Companys securities, the Company entered into a Letter Agreement including the Securities Purchase Agreement-Standard Terms, dated January 16, 2009, with the United States Department of the Treasury (the Agreement). The Agreement contains limitations on the payment of quarterly cash dividends on the Companys common stock in excess of $0.065 per share and on the Companys ability to repurchase its common stock. The Agreement also grants the holders of the Series A Preferred Stock, the Warrant and the common stock to be issued under the Warrant registration rights, and subjects the Company to executive compensation limitations included in the Emergency Economic Stabilization Act of 2008. Participants in the TARP Capital Purchase Program are required to have in place limitations on the compensation of Senior Executive Officers and other highly compensated employees. The Series A Preferred Stock will bear cumulative dividends at a rate of 5% per annum for the first five years and 9% per annum thereafter, in each case, applied to the $1,000 per share liquidation preference, but will only be paid when, as and if declared by the Companys Board of Directors out of funds legally available. The Series A Preferred Stock has no maturity date and ranks senior to the Companys common stock with respect to the payment of dividends and distributions and amounts payable upon liquidation, dissolution and winding up of the Company. In February 2009, following passage of the American Recovery and Reinvestment Act of 2009, the program terms were changed and the Company is no longer required to conduct a qualified equity offering prior to retirement of the preferred stock, however prior approval of the Company's primary regulator is required. The preferred stock is not subject to any contractual restrictions on transfer. The holders of the preferred stock have no general voting rights, and have only limited class voting rights including, authorization or issuance of shares ranking senior to the preferred stock, any amendment to the rights of the preferred stock, or any merger, exchange or similar transaction which would adversely affect the rights of the preferred stock. If dividends on the preferred stock are not paid in full for six dividend periods, whether or not consecutive, the preferred stock holders will have the right to elect two directors. The right to elect directors will end when full dividends have been paid for four consecutive dividend periods. The preferred stock is not subject to sinking fund requirements and has no participation rights. On January 13, 2009, the Companys shareholders approved an amendment to the Companys Restated Articles of Incorporation setting the specific terms and conditions of the preferred stock and designating such shares as the Series A Preferred Stock. The amendment was filed with the Secretary of State of the State of Washington on January 13, 2009. 24


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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (10) Shareholders Equity (continued) In accordance with the relevant accounting pronouncements and a letter from the SECs Office of the Chief Accountant, the Company recorded the preferred stock and detachable warrants within Shareholders Equity on theConsolidated Balance Sheets. The preferred stock and detachable warrants were initially recognized based on their relative fair values at the date of issuance. As a result, the preferred stocks carrying value is at a discount to the liquidation value or stated value. In accordance with the SECs Staff Accounting Bulletin No. 68,Increasing Rate Preferred Stock, the discount is considered an unstated dividend cost that shall be amortized over the period preceding commencement of the perpetual dividend using the effective interest method, by charging the imputed dividend cost against retained earnings and increasing the carrying amount of the preferred stock by a corresponding amount. The discount is therefore being amortized over five years using a 6.52% effective interest rate. The total stated dividends (whether or not declared) and unstated dividend cost combined represents a periods total preferred stock dividend, which is deducted from net income to arrive at net income available to common shareholders on the Condensed Consolidated Statements of Income. As of September 30, 2010, no dividends on the preferred stock were in arrears. (b)Stock Warrants:On January 16, 2009, in connection with the issuance of the preferred stock, the Company issued a warrant to the U.S. Treasury to purchase up to 492,164 shares of the Companys common stock, no par value per share, at an exercise price of $8.04 per share, subject to certain customary anti-dilution and other adjustments. The warrants issued are immediately exercisable, in whole or in part, and have a ten year term. The warrants are not subject to any other contractual restrictions on transfer. The Company has granted the warrant holder piggyback registration rights for the warrants and the common stock underlying the warrants and have agreed to take such other steps as may be reasonably requested to facilitate the transfer of the warrants and the common stock underlying the warrants. The holders of the warrants are not entitled to any common stockholder rights. The U.S. Treasury agrees not to exercise voting power with respect to any shares of common stock of the Company issued to it upon exercise of the warrants. The preferred stock and detachable warrants were initially recognized based on their relative fair values at the date of issuance in accordance with APB opinion No. 14,Accounting for Convertible Debt and Debt Issued with Stock Purchase Warrants. As a result, the value allocated to the warrants is different than the estimated fair value of the warrants as of the grant date. The following assumptions were used to determine the fair value of the warrants as of the grant date: Dividend yield
     
     5.00
     %Expected life (years)
     
     10Expected volatility
     
     49.56
     %Risk-free rate
     
     2.80
     %Fair value per warrant at grant date
     $
     3.27Relative fair value per warrant at grant date
     $
     3.49
  (c)Public Offering:On November 30, 2009, the Company raised $51.8 million through a public offering by issuing 5,000,000 shares of the Companys common stock, including 750,000 shares pursuant to the underwriters over-allotment option, at a share price of $9.00 per share. The net proceeds to the Company after deducting underwriting discounts and commissions and offering expenses were $49.0 million. The net proceeds from the offering qualify as Tier 1 capital and will be used for general corporate purposes, which may include capital to support growth and acquisition opportunities and to position the Company for redemption of preferred stock issued to the U.S. Treasury under the Capital Purchase Program. In connection with the Companys public offering in the fourth quarter of 2009, the number of shares of common stock underlying the warrant held by the U.S. Treasury was reduced by 50% to 246,082 shares. 25


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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (11)
     Fair Value Measurements (a)Fair Value Hierarchy and Fair Value Measurement: The Company groups its assets and liabilities that arerecorded at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. These levels are: Level 1: Quoted prices for identical instruments in active markets. Level 2: Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations whose inputs are observable or whose significant value drives are observable. Level 3: Significant inputs to the valuation model are unobservable. The following table summarizes our assets and liabilities that were required to be recorded at fair value on a recurring basis: (dollars in thousands)
     
     September 30, 2010Level 1
     
     
     Level 2
     
     Level 3
     
     
     TotalInvestment securities
     $
     -
     
     $
     200,448
     
     $
     -
     
     $
     200,448Total
     $
     -
     
     $
     200,448
     
     $
     -
     
     $
     200,448(dollars in thousands)
     
     December 31, 2009Level 1
     
     
     Level 2
     
     Level 3
     
     
     TotalInvestment securities
     $
     -
     
     $
     80,833
     
     $
     -
     
     $
     80,833Total
     $
     -
     
     $
     80,833
     
     $
     -
     
     $
     80,833
  When available, the Company uses quoted market prices to determine the fair value of investment securities. These investments are included in Level 1. When quoted market prices are unobservable, the Company uses quotes from independent pricing vendors based on recent trading activity and other relevant information including market interest rate curves, referenced credit spreads and estimated prepayment rates where applicable. These investments are included in Level 2 and comprise the Companys portfolio of U.S. agency securities, U.S. treasury securities, municipal bonds and other corporate bonds. Certain financial assets of the Company may be measured at fair value on a non-recurring basis. These assets are subject to fair value adjustments that result from application of lower-of-cost-or-market accounting or write-downs of individual assets. For example, when a loan is identified as impaired, it is reported at the lower of cost or fair value, measured based on the loans observable market price (Level 1), the present value of expected future cash flows discounted at the loans original effective interest rate (Level 2), or the current appraised value of the underlying collateral securing the loan if the loan is collateral dependent (Level 3). Securities held to maturity may be written down to fair value (determined using the same techniques discussed above for securities available for sale) as a result of other-than-temporary impairment, if any. 26


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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (11) Fair Value Measurements (continued) The following table presents the carrying value of financial instruments by level within the fair value hierarchy, for which a non-recurring change in fair value has been recorded: (dollars in thousands)
     
     September 30, 2010Total losses forLevel 1
     
     
     Level 2
     
     
     Level 3
     
     
     Total
     
     
     the periodNon-covered impaired loans (1)
     $
     -
     
     $
     -
     
     $
     19,410
     
     $
     19,410
     
     $
     (6,257
     )Non-covered other real estate owned (2)
     
     -
     
     
     -
     
     
     4,095
     
     
     4,095
     
     
     (146
     )Total
     $
     -
     
     $
     -
     
     $
     23,505
     
     $
     23,505
     
     $
     (6,403
     )(dollars in thousands)
     
     December 31, 2009Total losses forLevel 1
     
     
     Level 2
     
     
     Level 3
     
     
     Total
     
     
     the periodNon-covered impaired loans (1)
     $
     -
     
     $
     -
     
     $
     2,184
     
     $
     2,184
     
     $
     (1,211
     )Non-covered other real estate owned (2)
     
     -
     
     
     -
     
     
     4,549
     
     
     4,549
     
     
     (516
     )Total
     $
     -
     
     $
     -
     
     $
     6,733
     
     $
     6,733
     
     $
     (1,727
     )
  (1) Represents carrying value net of any related specific reserve in the allowance for loan losses. (2) Represents the carrying value and related losses on foreclosed real estate and other collateral owned that were measured at fair value at the time of transfer or subsequent to the initial transfer into other real estate owned. Following is a description of methods and assumptions used to estimate the fair value of each class of financial instrument for which a non-recurring change in fair value has been recorded: Non-covered impaired loans:A loan is considered impaired when, based upon currently known information, it is deemed probable that the Company will be unable to collect all amounts due as scheduled according to the original terms of the agreement. Non-covered impaired loans are measured based on the present value of expected future cash flows discounted at the loans effective interest rate or, as a practical expedient, based on the loans observable market price or the fair value of collateral, if the loan is collateral dependent. Non-covered other real estate owned:Non-covered other real estate owned includes properties acquired through foreclosure. These properties are recorded at the lower of cost or estimated fair value (less estimated cost to sell), based on periodic evaluations. The Company generally obtains appraisals for collateral dependent loans on an annual basis. Depending on the loan, the Company may obtain appraisals more frequently than 12 months, particularly if the credit is deteriorating. If the loan is performing and market conditions are stable, the Company may not obtain appraisals on an annual basis. This policy does not vary by loan type. The Company deducts a minimum of 10% of the appraised value for selling costs. If the property has been actively listed for sale for more than six months and has had limited interest, the Company will typically reduce the fair value further based upon input from third party industry experts. This includes adjustments for outdated appraisals based on knowledgeable third party opinions. 27


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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (11) Fair Value Measurements (continued) Impaired loans that are collateral dependent are reviewed quarterly. The review involves a collateral valuation review, which also contemplates an assessment of whether the last appraisal is outdated. Recent appraisals, adjustments to outdated appraisals, knowledgeable third party opinions of value and current market conditions are combined to determine whether a specific reserve and/or a loan charge-off is required. The Company does not specifically consider the potential for outdated appraisals in its calculation of the formula portion of the allowance for loan losses. In the rare case where an appraisal is not available, the Company consults with third party industry specific experts for estimates as well as relies upon the Companys market knowledge and expertise. (b)Disclosures about Fair Value of Financial Instruments:The table below is a summary of fair value estimates for financial instruments as of September 30, 2010 and December 31, 2009, excluding financial instruments recorded at fair value on a recurring basis (summarized in a separate table). The carrying amounts in the following table are recorded in the statement of condition under the indicated captions. The Company has excluded non-financial assets and non-financial liabilities defined by the Codification (ASC 820-10-15-1A), such as Bank premises and equipment, deferred taxes and other liabilities. In addition, the Company has not disclosed the fair value of financial instruments specifically excluded from disclosure requirements of the Financial Instruments Topic of the Codification (ASC 825-10-50-8), such as Bank-owned life insurance policies. (dollars in thousands)
     
     September 30, 2010
     
     
     December 31, 2009Carrying
     
     
     Estimated
     
     
     Carrying
     
     Estimatedvalue
     
     
     fair value
     
     
     value
     
     fair valueFinancial assets:Cash and cash equivalents
     $
     24,572
     
     $
     24,572
     
     $
     14,950
     
     $
     14,950Interest-bearing deposits
     
     141,630
     
     
     141,630
     
     
     86,891
     
     
     86,891Federal funds sold
     
     4,963
     
     
     4,963
     
     
     -
     
     
     -Investment securities available for sale
     
     200,448
     
     
     200,448
     
     
     80,833
     
     
     80,833FHLB stock
     
     7,576
     
     
     7,576
     
     
     2,430
     
     
     2,430Loans held for sale
     
     7,785
     
     
     7,785
     
     
     3,232
     
     
     3,232Non-covered loans
     
     819,081
     
     
     826,395
     
     
     797,640
     
     
     791,382Covered loans
     
     393,347
     
     
     393,347
     
     
     -
     
     
     -FDIC indemnification asset
     
     124,709
     
     
     124,709
     
     
     -
     
     
     -Financial liabilities:Deposits
     
     1,611,264
     
     
     1,607,372
     
     
     846,671
     
     
     837,586Other borrowed funds
     
     -
     
     
     -
     
     
     10,000
     
     
     10,175Junior subordinated debentures
     
     25,774
     
     
     9,609
     
     
     25,774
     
     
     9,210
  Following is a description of methods and assumptions used to estimate the fair value of each class of financial instrument not recorded at fair value but required for disclosure purposes: Cash and Cash Equivalents:The carrying value of cash and cash equivalent instruments approximates fair value. Interest-bearing Deposits:The carrying values of interest-bearing deposits maturing within ninety days approximate their fair values. Fair values of other interest-earning deposits are estimated using discounted cash flow analyses based on current rates for similar types of deposits. 28


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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (11) Fair Value Measurements (continued) Federal Funds Sold:The carrying value of federal funds sold approximates fair value. Investment Securities:Fair values for investment securities are based on quoted market prices when available or through the use of alternative approaches, such as matrix or model pricing, or broker indicative bids, when market quotes are not readily accessible or available. Loans Held for Sale:The carrying value of loans held for sale approximates fair value. Non-covered Loans:The loan portfolio is composed of commercial, consumer, real estate construction and real estate loans. The carrying value of variable rate loans approximates their fair value. The fair value of fixed rate loans is estimated by discounting the estimated future cash flows of loans, sorted by type and security, by the weighted average rate of such loans and rising rates currently offered by the Bank for similar loans. Covered Loans:Covered loans are measured at estimated fair value on the date of acquisition. Carrying value is calculated as the present value of expected cash flows and approximates fair value. FDIC Indemnification Asset:The FDIC indemnification asset is initially recorded at fair value and the ongoing carrying value approximates fair value, as it is based on the discounted value of expected future cash flows under the loss share agreement (See Note 1). Deposits:For deposits with no contractual maturity such as checking accounts, money market accounts and savings accounts, fair values approximate book values. The fair value of certificates of deposit are based on discounted cash flows using the difference between the actual deposit rate and an alternative cost of funds rate, currently offered by the Bank for similar types of deposits. FHLB Overnight Borrowings:The carrying value of FHLB overnight borrowings approximates fair value. Trust Preferred Securities/Junior Subordinated Debentures:The fair value of trust preferred securities is estimated at their recorded value due to the cost of the instrument re-pricing on a quarterly basis. Other Borrowed Funds:Other borrowed funds consist of FHLB advances. The carrying amount of FHLB advances is estimated using discounted cash flow analyses based on the Companys current incremental borrowing rates of similar types of borrowing arrangements. Off-Balance Sheet Items:Commitments to extend credit represent the principal category of off-balance sheet financial instruments (see Note 11). The fair value of these commitments are not material since they are for relatively short periods of time and are subject to customary credit terms, which would not include terms that would expose the Company to significant gains or losses. (12) Subsequent Events On October 28, 2010, the Company announced that its Board of Directors declared a cash dividend of $0.05 per share to shareholders of record as of November 8, 2010, payable on November 24, 2010. 29


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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (13) Commitments and Contingencies Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements, including commercial paper, bond financing and similar transactions. Except for certain long-term guarantees, most guarantees expire within one year. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Collateral supporting those commitments, for which collateral is deemed necessary, generally amounted to one hundred percent of the commitment amount at September 30, 2010. The Company routinely charges a fee for these credit facilities. Such fees are amortized into income over the life of the agreement and unamortized amounts were not significant as of September 30, 2010. At September 30, 2010, the commitments under these agreements totaled $2.7 million. At September 30, 2010, the Company was the guarantor of trust preferred securities. The Company issued junior subordinated debentures to a wholly owned special purpose trust, which has issued trust preferred securities. The sole assets of the special purpose trust are the junior subordinated debentures issued by the Company. Washington Banking Company has fully and unconditionally guaranteed the capital securities along with all obligations of the Trust under the trust agreements. The maximum amount of future payments the Company will be required to make under these agreements is the principal and interest of the trust preferred securities, the principal of which totaled $25.8 million at September 30, 2010. 30


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Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations Note Regarding Forward-Looking Statements: This Quarterly Report on Form 10-Q includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended and Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking statements describe Washington Banking Companys (the Company) managements expectations regarding future events and developments such as future operating results, growth in loans and deposits, credit quality and adequacy of the allowance for loan losses, and continued success of the Companys business plan. Readers should not place undue reliance on forward-looking statements, which reflect managements views only as of the date hereof. The words will, believe, expect, should, anticipate and words of similar meaning are intended in part to help identify forward-looking statements. Future events are difficult to predict, and the expectations described below are necessarily subject to risk and uncertainty that may cause actual results to differ materially. In addition to discussions about risks and uncertainties set forth from time to time in the Companys filings with the Securities and Exchange Commission (the SEC), factors that may cause actual results to differ materially from those contemplated in such forward-looking statements include, among others: (1) local and national general and economic condition; (2) changes in interest rates and their impact on net interest margin; (3) competition among financial institutions; (4) legislation or regulatory requirements; and (5) the ability to realize efficiencies expected from investment in personnel and infrastructure. However, the reader should be aware that these factors are not an exhaustive list, and it should not be assumed that these are the only factors that may cause actual results to differ from expectations. In addition, the reader should note that the Company does not intend to update any of the forward-looking statements or the uncertainties that may adversely impact those statements. The following discussion and analysis should be read in conjunction with the financial statements and notes thereto presented elsewhere in this report. Overview Washington Banking Company (referred to in this report as the Company) is a registered bank holding company with two wholly-owned subsidiaries: Whidbey Island Bank (the Bank), the Companys principal subsidiary and Washington Banking Master Trust (the Trust). Headquartered in Oak Harbor, the Companys market area is primarily northwestern Washington. The market area encompasses distinct economies and none are particularly dependent upon a single industrial or occupational source. The economies within the market areas have evolved from being heavily dependent upon forestry, fishing and farming to a more diverse blend of industries including retail trade, services, manufacturing, tourism and a large military presence. The Companys strategy is one of value-added growth. Management believes that qualitative and sustainable growth of the Company, coupled with maintaining profitability, is currently the most appropriate path to providing good value for its shareholders. The Companys primary objectives are to improve profitability and operating efficiencies and increase market penetrations in areas currently served and expand into adjacent markets. Executive Overview Significant items for the third quarter of 2010 were as follows: In September, the Bank entered into a purchase and assumption agreement with the FDIC to purchase certain assets and assume certain liabilities of North County Bank located in Arlington, Washington. Total assets assumed were $279.3 million and resulted in four new branches.Net income available to common shareholders per diluted share was $0.86 and $1.23 respectively, for the three and nine months ended September 30, 2010, as compared to net income available to common shareholders per diluted common share of $0.13 and $0.35 respectively, for the three and nine months ended September 30, 2009. Diluted operating earnings per common share, defined as earnings available to common shareholders before the bargain purchase gain relating to the City Bank and North County Bank acquisitions and merger related expenses, net of tax, divided by the same diluted share total used in determining diluted earnings per common share, was $0.16 and $0.48 respectively, for the three and nine months ended September 30, 2010, as compared to diluted operating earnings per common share of $0.13 and $0.35 respectively, for the three and nine months ended September 30, 2009. Operating income per diluted share is considered a non-GAAP financial measure. More information regarding this measurement and reconciliation to the comparable GAAP measurement is provided under the headingResults of OperationsOverviewbelow. 31


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Net interest margin, on a tax equivalent basis, was 4.68% and 4.67% for the three and nine months ended September 30, 2010, compared to 4.72% and 4.60% for the same periods a year ago.Total deposits were $1.6 billion at September 30, 2010, an increase of $764.6 million, or 90.3%, as compared to December 31, 2009. The second quarter acquisition of City Bank and the third quarter acquisition of North County Bank accounted for $741.1 million of the increase in total deposits for the period.At September 30, 2010, total assets were $1.8 billion, compared to $1.0 billion at December 31, 2009, an increase of $784.3 million, or 75.0%. The increase in total assets was primarily attributable to the purchase of certain assets in the FDIC-assisted acquisitions of City Bank and North County Bank.Total risk-based capital decreased to 18.88% at September 30, 2010, compared to 22.15% at December 31, 2009, related to the growth in total assets primarily due to the FDIC-assisted purchase and assumption of certain assets and liabilities of City Bank and North County Bank in the second and third quarters of 2010, respectively. Summary of Critical Accounting Policies 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 and the accompanying notes. 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. Significant accounting policies are described in Note (1) of the Notes to Consolidated Financial Statements for the year ended December 31, 2009, as filed on Form 10-K. Not all of these accounting policies require management to make difficult, subjective or complex judgments or estimates. Management believes that the following accounting policies could be considered critical under the SECs definition. Allowance for Loan Losses:There have been no material changes in the accounting policy relating to allowance for loan losses as compared to that contained in Note (1) of the Notes to Consolidated Financial Statements for the year ended December 31, 2009, as filed on Form 10-K. Acquired Loans:In accordance with FASB ASC 310-30, acquired loans are aggregated into pools, based on individually evaluated common risk characteristics, and aggregate expected cash flows were estimated for each pool. A pool is accounted for as a single asset with a single interest rate, cumulative loss rate and cash flow expectation. The Bank aggregated all of the loans acquired in the FDIC-assisted acquisitions of City Bank and North County Bank into 18 and 14 pools, respectively. A loan will be removed from a pool of loans only if the loan is sold, foreclosed, assets are received in satisfaction of the loan, or the loan is written off, and will be removed from the pool at the carrying value. If an individual loan is removed from a pool of loans, the difference between its relative carrying amount and the cash, fair value of the collateral, or other assets received will be recognized in income immediately and would not affect the effective yield used to recognize the accretable difference on the remaining pool. Loans originally placed into a performing pool will not be reported individually as 30-89 days past due, non-performing (90+ days past due or nonaccrual) or accounted for as a troubled debt restructuring as the pool is the unit of accounting. Rather, these metrics related to the underlying loans within a performing pool will be considered in our ongoing assessment and estimates of future cash flows. If, at acquisition, the loans are collateral dependent and acquired primarily for the rewards of ownership of the underlying collateral, or if cash flows expected to be collected cannot be reasonably estimated, accrual of income is inappropriate. Such loans will be placed into nonperforming (nonaccrual) loan pools. The cash flows expected to be received over the life of the pool were estimated by management with the assistance of a third party valuation specialist. These cash flows were input into a ASC 310-30 compliant accounting loan system which calculates the carrying values of the pools and underlying loans, book yields, effective interest income and impairment, if any, based on actual and projected events. Default rates, loss severity and prepayment speed assumptions will be periodically reassessed and updated within the accounting model to update the expectation of future cash flows. The excess of the cash flows expected to be collected over the pools carrying value is considered to be the accretable yield and is recognized as interest income over the estimated life of the loan or pool using the effective yield method. The accretable yield will change due to changes in the timing and amounts of expected cash flows. For the performing loan pools, a prepayment assumption as documented by the valuation specialist is initially applied. Changes in the accretable yield will be disclosed quarterly. 32


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The excess of the contractual balances due over the cash flows expected to be collected is considered to be the nonaccretable difference. The nonaccretable difference represents the estimate of the credit losses expected to occur and was considered in determining the fair value of the loans as of the acquisition date. Subsequent to the acquisition date, any increases in expected cash flows over those expected at purchase date in excess of fair value are adjusted through the accretable difference on a prospective basis. Any subsequent decreases in expected cash flows over those expected at purchase date are recognized by recording a provision for loan losses. Any disposals of loans, including sales of loans, payments in full or foreclosures, result in the removal of the loan from the pool at its carrying amount. FDIC Indemnification Asset:The Company has elected to account for amounts receivable under the loss share agreement as an indemnification asset in accordance with FASB ASC 805,Business Combinations. The FDIC indemnification asset is initially recorded at fair value, based on the discounted value of expected future cash flows under the loss share agreement. The difference between the present value and the undiscounted cash flows the Company expects to collect from the FDIC will be accreted into noninterest income over the life of the FDIC indemnification asset. The FDIC indemnification asset is reviewed quarterly and adjusted for any changes in expected cash flows based on recent performance and expectations for future performance of the covered portfolio. These adjustments are measured on the same basis as the related covered loans and covered other real estate owned. Any increases in cash flow of the covered assets over those expected will reduce the FDIC indemnification asset and any decreases in cash flow of the covered assets under those expected will increase the FDIC indemnification asset. Increases and decreases to the FDIC indemnification asset are recorded as adjustments to noninterest income over the life of the loss share agreements. Stock-based Compensation:There have been no material changes in the accounting policy relating to stock-based compensation as compared to that contained in Note (1) of the Notes to Consolidated Financial Statements for the year ended December 31, 2009, as filed on Form 10-K. Results of Operations Overview For the three months ended September 30, 2010, net income available to common shareholders increased to $13.3 million, or $0.86 per diluted common share, as compared to net income available to common shareholders of $1.3 million, or $0.13 per diluted common share, for the same period a year ago. The increase in net income available to common shareholders was principally attributable to increased noninterest income and increased net interest income, partially offset by increased noninterest expense. Noninterest income for the three months ended September 30, 2010, includes a bargain purchase gain on acquisition of $17.5 million relating to the acquisition of North County Bank and change in FDIC indemnification asset of $812 thousand relating to the acquisition of City Bank. The Bank assumed certain assets and liabilities of City Bank and North County Bank on April 16, 2010 and September 24, 2010 and the results of the acquired operations are included in the Banks financial results starting on April 17, 2010 and September 25, 2010, respectively. For the nine months ended September 30, 2010, net income available to common shareholders was $19.0 million, or $1.23 per diluted common share, as compared to net income available to common shareholders of $3.3 million, or $0.35 per diluted common share for the nine months ended September 30, 2009. The increase in net income available to common shareholders was principally attributable to the City Bank and North County Bank acquisitions that occurred during the second and third quarters of 2010, respectively. In addition to results presented in accordance with generally accepted accounting principles in the United States of America (GAAP), this filing presents certain non-GAAP financial measures. Management believes that certain non-GAAP financial measures provide investors with information useful in understanding the Company's financial performance; however, readers of this report are urged to review these non-GAAP measures in conjunction with the GAAP results, as reported. Operating earnings are not a measure of performance calculated in accordance with GAAP. However, management believes that operating earnings are an important indication of the ability to generate earnings through the Company's fundamental banking business. Since operating earnings exclude the effects of certain items that are unusual and/or difficult to predict, management believes that operating earnings provide useful supplemental information to both management and investors in evaluating the Company's financial results. Operating earnings should not be considered in isolation or as a substitute for net income, cash flows from operating activities or other income or cash flow statement data calculated in accordance with GAAP. Moreover, the manner in which the Company calculates operating earnings may differ from that of other companies reporting measures with similar names. 33


---



The following table provides the reconciliation of the Company's GAAP earnings to operating earnings (non-GAAP) for the periods presented: Reconciliation of Net Operating Earnings to GAAP Earnings Available to Common Shareholders (dollars in thousands)
     
     Three Months Ended
     
     
     
     Nine Months EndedSeptember 30,
     
     
     
     September 30,2010
     
     
     
     
     2009
     
     
     
     2010
     
     
     
     2009GAAP earnings available to common shareholders
     $
     13,285
     
     
     $
     1,259
     
     
     $
     19,017
     
     
     $
     3,292Provision for income taxes
     
     7,085
     
     
     
     
     740
     
     
     
     9,937
     
     
     
     
     1,96520,370
     
     
     
     
     1,999
     
     
     
     28,954
     
     
     
     
     5,257Adjustments to GAAP earnings available to common shareholders:Gain on Acquisitions
     
     (17,511
     )
     
     
     
     -
     
     
     
     (19,268
     )
     
     
     
     -Merger related expenses
     
     978
     
     
     
     
     -
     
     
     
     1,654
     
     
     
     
     -Operating earnings before taxes
     
     3,837
     
     
     
     
     1,999
     
     
     
     11,340
     
     
     
     
     5,257Provision for income taxes
     
     (1,343
     )
     
     
     
     (740
     )
     
     
     (3,969
     )
     
     
     (1,965
     )Net operating earnings
     $
     2,494
     
     
     $
     1,259
     
     
     $
     7,371
     
     
     $
     3,292Diluted GAAP earnings per common share
     $
     0.86
     
     
     $
     
     0.13
     
     
     $
     1.23
     
     
     $
     
     0.35Diluted operating earnings per common share
     $
     0.16
     
     
     $
     
     0.13
     
     
     $
     0.48
     
     
     $
     
     0.35
  Tangible common equity, tangible assets and tangible book value per common share are not measures that are calculated in accordance with GAAP. However, management uses these non-GAAP measures in their analysis of the Company's performance. Management believes that these non-GAAP measures are an important indication of the Company's ability to grow both organically and through business combinations, and with respect to tangible common equity, the Company's ability to pay dividends and to engage in various capital management strategies. Neither tangible common equity, tangible assets nor tangible book value per common share should be considered in isolation or as a substitute for common shareholders' equity or book value per common share or any other measure calculated in accordance with GAAP. Moreover, the manner in which the Company calculates tangible common equity, tangible assets and tangible book value per share may differ from that of other companies reporting measures with similar names. The following table provides the reconciliation of the Company's shareholders' equity (GAAP) to tangible common equity (non-GAAP) and total assets (GAAP) to tangible assets (non-GAAP) for the periods presented: Tangible Common Equity and Tangible Assets(dollars in thousands)
     
     September 30, 2010
     
     
     
     December 31, 2009Total shareholders' equity
     $
     179,742
     
     
     $
     159,521Adjustments to shareholders' equityPreferred stock
     
     (25,249
     )
     
     
     (24,995
     )Other intangible assets, net
     
     (2,919
     )
     
     
     -Tangible common equity
     $
     151,574
     
     
     $
     134,526Total assets
     $
     1,830,184
     
     
     $
     1,045,871Adjustments to total assetsOther intangible assets, net
     
     (2,919
     )
     
     
     -Tangible assets
     $
     1,827,265
     
     
     $
     1,045,871Common shares outstanding at end of period
     
     15,310,893
     
     
     
     15,297,801Tangible common equity
     
     8.30
     %
     
     
     12.86
     %Tangible book value per common share
     $
     9.90
     
     
     $
     8.79
  34


---



Net Interest Income:One of the Companys key sources of earnings is net interest income. To make it easier to compare results among several periods and the yields on various types of earning assets (some of which are taxable and others which are not), net interest income is presented in this discussion on a taxable-equivalent basis (i.e., as if it were all taxable at the same rate). There are several factors that affect net interest income including: The volume, pricing, mix and maturity of interest-earning assets and interest-bearing liabilities;The volume of free funds (consisting of noninterest-bearing deposits and other liabilities and shareholders equity);The volume of noninterest-earning assets;Market interest rate fluctuations; andAsset quality. 35


---



The following tables set forth various components of the balance sheet that affect interest income and expense and their respective yields or rates: (dollars in thousands)
     
     Three Months Ended
     
     
     
     Three Months EndedSeptember 30, 2010
     
     
     
     September 30, 2009Average
     
     Interest
     
     Average
     
     
     
     Average
     
     
     Interest
     
     Averagebalance
     
     earned/paid
     
     yield
     
     
     
     balance
     
     
     earned/paid
     
     yieldAssetsNon-covered loans (1)(2)
     $
     842,709
     
     $
     13,679
     
     6.44
     %
     
     $
     821,375
     
     $
     13,646
     
     6.59
     %Covered loans
     
     287,169
     
     
     5,479
     
     7.57
     %
     
     
     -
     
     
     -
     
     -Federal funds sold
     
     5,742
     
     
     2
     
     0.11
     %
     
     
     28,407
     
     
     18
     
     0.25
     %Interest-bearing deposits
     
     129,606
     
     
     98
     
     0.30
     %
     
     
     285
     
     
     -
     
     0.02
     %InvestmentsTaxable
     
     102,115
     
     
     699
     
     2.72
     %
     
     
     24,467
     
     
     191
     
     3.10
     %Non-taxable (2)
     
     71,487
     
     
     279
     
     1.55
     %
     
     
     17,572
     
     
     194
     
     4.38
     %Interest-earning assets
     
     1,438,828
     
     
     20,236
     
     5.58
     %
     
     
     892,106
     
     
     14,049
     
     6.25
     %Noninterest-earning assets
     
     174,084
     
     
     
     
     
     
     
     
     54,617Total assets
     $
     1,612,912
     
     
     
     
     
     
     
     $
     946,723Liabilities and shareholders' equityDeposits:NOW accounts and money market
     $
     459,313
     
     $
     676
     
     0.58
     %
     
     $
     283,805
     
     $
     604
     
     0.84
     %Savings
     
     82,937
     
     
     52
     
     0.25
     %
     
     
     45,901
     
     
     29
     
     0.25
     %Time deposits
     
     674,765
     
     
     2,347
     
     1.38
     %
     
     
     364,421
     
     
     2,568
     
     2.79
     %Total interest-bearing deposits
     
     1,217,015
     
     
     3,075
     
     1.00
     %
     
     
     694,127
     
     
     3,201
     
     1.83
     %Federal funds purchased
     
     -
     
     
     -
     
     0.00
     %
     
     
     10
     
     
     -
     
     0.00
     %Junior subordinated debentures
     
     25,774
     
     
     135
     
     2.09
     %
     
     
     25,774
     
     
     139
     
     2.14
     %Other interest-bearing liabilities
     
     6,196
     
     
     59
     
     3.78
     %
     
     
     10,000
     
     
     94
     
     3.72
     %Total interest-bearing liabilities
     
     1,248,985
     
     
     3,269
     
     1.04
     %
     
     
     729,911
     
     
     3,434
     
     1.87
     %Noninterest-bearing deposits
     
     176,314
     
     
     
     
     
     
     
     
     105,052Other liabilities
     
     20,400
     
     
     
     
     
     
     
     
     2,901Total liabilities
     
     1,445,699
     
     
     
     
     
     
     
     
     837,864Total shareholders' equity
     
     167,213
     
     
     
     
     
     
     
     
     108,859Total liabilities and shareholders' equity
     $
     1,612,912
     
     
     
     
     
     
     
     $
     946,723Net interest income/spread
     
     
     
     $
     16,967
     
     4.54
     %
     
     
     
     
     $
     10,615
     
     4.38
     %Credit for interest-bearing funds
     
     
     
     
     
     
     0.14
     %
     
     
     
     
     
     
     
     0.34
     %Net interest margin (2)
     
     
     
     
     
     
     4.68
     %
     
     
     
     
     
     
     
     4.72
     %
  (1) Average balance includes nonaccrual loans. (2) Interest income on non-taxable investments and loans is presented on a taxable-equivalent basis using the federal statutory rate of 35%. These adjustments were $236 and $172 for the three months ended September 30, 2010 and 2009, respectively. Taxable-equivalent is a non- GAAP performance measurement that management believes provides investors with a more accurate picture of the net interest margin and efficiency ratio for comparative purposes. Taxable-equivalent net interest income totaled $17.0 million for the third quarter of 2010, compared to $10.6 million for the third quarter of 2009. Changes in net interest income during the third quarter of 2010 reflect a $5.5 million increase in income on covered loans resulting from the FDIC-assisted acquisitions of City Bank and North County Bank, an increase in investment income of $593 thousand and a decrease in interest expense of $166 thousand. 36


---



Net interest margin (net interest income as a percentage of average interest-earning assets) on a taxable-equivalent basis was 4.68% for the third quarter of 2010, compared to 4.72% for the same period a year ago. The decline in net interest margin for the period resulted primarily from a $106.7 million increase in average low yielding interest bearing cash and federal funds sold and a $131.6 million increase in average low yielding investment securities. The increase in low yielding interest earning assets were partially offset by $287.2 million in average covered loans and a decrease in interest expense resulting from the lower cost of interest-bearing deposits. (dollars in thousands)
     
     Nine Months Ended
     
     
     
     
     
     Nine Months EndedSeptember 30, 2010
     
     
     
     
     
     September 30, 2009Average
     
     Interest
     
     Average
     
     
     
     Average
     
     
     Interest
     
     Averagebalance
     
     earned/paid
     
     yield
     
     
     
     balance
     
     
     earned/paid
     
     yieldAssetsNon-covered loans (1)(2)
     $
     830,919
     
     $
     40,367
     
     6.50
     %
     
     $
     825,871
     
     $
     40,105
     
     6.49
     %Covered loans
     
     182,895
     
     
     10,406
     
     8
     
     
     
     -
     
     
     -
     
     -Federal funds sold
     
     6,679
     
     
     5
     
     0.10
     %
     
     
     16,135
     
     
     28
     
     0.23
     %Interest-bearing deposits
     
     114,724
     
     
     226
     
     0.26
     %
     
     
     290
     
     
     -
     
     0.00
     %InvestmentsTaxable
     
     77,380
     
     
     1,620
     
     2.80
     %
     
     
     18,423
     
     
     468
     
     3.40
     %Non-taxable (2)
     
     57,859
     
     
     777
     
     1.80
     %
     
     
     12,099
     
     
     434
     
     4.80
     %Interest-earning assets
     
     1,270,456
     
     
     53,401
     
     5.62
     %
     
     
     872,818
     
     
     41,035
     
     6.29
     %Noninterest-earning assets
     
     124,219
     
     
     
     
     
     
     
     
     53,929Total assets
     $
     1,394,675
     
     
     
     
     
     
     
     $
     926,747Liabilities and shareholders' equityDeposits:NOW accounts and money market
     $
     403,878
     
     
     1,879
     
     0.62
     %
     
     $
     270,359
     
     
     1,738
     
     0.86
     %Savings
     
     69,805
     
     
     132
     
     0.25
     %
     
     
     44,048
     
     
     83
     
     0.25
     %Time deposits
     
     562,496
     
     
     6,372
     
     1.51
     %
     
     
     360,357
     
     
     8,285
     
     3.07
     %Total interest-bearing deposits
     
     1,036,179
     
     
     8,383
     
     1.08
     %
     
     
     674,764
     
     
     10,106
     
     2.00
     %Federal funds purchased
     
     372
     
     
     -
     
     0.02
     %
     
     
     691
     
     
     4
     
     0.82
     %Junior subordinated debentures
     
     25,774
     
     
     374
     
     1.94
     %
     
     
     25,774
     
     
     543
     
     2.82
     %Other interest-bearing liabilities
     
     8,718
     
     
     243
     
     3.73
     %
     
     
     16,960
     
     
     337
     
     2.66
     %Total interest-bearing liabilities
     
     1,071,043
     
     
     9,000
     
     1.12
     %
     
     
     718,189
     
     
     10,990
     
     2.05
     %Noninterest-bearing deposits
     
     148,880
     
     
     
     
     
     
     
     
     99,754Other liabilities
     
     11,271
     
     
     
     
     
     
     
     
     2,415Total liabilities
     
     1,231,194
     
     
     
     
     
     
     
     
     820,358Total shareholders' equity
     
     163,481
     
     
     
     
     
     
     
     
     106,389Total liabilities and shareholders' equity
     $
     1,394,675
     
     
     
     
     
     
     
     $
     926,747Net interest income/spread
     
     
     
     $
     44,401
     
     4.50
     %
     
     
     
     
     $
     30,045
     
     4.24
     %Credit for interest-bearing funds
     
     
     
     
     
     
     0.17
     %
     
     
     
     
     
     
     
     0.36
     %Net interest margin (2)
     
     
     
     
     
     
     4.67
     %
     
     
     
     
     
     
     
     4.60
     %
  (1) Average balance includes nonaccrual loans. (2) Interest income on non-taxable investments and loans is presented on a taxable-equivalent basis using the federal statutory rate of 35%. These adjustments were $668 and $465 for the nine months ended September 30, 2010 and 2009, respectively. Taxable-equivalent is a non- GAAP performance measurement that management believes provides investors with a more accurate picture of the net interest margin and efficiency ratio for comparative purposes. Net interest margin on a taxable-equivalent basis was 4.67% for the first nine months of 2010, compared to 4.60% for the same period in 2009. The change in net interest margin in the first nine months of 2010 resulted primarily from a $105.0 million increase in average low yielding interest-bearing cash and federal funds sold and $104.7 million in average low yielding investment securities. The increase in low yielding interest-earning assets was partially offset by $182.9 million in average covered loans and a decrease in interest expense resulting from the lower cost of interest-bearing deposits. 37


---



The following table sets forth the changes in yields or rates and average balances that affected net interest income: (dollars in thousands)
     
     Three Months Ended
     
     
     
     
     Nine Months EndedSeptember 30,
     
     
     
     
     September 30,2010 versus 2009
     
     
     
     
     2010 versus 2009Increase (decrease) due to (2):
     
     
     
     
     Increase (decrease) due to (2):Volume
     
     
     
     Rate
     
     
     
     Total
     
     
     
     Volume
     
     
     
     Rate
     
     
     
     TotalAssetsNon-covered loans (1)(3)
     
     $
     284
     
     
     $
     (251
     )
     
     $
     33
     
     
     
     $
     246
     
     
     $
     16
     
     
     $
     262Covered loans
     
     
     5,479
     
     
     
     -
     
     
     
     5,479
     
     
     
     
     10,406
     
     
     
     -
     
     
     
     10,406Federal funds sold
     
     
     (9
     )
     
     
     (7
     )
     
     
     (16
     )
     
     
     
     (12
     )
     
     
     (11
     )
     
     
     (23
     )Interest-bearing deposits
     
     
     98
     
     
     
     -
     
     
     
     98
     
     
     
     
     213
     
     
     
     13
     
     
     
     226Investments (1)Taxable
     
     
     528
     
     
     
     (20
     )
     
     
     508
     
     
     
     
     1,190
     
     
     
     (38
     )
     
     
     1,152Non-taxable
     
     
     108
     
     
     
     (23
     )
     
     
     85
     
     
     
     
     401
     
     
     
     (58
     )
     
     
     343Interest-earning assets
     $
     6,488
     
     
     $
     (301
     )
     
     $
     6,187
     
     $
     
     12,444
     
     
     $
     (78
     )
     
     $
     12,366LiabilitiesDeposits:NOW accounts and money market
     
     $
     143
     
     
     $
     (71
     )
     
     $
     72
     
     
     
     $
     321
     
     
     $
     (180
     )
     
     $
     141Savings
     
     
     23
     
     
     
     -
     
     
     
     23
     
     
     
     
     49
     
     
     
     -
     
     
     
     49Time deposits
     
     
     (543
     )
     
     
     322
     
     
     
     (221
     )
     
     
     
     (19,993
     )
     
     
     18,080
     
     
     
     (1,913
     )Total interest-bearing deposits
     
     
     (377
     )
     
     
     251
     
     
     
     (126
     )
     
     
     
     (19,623
     )
     
     
     17,900
     
     
     
     (1,723
     )Federal funds purchased
     
     
     -
     
     
     
     -
     
     
     
     -
     
     
     
     
     (1
     )
     
     
     (3
     )
     
     
     (4
     )Junior subordinated debentures
     
     
     -
     
     
     
     (4
     )
     
     
     (4
     )
     
     
     
     -
     
     
     
     (169
     )
     
     
     (169
     )Other interest-bearing liabilities
     
     
     (36
     )
     
     
     1
     
     
     
     (35
     )
     
     
     
     (560
     )
     
     
     466
     
     
     
     (94
     )Total interest-bearing liabilities
     
     $
     (413
     )
     
     $
     248
     
     
     $
     (165
     )
     $
     
     (20,184
     )
     
     $
     18,194
     
     
     $
     (1,990
     )
 (1) Interest on loans and investments is presented on a fully tax-equivalent basis.
(2) The changes attributable to the combined effect of volume and interest rates have been allocated proportionately. 
(3) Interest income previously accrued on nonaccrual loans is reversed in the period the loan is placed on nonaccrual status. 38


---



Provision for Loan Losses:The provision for loan losses is highly dependent on the Companys ability to manage asset quality and control the level of net charge-offs through prudent underwriting standards. In addition, decline in general economic conditions could increase future provisions for loan losses and materially impact the Companys net income. For further discussion of the Companys asset quality see the Credit Risks and Asset Quality section found in Item 2- Managements Discussion and Analysis of Financial Condition and Results of Operations. For the three months ended September 30, 2010, the Company recorded a $4.0 million provision for loan losses, compared to $2.5 million for the same period a year ago. Net charge-offs of non-covered loansfor third quarter of 2010 were $3.0 million, a $1.6 million increase over the third quarter of 2009. The increase in net charge-offsof non-covered loansfor the period were due to an increase in real estate loan charge-offs. At September 30, 2010 and 2009, the allowance for loan losses, as a percent of total non-covered loans, was 2.14% and 1.99%, respectively. For the nine months ended September 30, 2010, the Company recorded an $8.7 million provision for loan losses compared to $8.0 million for the same period of 2009. Changes in the provision for loan losses were primarily due to the $2.6 million increase in net charge-offsof non-covered loansfor the period. Noninterest Income:For the three months ended September 30, 2010, noninterest income totaled $20.8 million, compared to $1.8 million for the same period a year ago, an increase of $19.0 million. For the nine months ended September 30, 2010, noninterest income totaled $27.7 million, an increase of $21.7 million from the same period a year ago. The following table presents the key components of noninterest income for the three and nine months ended September 30, 2010 and 2009 (dollars in thousands)
     
     Three Months Ended
     
     
     Nine Months EndedSeptember 30,
     
     
     September 30,
     
     
     Three Month
     
     
     
     Nine Month2010
     
     
     2009
     
     
     2010
     
     
     2009
     
     
     Change
     
     
     
     ChangeService charges and fees
     $
     907
     
     $
     909
     
     $
     2,498
     
     $
     2,620
     
     $
     (2
     )
     
     $
     (122
     )Electronic banking income
     
     511
     
     
     376
     
     
     1,325
     
     
     1,034
     
     
     135
     
     
     
     291Investment products
     
     120
     
     
     38
     
     
     348
     
     
     368
     
     
     82
     
     
     
     (20
     )Bank owned life insurance income
     
     61
     
     
     106
     
     
     241
     
     
     312
     
     
     (45
     )
     
     
     (71
     )Income from the sale of mortgage loans
     
     352
     
     
     138
     
     
     697
     
     
     708
     
     
     214
     
     
     
     (11
     )SBA premium income
     
     126
     
     
     49
     
     
     378
     
     
     83
     
     
     77
     
     
     
     295Bargain purchase gain on acquisition
     
     17,511
     
     
     -
     
     
     19,268
     
     
     -
     
     
     17,511
     
     
     
     19,268Change in FDIC indemnification asset
     
     812
     
     
     -
     
     
     1,596
     
     
     -
     
     
     812
     
     
     
     1,596Other
     
     448
     
     
     232
     
     
     1,310
     
     
     800
     
     
     216
     
     
     
     510Total noninterest income
     $
     20,848
     
     $
     1,848
     
     $
     27,661
     
     $
     5,925
     
     $
     19,000
     
     
     $
     21,736
  The bargain purchase gain on acquisition for the three and nine months ended September 30, 2010, represents the excess of the estimated fair value of the assets acquired over the estimated fair value of the liabilities assumed for the City Bank ($1.8 million) and North County Bank ($17.5 million) acquisitions. Change in FDIC indemnification asset for the three and nine months ended September 30, 2010, represents the accretion of the FDIC indemnification related to the acquisition of City Bank in the second quarter of 2010. 39


---



Noninterest Expense:The Company continues to focus on controlling noninterest expenses and addressing long term operating expenses. The following table presents the key elements of noninterest expense: (dollars in thousands)
     
     Three Months Ended
     
     
     Nine Months EndedSeptember 30,
     
     
     September 30,
     
     
     Three Month
     
     
     
     Nine Month2010
     
     
     
     2009
     
     
     2010
     
     
     2009
     
     
     Change
     
     
     
     ChangeSalaries and benefits
     $
     6,615
     
     
     $
     3,638
     
     $
     17,471
     
     $
     10,499
     
     $
     2,977
     
     
     $
     6,972Occupancy and equipment
     
     1,677
     
     
     
     1,099
     
     
     4,042
     
     
     3,203
     
     
     578
     
     
     
     839Office supplies and printing
     
     299
     
     
     
     198
     
     
     820
     
     
     577
     
     
     101
     
     
     
     243Data processing
     
     403
     
     
     
     141
     
     
     1,011
     
     
     418
     
     
     262
     
     
     
     593Consulting and professional fees
     
     92
     
     
     
     184
     
     
     490
     
     
     564
     
     
     (92
     )
     
     
     (74
     )Intangible amortization
     
     234
     
     
     
     -
     
     
     425
     
     
     -
     
     
     234
     
     
     
     425Merger related expenses
     
     978
     
     
     
     -
     
     
     1,654
     
     
     -
     
     
     978
     
     
     
     1,654FDIC premiums
     
     562
     
     
     
     283
     
     
     1,068
     
     
     1,106
     
     
     279
     
     
     
     (38
     )OREO and repossession expenses
     
     (23
     )
     
     
     389
     
     
     641
     
     
     982
     
     
     (412
     )
     
     
     (341
     )Other
     
     2,007
     
     
     
     1,446
     
     
     4,924
     
     
     3,763
     
     
     561
     
     
     
     1,161Total noninterest expense
     $
     12,844
     
     
     $
     7,378
     
     $
     32,546
     
     $
     21,112
     
     $
     5,466
     
     
     $
     11,434
  The increase in salaries and benefits for the three and nine months ended September 30, 2010, compared to the same periods a year ago, is primarily attributable to the increase in full-time equivalents due to the acquisitions of City Bank and North County Bank. Total full-time equivalents were 424 and 279 at September 30, 2010 and 2009, respectively. The increase in occupancy expense for the three and nine months ended September 30, 2010, compared to the same periods in 2009, was due primarily to the additional cost of operating the eight new branches acquired in the City Bank acquisition. The Bank did not immediately acquire the real estate, banking facilities, furniture or equipment of the four North County branches. The Bank has 90 days from the date of acquisition to purchase or lease the real estate and furniture and equipment from the FDIC. Data processing expense increased during the three and nine months ended September 30, 2010, compared to the same periods in 2009, due to additional expenses related to the Company moving its core processing to an outsourced environment. The Company outsourced its processing during the fourth quarter of 2009. Additionally, the Company has incurred additional data processing expenses related to the City Bank and North County Bank acquisitions. The consolidation of City Banks data system was completed at the end of the third quarter 2010. Management anticipates the consolidation of North County Banks data systems during the first half of 2011. Intangible amortization for the three and nine months ended September 30, 2010, represents amortization related to the core deposit intangible recorded as part of the fair valuation of the City Bank acquisition. Merger related expenses for the three and nine months ended September 30, 2010, relate to one-time expenses of the City Bank and North County Banks acquisitions. Merger related expenses include conversion expense, severance and professional and consulting services. The increase in FDIC premiums for the three months ended September 30, 2010, compared to the three months ended September 30, 2009, was a result of the increase in deposits primarily attributable to the City Bank acquisition in the second quarter of 2010. The slight decrease in FDIC premiums for the nine months ended September 30, 2010, compared to the same period a year ago, primarily resulted from an industry wide increase in the assessment rate and deposit growth, partially offset by the FDICs levy of a special one-time assessment totaling $400,000 in the first half of 2009. OREO and repossession expense represents costs the Company incurs in reclaiming, repairing and selling real estate properties and automobiles, as well as any write-downs or gains and losses on the sale of OREO properties. The credit for OREO expense in the third quarter 2010 relates to an adjustment to the prior quarters OREO expenses recoverable from the FDIC. 40


---



Income Taxes:The Companys consolidated effective tax rates for the third quarter of 2010 and 2009 were 34.1% and 30.7%, respectively. The effective tax rates for the nine months ended September 30, 2010 and 2009 were 32.9% and 30.5%, respectively. The quarterly and year-to-date effective tax rates are below the federal statutory rate of 35% principally due to nontaxable income generated from investments in bank owned life insurance, tax-exempt municipal bonds and loans. Additionally, the Companys year-to-date and quarterly 2010 tax rates reflect a benefit from the New Market Tax Credit Program. The tax benefits related to these credits will be recognized in the same periods that the credits are recognized on the Companys income tax returns. Financial Condition Overview Total assets at September 30, 2010, were $1.8 billion, compared to $1.0 billion at December 31, 2009, an increase of $784.3 million, or 75.0%. The increase in total assets was primarily due to the acquisitions of City Bank and North County in the second and third quarters of 2010, respectively. The City Bank and North County Bank acquisitions added an additional $715.1 million and $279.2 million in assets, respectively, to the Companys balance sheet at the time of each closing. Excluding the acquisitions, non-covered loans, net of allowance for loan losses, increased to $819.1 million, compared to $797.6 million at December 31, 2009, an increase of $21.4 million, or 2.7%. Deposits, excluding the City Bank and North County Bank acquisitions, increased to $870.2 million at September 30, 2010, compared to $846.7 million at December 31, 2009, an increase of $23.5 million, or 2.8%. Investment Securities:The composition of the Companys investment portfolio reflects managements investment strategy of maintaining an appropriate level of liquidity while providing a relatively stable source of investment income. The investment securities portfolio mitigates interest rate risk inherent in the loan portfolio, while providing a vehicle for the investment of available funds and a source of liquidity. Total investment securities increased $119.6 million to $200.4 million at September 30 2010, compared to $80.8 million December 31, 2009. The increase was a result of the Company actively adding investment securities to the portfolio due to decreased loan demand and additional cash proceeds from the City Bank and North County Bank acquisitions. As part of the City Bank and North County Bank acquisitions, the Company acquired $9.1 million and $21.2 million in investments, respectively, at the time of each closing. The Companys investment portfolio mix, based upon fair value, is outlined in the table below: (dollars in thousands)
     
     September 30, 2010
     
     
     December 31, 2009U. S. government agencies
     $
     106,429
     
     $
     37,193U.S. Treasuries
     
     54,951
     
     
     23,983Pass-through securities
     
     1,396
     
     
     666Taxable state and political subdivisions
     
     5,712
     
     
     1,491Tax exempt state and political subdivision
     
     23,893
     
     
     16,463Corporate obligations
     
     4,018
     
     
     1,037Investments in mutual funds and other equity securities
     
     4,049
     
     
     -Total investment securities available for sale
     $
     200,448
     
     $
     80,833
  41


---



Non-Covered Loans:Total non-covered loans, net of allowance for loans losses, totaled $819.1 million at September 30, 2010, compared to $797.6 million at December 31, 2009, an increase of $21.4 million, or 2.7%. Loan portfolio growth during 2010 was primarily in commercial loans, which were offset by decreases in real estate mortgage, construction loans and consumer loans. The Company attempts to balance the diversity of its portfolio, believing that this provides a good means of minimizing risk due to loss and interest rate sensitivity. Active portfolio management has resulted in a diversified portfolio that is not heavily concentrated in any one industry or community. The following table further details the major components of the non-covered loan portfolio: (dollars in thousands)
     
     September 30, 2010
     
     
     
     December 31, 2009Balance
     
     
     % of total
     
     
     
     Balance
     
     
     % of total
     
     
     
     ChangeCommercial
     $
     146,997
     
     
     17.61
     %
     
     $
     93,295
     
     
     11.50
     %
     
     $
     53,702Real estate mortgages:One-to-four family residential
     
     47,723
     
     
     5.72
     %
     
     
     53,313
     
     
     6.57
     %
     
     
     (5,590
     )Multi-family residential and commercial
     
     351,560
     
     
     42.11
     %
     
     
     360,745
     
     
     44.46
     %
     
     
     (9,185
     )Total real estate mortgages
     
     399,283
     
     
     47.83
     %
     
     
     414,058
     
     
     51.03
     %
     
     
     (14,775
     )Real estate construction:One-to-four family residential
     
     69,341
     
     
     8.31
     %
     
     
     76,046
     
     
     9.37
     %
     
     
     (6,705
     )Multi-family and commercial
     
     38,943
     
     
     4.67
     %
     
     
     34,231
     
     
     4.22
     %
     
     
     4,712Total real estate construction
     
     108,284
     
     
     12.98
     %
     
     
     110,277
     
     
     13.59
     %
     
     
     (1,993
     )Consumer:Indirect
     
     93,356
     
     
     11.18
     %
     
     
     100,697
     
     
     12.41
     %
     
     
     (7,341
     )Direct
     
     86,844
     
     
     10.40
     %
     
     
     93,051
     
     
     11.47
     %
     
     
     (6,207
     )Total consumer
     
     180,200
     
     
     21.58
     %
     
     
     193,748
     
     
     23.88
     %
     
     
     (13,548
     )Subtotal
     
     834,764
     
     
     100.00
     %
     
     
     811,378
     
     
     100.00
     %
     
     
     23,386Deferred loan costs, net
     
     2,253
     
     
     
     
     
     
     2,474
     
     
     
     
     
     
     (221
     )Allowance for loan losses
     
     (17,936
     )
     
     
     
     
     
     (16,212
     )
     
     
     
     
     
     (1,724
     )Total non-covered loans
     $
     819,081
     
     
     
     
     
     $
     797,640
     
     
     
     
     
     $
     21,441
  42


---



Covered Loans:At September 30, 2010, covered loans totaled $393.3 million, resulting from the second quarter acquisition of City Bank and the third quarter acquisition of North County Bank. The following table further details the major components of the covered loan portfolio: (dollars in thousands)
     
     September 30, 2010Commercial
     $
     37,250Real estate mortgages:One-to-four family residential
     
     19,217Multi-family residential and commercial
     
     309,346Total real estate mortgages
     
     328,563Real estate construction:One-to-four family residential
     
     78,411Multi-family and commercial
     
     92,906Total real estate construction
     
     171,317Consumer - direct
     
     23,159Subtotal
     
     560,289Fair value discount
     
     (166,942
     )Total covered loans
     $
     393,347
  The covered loans are subject to loss sharing agreements with the FDIC. The covered loans acquired are, and will continue to be, subject to the Companys internal and external credit review and monitoring. If credit deterioration is experienced subsequent to the initial acquisition fair value amount, such deterioration will be measured, and a provision for credit losses will be charged to earnings. These provisions will be mostly offset by an increase to the FDIC indemnification asset, and will be recognized in noninterest income. Credit Risks and Asset Quality Credit Risks:The extension of credit, in the form of loans or other credit substitutes, to individuals and businesses is a major portion of the Companys principal business activity. Company policies and applicable laws and regulations require risk analysis as well as ongoing portfolio and credit management. The Company manages its credit risk through lending limits, credit review, approval policies and extensive, ongoing internal monitoring. Through this monitoring process, nonperforming loans are identified. Nonperforming assets consist of nonaccrual loans, restructured loans, past due loans greater than ninety days and other real estate owned. Nonperforming assets are assessed for potential loss exposure on an individual or homogeneous group basis. Loans are placed on nonaccrual status when collection of principal or interest is considered doubtful (generally, loans are 90 days or more past due). Loans are reported as restructured when the Bank grants a concession(s) to a borrower experiencing financial difficulties that it would not otherwise consider. Examples of such concessions include forgiveness of principal or accrued interest, extending the maturity date(s) or providing a lower interest rate than would be normally available for a transaction of similar risk. As a result of these concessions, restructured loans are impaired as the Bank will not collect all amounts due, both principal and interest, in accordance with the terms of the original loan agreement. A loan is considered impaired when, based upon currently known information, it is deemed probable that the Company will be unable to collect all amounts due as scheduled according to the original terms of the agreement. Impaired loans are measured based on the present value of expected future cash flows discounted at the loans effective interest rate or, as a practical expedient, based on the loans observable market price or the fair value of collateral, if the loan is collateral dependent. 43


---



Interest income previously accrued on nonaccrual loans, but not yet received, is reversed in the period the loan is placed on nonaccrual status. Payments received are generally applied to principal. However, based on managements assessment of the ultimate collectability of an impaired or nonaccrual loan, interest income may be recognized on a cash basis. Nonaccrual loans are returned to an accrual status when management determines the circumstances have improved to the extent that there has been a sustained period of repayment performance and both principal and interest are deemed collectible. Non-Covered Nonperforming Assets The following table summarizes the Companys non-covered, nonperforming assets at September 30, 2010 and December 31, 2009: (dollars in thousands)
     
     September 30,
     
     
     
     December 31,2010
     
     
     
     2009Non-covered nonaccrual loans
     $
     16,420
     
     
     $
     3,395Non-covered restructured loans
     
     5,098
     
     
     
     -Total non-covered nonperforming loans
     
     21,518
     
     
     
     3,395Non-covered other real estate owned
     
     4,095
     
     
     
     4,549Total non-covered nonperforming assets
     $
     25,613
     
     
     $
     7,944Total non-covered impaired loans
     $
     21,518
     
     
     $
     3,395Non-covered accruing loans past due 90days or more
     
     -
     
     
     
     -Non-covered potential problem loans (1)
     
     12,497
     
     
     
     4,586Allowance for loan losses
     
     17,936
     
     
     
     16,212Non-covered nonperforming loans to totalnon-covered loans
     
     2.57
     %
     
     
     0.42
     %Allowance for loan losses to total non-covered loans
     
     2.14
     %
     
     
     1.99
     %Allowance for loan losses to non-coverednonperfoming loans
     
     83.35
     %
     
     
     477.53
     %Non-covered nonperforming assets to total assets
     
     1.40
     %
     
     
     0.76
     %
  (1) Non-covered potential problem loans represent loans where known information about possible credit problems of borrowers causes management to have serious doubts about the ability of such borrowers to comply with the present loan repayment terms. At September 30, 2010 and December 31, 2009, non-covered impaired loans totaling $12.1 million and $3.4 million had related specific reserves in the allowance for loan losses of $2.1 million and $1.2 million, respectively. Non-covered impaired loans without related specific reserves in the allowance for loan losses at September 30, 2010, totaled $9.4 million. At December 31, 2009, all non-covered impaired loans had related specific reserves in the allowance for loan losses. The average recorded investment in non-covered impaired loans was approximately $6.9 million during the nine months ended September 30, 2010, and $5.7 million for the year ended December 31, 2009. At September 30, 2010, non-covered impaired loans of $5.1 million were classified as nonaccruing restructured loans. There were no restructured loans at December 31, 2009. The restructurings were granted in response to borrower financial difficulty, and generally provide for a temporary modification of loan repayment terms. The Company has no obligations to lend additional funds on the non-covered restructured loans at September 30, 2010. Non-covered impaired loans totaled $21.5 million at September 30, 2010, compared to $3.4 million at December 31, 2009.  The increase in total non-covered impaired loans for the period was attributable to the continued deterioration in the Company's loan portfolio resulting from the low-level of regional economic activity.  Non-covered impaired loans are primarily concentrated in construction and development within Skagit County. 44


---



The following table summarizes the Companys non-covered, nonperforming loans, by location, at September 30, 2010: (dollars in thousands)Percent oftotal NPLIsland
     
     
     King
     
     
     Skagit
     
     
     Whatcom
     
     
     
     
     
     
     
     by loanNPL by location
     
     County
     
     
     County
     
     
     County
     
     
     County
     
     
     Other
     
     
     Total
     
     typeCommercial loans
     $
     369
     
     $
     -
     
     $
     2,201
     
     $
     -
     
     $
     102
     
     $
     2,672
     
     12.42
     %Real estate mortgages
     
     1,090
     
     
     2,109
     
     
     1,363
     
     
     884
     
     
     -
     
     
     5,446
     
     25.31
     %Real estate construction loans
     
     5,483
     
     
     -
     
     
     6,944
     
     
     825
     
     
     -
     
     
     13,252
     
     61.59
     %Consumer loans
     
     148
     
     
     -
     
     
     -
     
     
     -
     
     
     -
     
     
     148
     
     0.68
     %Total
     $
     7,090
     
     $
     2,109
     
     $
     10,508
     
     $
     1,709
     
     $
     102
     
     $
     21,518
     
     100.00
     %Percent of total NPL by location
     
     32.95
     %
     
     9.80
     %
     
     48.83
     %
     
     7.94
     %
     
     0.48
     %
     
     100.00
     %
  Covered Nonperforming Assets The following table summarizes the Companys covered, nonperforming assets at September 30, 2010: (dollars in thousands)
     
     September 30, 2010Covered nonaccrual loans
     $
     102,917Covered restructured loans
     
     14,762Total covered nonperforming loans
     
     117,679Covered other real estate owned
     
     27,250Total covered nonperforming assets
     $
     144,929Total covered impaired loans
     $
     117,679Covered accruing loans past due 90days or more
     
     -Covered nonperforming loans to total covered loans
     
     29.92
     %Covered nonperforming assets to total assets
     
     7.92
     %
  There were no specific reserves in the allowance for loan losses related to covered impaired loans at September 30, 2010. Allowance for Loan Losses:The allowance for loan losses is maintained at a level considered adequate by management to provide for potential loan losses inherent in the portfolio. The Company assesses the allowance for loan losses on a quarterly basis. The Company's methodology for making such assessments and determining the adequacy of the allowance includes the following key elements: Specific Allowances:A specific allowance is established when management has identified unique or particular risks that are related to a specific loan that demonstrate risk characteristics consistent with impairment. Specific allowances may also be established to address the unique risks associated with a group of loans or particular type of credit exposure. 45


---



Formula Allowance:The calculations of expected loss rates are determined utilizing a two factor approach; loss default (LGD) and probability of default (PD). Taken together, these two factors produce the expected rate.>
     LGD is defined as the rate of loss as determined by dividing the expected net charge-off by defaulted loans, where defaulted loans are defined as loans that have 30 days or greater payment delinquency plus non-accrual and gross loans charged off. LGD rates utilized reflect industry experience as determined by state and loan type, and are based upon banks with total assets below one billion dollars. Banks falling into these size and state groupings will better capture state/geographic differences that occur in LGD rates, as well as provide a sufficient number of observations to be statistically meaningful. LGD rates will be based upon industry experience starting in 1992 and applied at a two standard deviation level. Bank specific LGD rates will be utilized when there are sufficient observations to generate a meaningful result, and these observations should include at least three observations as observed over a minimum of at least one full economic cycle for each type/sector/subsector/geographic combination to be considered meaningful.>
     PD is defined as the actual payment default rate (defined as the number of times a loan has been delinquent 30 or more days divided by the number of months the loan has been outstanding from the origination date to the valuation date), or for loans which have not generated an actual payment default rate, the rate applied is based upon industry experience for such loans as applied by loan type and state in which the loan applies to (in the case of real estate loans, the state determination is based upon were the collateral resides), where the expected payment default rate is defined as the sum loans where payment delinquencies are 30 or more days delinquent, plus non-accrual and gross loans charged off divided by total loans for each group. Expected payment default rates are then scaled against the banks loan risk grades with the banks lowest pass/non-watch grade set to equal the industry PD and then scaled lower or higher against the banks remaining loan grades. The Company refined its formula component of the allowance for loan losses model at March 31, 2010. Previous to March 31, 2010, the Company used a less robust model. The Company back-tested the revised model as of December 31, 2009 and ran both models as of March 31, 2010 to ensure consistency and reasonableness of results. At March 31, 2010, the Company chose to move to the revised model as we believe it is more robust, consistent with GAAP and provides additional granularity to the analysis. Given the fact that the Company ran both models for two periods and both models produced materially similar results, it was determined there was no impact to the allowance or provision for loan losses, nor any significant changes to internal controls, as a result of the change. The similarities of the models include: Consideration of loan grade classificationConsideration of loan typeConsideration of historical loss ratesConsideration of the underlying business and economic and business conditions The improvements included in the new model include: Consideration of PD and LGD rates based on geographic/size peer dataAdditional weight given to recent periods when calculating PD and LGDPD and LGD based on loan typeLoan level consideration given to Past Due historyAdditional detail/input for economic conditions/trends available 46


---



The following table summarizes the Companys allocation of allowance for loan losses:(dollars in thousands)
     
     September 30, 2010
     
     
     
     December 31, 2009% of
     
     
     % of
     
     
     
     
     
     % of
     
     
     % ofAmount
     
     Allowance
     
     
     Loans
     
     
     
     Amount
     
     Allowance
     
     
     LoansCommercial
     $
     4,227
     
     23.57
     %
     
     17.61
     %
     
     $
     1,515
     
     9.34
     %
     
     11.50
     %Real estate mortgage
     
     6,040
     
     33.68
     %
     
     47.83
     %
     
     
     8,060
     
     49.72
     %
     
     51.03
     %Real estate construction
     
     4,596
     
     25.62
     %
     
     12.97
     %
     
     
     2,330
     
     14.37
     %
     
     13.59
     %Consumer
     
     3,073
     
     17.13
     %
     
     21.59
     %
     
     
     4,307
     
     26.57
     %
     
     23.88
     %Total
     $
     17,936
     
     100.00
     %
     
     100.00
     %
     
     $
     16,212
     
     100.00
     %
     
     100.00
     %
  The increase in the allocation of the allowance for loan losses for commercial loans was primarily attributable to the growth in the commercial loan portfolio. At September 30, 2010, commercial loans totaled $147.0 million, compared to $93.3 million at December 31, 2009, an increase of $53.7 million, or 57.6%. The increase in the allocation of the allowance for loan losses related to real estate construction loans was primarily attributable to the continued stress on the portfolio. While the Company believes that it uses the best information available to determine the allowance for loan losses, unforeseen market conditions could result in adjustments to the allowance for loan losses, and net income could be significantly affected if circumstances differ substantially from the assumptions used in making the final determination. Based on the assessment of loan quality, the Company believes that the current allowance for loan losses is appropriate under the current circumstances and economic conditions. Asset Quality:The following table sets forth historical information regarding the Company's allowance for loan losses and net charge-offs: (dollars in thousands)
     
     Three Months Ended
     
     
     
     Nine Months EndedSeptember 30,
     
     
     
     September 30,2010
     
     
     
     2009
     
     
     
     2010
     
     
     
     2009Balance at beginning of period
     $
     16,975
     
     
     $
     14,770
     
     
     $
     16,212
     
     
     $
     12,250Provision for loan losses
     
     3,950
     
     
     
     2,500
     
     
     
     8,650
     
     
     
     7,950Charge-offs:Commercial
     
     (763
     )
     
     
     (63
     )
     
     
     (1,887
     )
     
     
     (620
     )Real estate mortgage
     
     (791
     )
     
     
     (829
     )
     
     
     (1,478
     )
     
     
     (1,113
     )Real estate construction
     
     (1,175
     )
     
     
     (431
     )
     
     
     (2,872
     )
     
     
     (1,878
     )ConsumerDirect
     
     (134
     )
     
     
     (218
     )
     
     
     (467
     )
     
     
     (570
     )Indirect
     
     (352
     )
     
     
     (650
     )
     
     
     (1,149
     )
     
     
     (1,781
     )Total charge-offs
     
     (3,215
     )
     
     
     (2,191
     )
     
     
     (7,853
     )
     
     
     (5,962
     )Recoveries:Commercial
     
     16
     
     
     
     208
     
     
     
     159
     
     
     
     474Real estate mortgage
     
     20
     
     
     
     326
     
     
     
     25
     
     
     
     357Real estate construction
     
     1
     
     
     
     36
     
     
     
     108
     
     
     
     49ConsumerDirect
     
     21
     
     
     
     31
     
     
     
     82
     
     
     
     104Indirect
     
     168
     
     
     
     202
     
     
     
     553
     
     
     
     660Total recoveries
     
     226
     
     
     
     803
     
     
     
     927
     
     
     
     1,644Net charge-offs
     
     (2,989
     )
     
     
     (1,388
     )
     
     
     (6,926
     )
     
     
     (4,318
     )Balance at end of period
     $
     17,936
     
     
     $
     15,882
     
     
     $
     17,936
     
     
     $
     15,882
  47


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Other Intangible Assets:At September 30, 2010, the Company had other intangible assets totaling $2.9 million. As part of the FDIC-assisted acquisitions of City Bank and North County Bank, $3.3 million and $50 thousand, respectively, of the purchase price was allocated to the value of other intangible assets such as the core deposits, which includes all deposits except certificates of deposit. The values of the core deposit intangible assets were determined by an analysis of the cost differential between the core deposits and alternative funding sources. Intangible assets with definite useful lives are amortized to their estimated residual values over their estimated useful life, and are also reviewed for impairment. The Company amortizes other intangible assets on an accelerated or straight-line basis over an estimated nine year life for City Bank and an estimated eight year life for North County Bank. No impairment losses separate from the scheduled amortization have been recognized in the periods presented. Deposits:Deposits totaled $1.6 billion at September 30, 2010, compared to $846.7 million at December 31, 2009, an increase of $764.6 million, or 90.3%. Excluding the deposits acquired through the FDIC-assisted acquisitions of City Bank and North County Bank, organic deposit growth for the nine months ended September 30, 2010 totaled $23.5 million. At December 31, 2009, the Company had $7.5 million in brokered time deposits, which subsequently paid in the first quarter of 2010. Additionally, of the $43.6 million of brokered money market deposits at December 31, 2009, $17.6 million paid also paid in the first quarter of 2010. The following table further details the major components of the Companys deposit portfolio: (dollars in thousands)
     
     September 30, 2010
     
     
     
     December 31, 2009Balance
     
     % of total
     
     
     
     Balance
     
     % of total
     
     
     
     ChangeNoninterest-bearing demand
     $
     187,009
     
     11.6
     %
     
     $
     104,070
     
     12.3
     %
     
     $
     82,939NOW accounts
     
     194,370
     
     12.1
     %
     
     
     141,121
     
     16.7
     %
     
     
     53,249Money market
     
     336,329
     
     20.9
     %
     
     
     202,144
     
     23.9
     %
     
     
     134,185Savings
     
     88,085
     
     5.4
     %
     
     
     49,003
     
     5.7
     %
     
     
     39,082Time deposits
     
     805,471
     
     50.0
     %
     
     
     350,333
     
     41.4
     %
     
     
     455,138Total deposits
     $
     1,611,264
     
     100.0
     %
     
     $
     846,671
     
     100.0
     %
     
     $
     764,593
  The following table details the major components of the Companys deposit portfolio, the City Bank and North County Bank acquisitions deposit portfolios and an organic column for comparison purposes: (dollars in thousands)
     
     September 30, 2010
     
     
     December 31, 2009Consolidated
     
     
     
     
     
     North
     
     
     
     
     
     ConsolidatedBalance
     
     
     City Bank
     
     County Bank
     
     
     Organic
     
     
     Balance
     
     
     ChangeNoninterest-bearing demand
     $
     187,009
     
     $
     43,234
     
     $
     13,927
     
     $
     129,848
     
     $
     104,070
     
     $
     82,939NOW accounts
     
     194,370
     
     
     25,708
     
     
     18,116
     
     
     150,546
     
     
     141,121
     
     
     53,249Money market
     
     336,329
     
     
     62,391
     
     
     30,282
     
     
     243,656
     
     
     202,144
     
     
     134,185Savings
     
     88,085
     
     
     26,856
     
     
     4,244
     
     
     56,985
     
     
     49,003
     
     
     39,082Time deposits
     
     805,471
     
     
     337,571
     
     
     178,764
     
     
     289,136
     
     
     350,333
     
     
     455,138Total deposits
     $
     1,611,264
     
     $
     495,760
     
     $
     245,333
     
     $
     870,171
     
     $
     846,671
     
     $
     764,593
  Wholesale Deposits:The following table further details wholesale deposits, which are included in total deposits shown above: (dollars in thousands)
     
     September 30, 2010
     
     
     
     December 31, 2009Balance
     
     
     % of total
     
     
     
     Balance
     
     
     % of totalBrokered time deposits
     $
     -
     
     
     0.0
     %
     
     $
     7,500
     
     
     10.4
     %Mutual fund money market deposits
     
     26,204
     
     
     60.2
     %
     
     
     43,579
     
     
     60.1
     %Certificate Deposits Account Registry System deposits
     
     17,343
     
     
     39.8
     %
     
     
     21,416
     
     
     29.5
     %Total wholesale deposits
     $
     43,547
     
     
     100.0
     %
     
     $
     72,495
     
     
     100.0
     %Wholesale deposits to total deposits
     
     2.7
     %
     
     
     
     
     
     8.6
     %
  48


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Brokered time deposits are obtained through intermediary brokers that sell the certificates on the open market. All $7.5 million of the brokered time deposits at December 31, 2009 matured in January 2010. Mutual fund money market deposits are obtained from an intermediary that provides cash sweep services to broker-dealers and clearing firms. Currently, the Company anticipates limiting the growth of these types of deposits. The deposits are payable upon demand. Certificate Deposit Account Registry System (CDARS) deposits are obtained through a broker and represent a reciprocal agreement, whereby the Company obtains a portion of time deposits from another financial institution, not to exceed $250,000 per customer. In return, the other financial institution obtains a portion of the Companys time deposits. All CDARS deposits represent direct customer relationships with the Company, but for regulatory purposes are required to be classified as brokered deposits. Deposit maturities range between four weeks and twenty four months. Borrowings:At September 30, 2010, borrowings totaled $25.8 million, compared to $35.8 million at December 31, 2009. During the third quarter 2010, $10.0 million of other borrowed funds matured. The Companys sources of funds consist of borrowings from correspondent banks, the FHLB and junior subordinated debentures. FHLB Overnight Borrowings and Other Borrowed Funds:The Company relies upon advances from the FHLB to supplement funding needs. The FHLB provides credit for member financial institutions in the form of overnight borrowings, short term and long term advances. As a member, the Bank is required to own capital stock in the FHLB and is authorized to apply for advances on the pledge of certain of its mortgage loans and other assets (principally, securities which are obligations of, or guaranteed by, the United States) provided certain standards related to creditworthiness have been met. At September 30, 2010, the Company had no outstanding overnight borrowings or other borrowed funds.The Company had a remaining unused line of credit of $188.5 million, subject to certain collateral and stock requirements at September 30, 2010.Federal Funds Purchased:The Company also uses lines of credit at correspondent banks to purchase federal funds for short-term funding. There were no outstanding borrowings at September 30, 2010. Available borrowings under these lines of credit totaled $60.0 million at September 30, 2010.Federal Reserve Bank Overnight Borrowings:The Company can use advances from the Federal Reserve Bank (FRB) of San Francisco to supplement funding needs. The FRB provides credit for financial institutions in the form of overnight borrowings. The Bank is required to pledge certain of its loans and other assets (principally, securities which are obligations of, or guaranteed by, the United States) provided certain standards related to creditworthiness have been met. The Company had a remaining unused line of credit of $72.8 million, subject to certain collateral and stock requirements.Junior Subordinated Debentures:A wholly-owned subsidiary of the Company issued $25.8 million of trust preferred securities with a quarterly adjustable rate based upon the London Interbank Offered Rate (LIBOR) plus 1.56%. The debentures, within certain limitations, are considered Tier 1 capital for regulatory capital requirements. Capital Shareholders Equity:Shareholders equity increased $20.2 million to $179.7 million at September 30, 2010, from $159.5 million at December 31, 2009. The increase in shareholders equity was due principally to $20.3 million in net income and $1.9 million in unrealized gains on investment securities available for sale. This increase was partially offset by the payment of preferred stock dividends of $990 thousand and common stock dividends of $1.3 million. On October 28, 2010, the Company announced that its Board of Directors declared a cash dividend of $0.05 per share to shareholders of record as of November 8, 2010, payable on November 24, 2010. Cash dividends are approved by the Board of Directors in connection with its review of the Companys capital plan. The cash dividend is subject to regulatory limitation. There is no assurance that future cash dividends will be declared or increased. 49


---



Regulatory Capital Requirements:Banking regulations require bank holding companies and banks to maintain a minimum leverage ratio of core capital to adjusted average total assets of at least 4%. In addition, banking regulators have adopted risk-based capital guidelines, under which risk percentages are assigned to various categories of assets and off-balance sheet items to calculate a risk-adjusted capital ratio. Tier I capital generally consists of common shareholders' equity (which does not include unrealized gains and losses on securities), less goodwill and certain identifiable intangible assets, while Tier II capital includes the allowance for loan losses and subordinated debt, both subject to certain limitations. The FDIC established the qualifications necessary to be classified as a well-capitalized bank, primarily for assignment of FDIC insurance premium rates. As the following table indicates, the Company and Bank qualified as well-capitalized at September 30, 2010 and December 31, 2009: Regulatory Requirements
     
     
     Actual RatiosAdequately-
     
     
     
     Well-
     
     
     September 30,
     
     
     December 31,capitalized
     
     
     
     capitalized
     
     
     2010
     
     
     2009Total risk-based capital ratioCompany (consolidated)
     8.00
     %
     
     
     N/A
     
     
     18.88
     %
     
     22.15
     %Whidbey Island Bank
     8.00
     %
     
     
     10.00
     %
     
     18.61
     %
     
     21.55
     %Tier 1 risk-based capital ratioCompany (consolidated)
     4.00
     %
     
     
     N/A
     
     
     17.63
     %
     
     20.89
     %Whidbey Island Bank
     4.00
     %
     
     
     6.00
     %
     
     17.35
     %
     
     20.29
     %Leverage ratioCompany (consolidated)
     4.00
     %
     
     
     N/A
     
     
     12.40
     %
     
     18.73
     %Whidbey Island Bank
     4.00
     %
     
     
     5.00
     %
     
     12.20
     %
     
     18.17
     %
  There can be no assurance that additional capital will not be required in the future due to greater-than-expected growth, unforeseen expenses or revenue shortfalls. Liquidity and Cash Flows Whidbey Island Bank:The principal objective of the Banks liquidity management program is to maintain the ability to meet day-to-day cash flow requirements of its customers who either wish to withdraw funds or to draw upon credit facilities to meet their cash needs. The Bank monitors the sources and uses of funds on a daily basis to maintain an acceptable liquidity position. In addition to liquidity from core deposits and the repayment and maturities of loans, the Bank can utilize established lines of credit with correspondent banks, sale of investment securities or borrowings from the FHLB. Washington Banking Company:The Company is a separate legal entity from the Bank and must provide for its own liquidity. Substantially all of the Companys revenues are obtained from dividends declared and paid by the Bank. There are statutory and regulatory provisions that could limit the ability of the Bank to pay dividends to the Company. However, management believes that such restrictions will not have an adverse impact on the ability of the Company to meets its ongoing cash obligations, which consist principally of debt service on the $25.8 million of outstanding junior subordinated debentures. Consolidated Cash Flows:As disclosed in theCondensed Consolidated Statements of Cash Flows, net cash used in operating activities was $1.9 million for the nine months ended September 30, 2010. Included in net income of $20.3 million were bargain purchase gains of $19.3 million related to the acquisitions of City Bank and North County Bank and the change in the FDIC indemnification asset of $1.6 million. Net cash provided by investing activities was $277.0 million for the period. The Company acquired $351.3 million in cash from the City Bank and North County Bank acquisition, which was partially offset by $127.5 million in investment security purchases. Net cash used in financing activities was $205.8 million for the nine months ended September 30, 2010. Deposits decreased $143.4 million during the period, primarily related to the repricing of the City Bank deposit portfolio. The Company also paid off $50.2 million in FHLB advances acquired from City Bank and $10.0 million of other borrowed funds matured. 50


---



Capital Resources: Off-Balance Sheet Items:The Company is a party to financial instruments with off-balance sheet risk. Among the off-balance sheet items entered into in the ordinary course of business are commitments to extend credit and the issuance of letters of credit. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amounts recognized on the balance sheet. Certain commitments are collateralized. At September 30, 2010 and December 31, 2009, the Companys commitments under letters of credit and financial guarantees amounted to $2.7 million and $2.1 million, respectively. Since many of the commitments are expected to expire without being drawn upon, these total commitment amounts do not necessarily represent future cash requirements. Item 3. Quantitative and Qualitative Disclosures about Market Risk At September 30, 2010, based on the measures used to monitor and manage interest rate risk, there has not been a material change in the Company's interest rate risk since December 31, 2009. Should rates increase, the Company may, or may not be positively impacted due to its current slightly liability sensitive position. For additional information, refer to the Company's Form 10-K for year ended December 31, 2009 filed with the SEC. Item 4. Controls and Procedures Evaluation of Disclosure Controls and Procedures As of the end of the period covered by this report, management evaluated the effectiveness of the design and operation of its disclosure controls and procedures. The principal executive and financial officers supervised and participated in this evaluation. Based on this evaluation, the chief executive and financial officer each concluded that the Companys disclosure controls and procedures are effective in timely alerting them to material information required to be included in the periodic reports to the SEC. The design of any system of controls is based in part upon various assumptions about the likelihood of future events, and there can be no assurance that any of the Companys plans, products, services or procedures will succeed in achieving their intended goals under future conditions. Management found no facts that would require the Company to take any corrective actions with regard to significant deficiencies or material weaknesses. Changes in Internal Control over Disclosure and Reporting There was no change in the Companys internal control over financial reporting that occurred during the period ended September 30, 2010, that has materially affected, or is reasonably likely to materially affect, the internal control over financial reporting. 51


---



PART II  OTHER INFORMATION Item 1. Legal Proceedings The Company may be involved in legal proceedings in the regular course of business. At this time, based on information currently available, we believe that the eventual outcome of such pending litigation will not have a material adverse effect on the Companys financial condition, results of operations or cash flows. Item 1A. Risk Factors For information regarding risk factors, please refer to Part I, Item 1A in the Companys Annual Report on Form 10-K for the year ended December 31, 2009. In addition, the following risk factors supplement the risk factors in our 2009 Form 10-K. A part of the Companys strategic plan is to bid on suitable FDIC-assisted acquisition opportunities, but these opportunities may not become available or may be available on less desirable terms due to increased competition. Banks that meet the Companys strategic objectives might not be placed into receivership. Failed bank transactions are attractive because in many cases the winning bidder has discretion over the liabilities assumed and also enters into a loss-sharing agreement with the FDIC that limits risk on acquired assets. In addition, assets purchased from the FDIC are marked to their fair value at the time of acquisition, which generally mitigates the risk of acquiring loans. Due to the attractiveness of the terms, bidding could become very competitive. The Company may not be able to beat the bids of other acquirers unless the bid is addressed aggressively by increasing the premium paid on assumed deposits or reducing the discount bid on assets purchased, which could make the acquisition less attractive. There may be difficulty integrating acquired banks and the Company could fail to realize anticipated cost savings and synergies. The Company recently purchased assets and assumed liabilities of City Bank and North County Bank in FDIC-assisted transactions. The City Bank and North County Bank acquisitions, and future acquisitions, may not result in anticipated positive results due to a variety of factors including: the ability to retain key customers and employees of acquired banks after making changes to the operations of the acquired entity; whether or not the quality of the assets acquired were accurately assessed; the ability to profitably deploy acquired funds; the diversion of management's attention from its business to the integration process; and unanticipated costs of and delays in completing the integration process. There could also be difficulties in complying with the technical requirements of the loss sharing agreement with the FDIC, which could result in acquired assets losing their coverage. Compliance with the recently enacted financial reform legislation may require us to change business practices, increase our costs of operations or adversely impact our earnings. On July 21, 2010, President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Reform Act) into law. The Dodd-Frank Reform Act will change the current bank and bank holding company regulatory structure and affect the lending, deposit, investment, trading and operating activities of financial institutions and their holding companies. The Dodd-Frank Act requires various federal agencies to adopt a broad range of new implementing rules and regulations, and to prepare numerous studies and reports for Congress. The federal agencies are given significant discretion in drafting the implementing rules and regulations, and consequently, many of the details and much of the impact of the Dodd-Frank Act may not be known for many months or years. Significant changes will include: The establishment of the Financial Stability Oversight Counsel, which will be responsible for identifying and monitoring systemic risks posed by financial firms, activities, and practices.The establishment of a Bureau of Consumer Financial Protection, within the Federal Reserve, to serve as a dedicated consumer-protection regulatory body with broad powers to supervise and enforce consumer protection laws. The Consumer Financial Protection Bureau has broad rule-making authority for a wide range of consumer protection laws that apply to all banks and savings institutions, including the authority to prohibit unfair, deceptive or abusive acts and practices.Amendments to the Truth in Lending Act aimed at improving consumer protections with respect to mortgage originations, including originator compensation, minimum repayment standards, and prepayment considerations. 52


---



Elimination of federal prohibitions on paying interest on demand deposits, thus allowing businesses to have interest bearing checking accounts. Depending on competitive responses, this significant change to existing law could have an adverse impact on the Companys interest expense.Broadened base for Federal Deposit Insurance Corporation insurance assessments. Assessments will now be based on the average consolidated total assets less tangible equity capital of a financial institution.Federal Reserve determination of reasonable debit card fees.Permanent increase to the maximum amount of deposit insurance for banks, savings institutions and credit unions to $250,000 per depositor, retroactive to January 1, 2009, and non-interest bearing transaction accounts have unlimited deposit insurance through December 31, 2013.Requirement of publicly traded companies to provide stockholders a non-binding vote on executive compensation and so-called golden parachute payments, and by authorizing the Securities and Exchange Commission to promulgate rules that would allow stockholders to nominate their own candidates using a companys proxy materials. The legislation also directs the Federal Reserve Board to promulgate rules prohibiting excessive compensation paid to bank holding company executives, regardless of whether the company is publicly traded or not. Many provisions in the Dodd-Frank Reform Act are aimed at financial institutions that are significantly larger than the Company or the Bank. Nonetheless, there are provisions that apply to the Company and must begin to comply with immediately. In addition, federal agencies will promulgate rules and regulations to implement and enforce provisions in the Dodd-Frank Reform Act. The Company will have to apply resources to ensure that it is in compliance with all applicable provisions, which may adversely impact its earnings. The precise nature, extent and timing of many of these reforms and the impact on the Company is uncertain. Item 2. Unregistered Sales of Equity Securities and Use of Proceeds (a)  (c) NoneItem 3. Defaults Upon Senior SecuritiesNoneItem 4. (Removed and Reserved)Item 5. Other Information (a)
     Not applicable(b)
     There have been no material changes in the procedures for shareholders to nominate directors to the Companys board. 53


---



Item 6. ExhibitsExhibits 2.1
     Purchase and Assumption Agreement with FDIC dated September 24, 2010 (incorporated by reference to Exhibit 2.1 to Form 8-K filed September 28, 2010)3.1
     Amended and Restated Articles of Incorporation (incorporated by reference to Exhibit 3.1 to the Form 10- K filed March 12, 2010)3.2
     Bylaws of the Company (incorporated by reference to Exhibit 4.1 to the Registrants Form SB-2 (Registration No. 333-49925) filed April 10, 1998)4.1
     Form of Common Stock Certificate (incorporated by reference to Exhibit 4.1 to the Registrants Form SB-2 (Registration No. 333-49925) filed April 10, 1998)4.2
     Form of Stock Certificate for Series A Preferred Stock (incorporated by reference to Exhibit 4.1 to the Registrants Current Report on Form 8-K filed January 20, 2009)4.3
     Warrant to purchase shares of common stock, issued January 16, 2009 (incorporated by reference to Exhibit 4.2 to the Registrants Current Report on Form 8-K filed January 20, 2009)4.4
     Pursuant to Section 601(b)(4)(iii)(A) of Regulation S-K, copies of instruments defining the rights of holders of long-term debt are not filed. The Company agrees to furnish a copy thereof to the Securities and Exchange Commission upon request.10.1
     *Executive Change of Control Agreement dated August 15, 2008 with Bryan McDonald.31.1
     Certification of Chief Executive Officer required by Rule 13a-14(a) or Rule 15d-14(a) and Section 302 of the Sarbanes Oxley Act of 200231.2
     Certification of Chief Financial Officer required by Rule 13a-14(a) or Rule 15d-14(a) and Section 302 of the Sarbanes Oxley Act of 200232.1
     Certification of Chief Executive Officer required by Rule 13a-14(b) or Rule 15d-14(b) and Section 906 of the Sarbanes Oxley Act of 2002, 18 U.S.C. Section 135032.2
     Certification of Chief Financial Officer required by Rule 13a-14(b) or Rule 15d-14(b) and Section 906 of the Sarbanes Oxley Act of 2002, 18 U.S.C. Section 1350*Management contract, compensatory plan or arrangement. 54


---



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. WASHINGTON BANKING COMPANY Date: November 9, 2010
     By /s/ John L. Wagner
      John L. Wagner
      President and 
      Chief Executive OfficerDate: November 9, 2010
     By /s/ Richard A. ShieldsRichard A. Shields 
       Executive Vice President and 
       Chief Financial Officer
  55


---