UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C.  20549





FORM
10-K





x
            Annual
      report pursuant to Section 13 or 15(d) of the Securities Exchange Act of
      1934




For the
fiscal year ended December 31, 2008;
or




o
            Transition
      report pursuant to Section 13 or 15(d) of the Securities Exchange Act of
      1934





Commission
file number  000-29829





PACIFIC
FINANCIAL CORPORATION


(Exact
Name of Registrant as specified in its Charter)




Washington
            91-1815009(State
      or Other Jurisdiction of
            (IRS
      Employer Identification No.)Incorporation
      or Organization)




1101
S. Boone Street


Aberdeen,
Washington  98520-5244


(Address
of Principal Executive Offices) (Zip Code)





Registrant’s
telephone number, including area code:  (360) 533-8870





Securities
Registered Pursuant to Section 12(b) of the Exchange Act:  None





Securities
Registered Pursuant to Section 12(g) of the Exchange Act:


Common
Stock, par value $1.00 per share





Indicate
by check mark whether the registrant is a well known seasoned issuer, as defined
in Rule 405 of the Securities Act.


Yes oNo x





Indicate
by check mark if the registrant is not required to file reports pursuant to
Section 13 or Section 15(d) of the Exchange Act.


Yes oNo x





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 periods that the Registrant was required to file
such reports), and (2) has been subject to such requirements for the past 90
days.


Yes xNo o





Indicate
by check mark if disclosure of delinquent filers pursuant to Item 405 of
Regulation S-K is not contained herein, and will not be contained, to the best
of the registrant’s knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. o





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


Large
      accelerated filer 0
            
            Accelerated
      filer TNon-accelerated
      filer 0
            
            Smaller
      reporting company 0





Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act).Yes o No x





The
aggregate market value of the common stock held by non-affiliates of the
registrant at June 30, 2008, was $75,449,052.





The
number of shares outstanding of the registrant’s common stock, $1.00 par value
as of February 28, 2009, was 7,317,430 shares.





DOCUMENTS
INCORPORATED BY REFERENCE




Portions
of the registrant's Proxy Statement filed in connection with its annual meeting
of shareholders to be held April 22, 2009 are incorporated by reference into
Part III of this Form 10-K.







PACIFIC
FINANCIAL CORPORATION


ANNUAL
REPORT ON FORM 10-K FOR THE FISCAL YEAR


ENDED
DECEMBER 31, 2008





TABLE
OF CONTENTS




PART  I
              
              PageForward
      Looking Information
              3Item
      1.
              Business
              4Item
      1A.
              Risk
      Factors
              11Item
      1B.
              Unresolved Staff Comments
              16Item
      2.
              Properties
              16Item
      3.
              Legal
      Proceedings
              16Item
      4.
              Submission
      of Matters to a Vote of Security Holders
              16PART  IIItem
      5.
              Market
      for Registrant’s Common Equity, Related Stockholder Matters and Issuer
      Purchases of Equity Securities
              17Item
      6.
              Selected
      Financial Data
              19Item
      7.
              Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
              20Item
      7A.
              Quantitative
      and Qualitative Disclosures About Market Risk
              42Item
      8.
              Financial
      Statements and Supplementary Data
              43Item
      9.
              Changes
      in and Disagreements with Accountants on Accounting and Financial
      Disclosure
              43Item
      9A.
              Controls
      and Procedures
              43Item
      9B.
              Other
      Information
              45PART  IIIItem
      10.
              Directors,
      Executive Officers and Corporate Governance
              45Item
      11.
              Executive
      Compensation
              46Item
      12.
              Security
      Ownership of Certain Beneficial Owners and Management and Related
      Stockholder Matters
              46Item
      13.
              Certain
      Relationships and Related Transactions and Director
      Independence
              46Item
      14.
              Principal
      Accountant Fees and Services
              46PART  IVItem
      15.
              Exhibits
      and Financial Statement Schedules
              47FINANCIAL
      STATEMENTS
              F-1
      - F-33SIGNATURES
              
              48




2




PART
I




Forward Looking
Information





This
document contains forward-looking statements that are subject to risks and
uncertainties.  These statements are based on the beliefs and
assumptions of our management, and on information currently available to
them.  Forward-looking statements include the information concerning
our possible future results of operations set forth under “Management's
Discussion and Analysis of Financial Condition and Results of Operations” and
statements preceded by, followed by or that include the words “believes,”
“expects,” “anticipates,” “intends,” “plans,” “estimates” or similar
expressions.





Any forward-looking statements in this
document are subject to risks relating to, among other things, the factors
described under the heading “Risk Factors” below, as well as the
following:





1.           competitive
pressures among depository and other financial institutions that may impede our
ability to attract and retain depositors, borrowers and other customers, retain
our key employees, and/or maintain our interest margins and fee
income;




2.           changing
laws, regulations, standards, and government programs, that may significantly
increase our costs, including compliance and insurance costs, and place
additional burdens on our limited management resources, change the competitive
balance among financial institutions, or lead us to change our strategic
focus;





3.           deteriorating
economic or business conditions, nationally and in the regions in which we do
business, that are expected to result in, among other things, a deterioration in
credit quality and/or reduced demand for credit, increases in nonperforming
assets, and additional workout and OREO expenses;





4.           decreases
in real estate and other asset prices, whether or not due to changes in economic
conditions, that may reduce the value of the assets that serve as collateral for
many of our loans;





5.           any
failure to comply with developing and changing standards of corporate governance
and disclosure and internal control that could result in negative publicity,
leading to declines in our stock price;





6.           our
growth strategy, particularly if accomplished through acquisitions, which may
not be successful if we fail to accurately assess market opportunities, asset
quality, anticipated cost savings, and transaction costs, or experience
significant difficulty integrating acquired businesses or assets or opening new
branches or lending offices; and





7.           a
lack of liquidity in the market for our common stock that may make it difficult
or impossible for you to liquidate your investment in our stock or lead to
distortions in the market price of our stock.





Our management believes our
forward-looking statements are reasonable; however, you should not place undue
reliance on them.  Forward-looking statements are not guarantees of
performance.  They involve risks, uncertainties and
assumptions.  Many of the factors that will determine our future
results, financial condition, and share value are beyond our ability to predict
or control.  We undertake no obligation to update forward-looking
statements.




3





ITEM
      1.
            Business




Pacific
Financial Corporation (the Company or Pacific) is a bank holding company
headquartered in Aberdeen, Washington.  The Company owns one bank,
Bank of the Pacific (sometimes referred to as the “Bank”), which is also located
in Washington.  The Company was incorporated in the State of
Washington on February 12, 1997, pursuant to a holding company reorganization of
the Bank.





The
Company conducts its banking business through 17 branches located in communities
throughout Grays Harbor, Pacific, and Wahkiakum Counties in Southwest
Washington, and Whatcom and Skagit Counties in Northwest
Washington.  The Company also operates a branch in Gearhart,
Oregon.  There were no new branches opened during 2008.  One
branch in Whatcom County was closed during 2008, with an additional branch in
Whatcom County scheduled for closure in April 2009.  Construction for
a new branch in Warrenton, Oregon has been placed on hold.  Five
locations in Whatcom County were acquired as part of Pacific’s acquisition of
BNW Bancorp, Inc. (BNW) completed on February 27, 2004.





Pacific
Financial Corporation is a reporting company with the Securities and Exchange
Commission (SEC), and the Company’s common stock is listed on the OTC Bulletin
BoardTM under the symbol PFLC.OB.  At December 31, 2008, the Company
had total consolidated assets of $625.8 million, total loans, including loans
held for sale, of $497.8 million, total deposits of $511.3 million, and total
shareholders’ equity of $50.1 million.





Pacific’s
filings with the SEC, including its annual report on Form 10-K, quarterly
reports on Form 10-Q, periodic current reports on Form 8-K and amendments to
these reports, are available free of charge through links from our website at
http://www.thebankofpacific.com
to the SEC’s site at http://www.sec.gov,
as soon as reasonably practicable after filing with the SEC.  You may
also access our filings with the SEC directly from the EDGAR database found on
the SEC’s website.  By making reference to our website above and
elsewhere in this report, we do not intend to incorporate any information from
our site into this report.





The Bank





Bank of
the Pacific was organized in 1978 and opened for business in 1979 to meet the
need for a regional community bank with local interests to serve the small to
medium-sized businesses and professionals in the coastal region of Western
Washington.  Services offered by the Bank include commercial loans,
agriculture loans, installment loans, real estate loans, residential mortgage
loans and personal and business deposit products.





The Bank
originates loans primarily in its local markets.  Its underwriting
policies focus on assessment of each borrower’s ability to service and repay the
debt, and the availability of collateral that can be used to secure the
loan.  Depending on the nature of the borrower and the purpose and
amount of the loan, the Bank’s loans may be secured by a variety of collateral,
including business assets, real estate, and personal assets.  The
value of our collateral is subject to change.





The
Bank’s commercial and agricultural loans consist primarily of secured revolving
operating lines of credit and business term loans, some of which may be
partially guaranteed by the Small Business Administration or the U.S. Department
of Agriculture. Consumer installment loans and other loans represent a small
percentage of total outstanding loans and include home equity loans, auto loans,
boat loans, and personal lines of credit.





The
Bank’s primary sources of deposits are from individuals and businesses in its
local markets.  A concerted effort has been made to attract deposits
in the local market areas through competitive pricing and delivery of quality
products.  These products include demand accounts, negotiable order of
withdrawal accounts, money market investment accounts, savings accounts and time
deposits.  The Bank also utilizes brokered deposits from time to
time.




4





The Bank
provides 24 hour online banking to its customers with access to account balances
and transaction histories, plus an electronic check register to make account
management and reconciliation easier.  The online banking system is
compatible with budgeting software like Intuit’s Quicken® or Microsoft’s
Money®.  In addition, the online banking system includes the ability
to transfer funds, make loan payments, reorder checks, and request statement
reprints, provides loan calculators and allows for e-mail exchanges with
representatives of the Bank.  Also, for a nominal fee, customers can
request stop payments and pay an unlimited number of bills
online.  These services along with rate information and other
information can be accessed through the Bank’s website at http://www.thebankofpacific.com.





The
Bank’s deposits are insured by the Federal Deposit Insurance Corporation (FDIC)
up to applicable legal limits under the Bank Insurance Fund.  The Bank
is a member of the Federal Home Loan Bank (FHLB) and is regulated by the
Washington Department of Financial Institutions, Division of Banks (Division),
and the FDIC.





PFC Statutory Trusts I and
II





PFC
Statutory Trust I and II are wholly-owned subsidiary trusts of the Company
formed to facilitate the issuance of pooled trust preferred securities (“trust
preferred securities”).  The trusts were organized in December 2005
and June 2006 in connection with two offerings of trust preferred
securities.  For more information regarding the Company’s issuance of
trust preferred securities, see Note 8 “Junior Subordinated Debentures” to
Pacific’s audited consolidated financial statements included in Item 15 of this
report.





Competition





Competition
in the banking industry is significant and has intensified as the regulatory
environment has grown more permissive.  Banks face a growing number of
competitors and greater degree of competition with respect to the provision of
banking services and the attracting of deposits.  Competition comes
from both bank and non-bank sources, including in the case of banks several
institutions that have recently elected to become bank holding companies in
order to participate in the Capital Purchase Program that is part of the
government's Troubled Asset Relief Program.  Most of these
institutions, such as American Express and GMAC, have significantly greater
resources than the Company and the Bank and a history of competing aggressively
in the market.  As a result, competition for deposits and loan and
other products may continue to increase.





The Bank
competes in Grays Harbor County with well-established thrifts which are
headquartered in the area along with branches of large banks with headquarters
outside the area.  The Bank also competes with well-established small
community banks, branches of large banks, thrifts and credit unions in Pacific
and Wahkiakum Counties in the state of Washington and Clatsop County in the
state of Oregon.  In Whatcom County and Skagit County, Washington, the
Bank also competes with large regional and super-regional financial institutions
that do not have a significant presence in the Company’s historical market
areas.  The Company believes Whatcom County provides opportunities for
expansion, but in pursuing that expansion it faces greater competitive
challenges than it faces in its historical market areas.





The
adoption of the Gramm-Leach-Bliley Act of 1999 (the Financial Services
Modernization Act) eliminated many of the barriers to affiliation among
providers of financial services and further opened the door to business
combinations involving banks, insurance companies, securities or brokerage
firms, and others.  This regulatory change has led to further
consolidation in the financial services industry and the creation of financial
conglomerates which frequently offer multiple financial services, including
deposit services, brokerage and others.  When combined with
technological developments such as the Internet that have reduced barriers to
entry faced by companies physically located outside the Company’s market area,
changes in the market have resulted in increased competition and can be expected
to result in further increases in competition in the
future.  Competition in the market for deposits has increased
significantly.




5





Although
it cannot guarantee that it will continue to do so, the Company has been able to
maintain a competitive advantage in its historical markets as a result of its
status as a local institution, offering products and services tailored to the
needs of the community.  Further, because of the extensive experience
of management in its market area and the business contacts of management and the
Company’s directors, management believes the Company can continue to compete
effectively.





According
to the Market Share Report compiled by the FDIC, as of June 30, 2008, the
Company held a deposit market share of 27.1% in Pacific County, 45.7% in
Wahkiakum County, 22.5% in Grays Harbor County, 2.8% in Whatcom County, 0.6% in
Skagit County and 1.1% in Clatsop County.





Employees





As of
December 31, 2008, the Bank employed 221 full time equivalent
employees.  Management believes relations with its employees are
good.





Supervision and
Regulation





The
following is a general description of certain significant statutes and
regulations affecting the banking industry.  The laws and regulations
applicable to the Company and its subsidiaries are primarily intended to protect
depositors and borrowers of the Bank and not stockholders of the
Company.  Proposals to change the laws and regulations governing the
banking industry are frequently introduced in Congress, in state legislatures
and before the various bank regulatory agencies.  In the current
economic climate and regulatory environment, the likelihood of enactment of new
banking legislation and promulgation of new banking regulations is greater than
it has been in recent years.  The potential impact of new laws and
regulations on the Company and its subsidiaries cannot be determined, but any
such laws and regulations may materially affect the business and prospects of
the Company and its subsidiaries.  Violation of the laws and
regulations applicable to the Company and its subsidiaries may result in
assessment of substantial civil monetary penalties, the imposition of a cease
and desist order, and other regulatory sanctions, as well as private
litigation.




The
Company




General




As a bank
holding company, the Company is subject to the Bank Holding Company Act of 1956,
as amended (BHCA), which places the Company under the primary supervision of the
Board of Governors of the Federal Reserve System (the Federal
Reserve).  The Company must file annual reports with the Federal
Reserve and must provide it with such additional information as it may
require.  In addition, the Federal Reserve periodically examines the
Company and the Bank.




Bank
Holding Company Regulation




General.  The
BHCA restricts the direct and indirect activities of the Company to banking,
managing or controlling banks and other subsidiaries authorized under the BHCA,
and activities that are closely related to banking or managing or controlling
banks.  The Company must obtain approval of the Federal Reserve before
it: (1) acquires direct or indirect ownership or control of any voting shares of
any bank or bank holding company that results in total ownership or control,
directly or indirectly, of more than 5% of the outstanding shares of any class
of voting securities of such bank or bank holding company; (2) merges or
consolidates with another bank holding company; or (3) acquires substantially
all of the assets of another bank or bank holding company.  In acting
on applications for such prior approval, the Federal Reserve considers various
factors, including, without limitation, the effect of the proposed transaction
on competition in relevant geographic and product markets, and each transaction
party's financial condition, managerial resources, and the convenience and needs
of the communities to be served, including the performance record under the
Community Reinvestment Act.




6





Source of
Strength.  Under Federal Reserve policy, the Company must act
as a source of financial and managerial strength to the Bank.  This
means that the Company is required to commit, as necessary, resources to support
the Bank, and that under certain conditions, the Federal Reserve may conclude
that certain actions of Company, such as payment of cash dividends, would
constitute unsafe and unsound banking practices.





Tie-In
Arrangements





The
Company and the Bank cannot engage in certain tie-in arrangements in connection
with any extension of credit, sale or lease of property or furnishing of
services.  For example, with certain exceptions, neither the Company
nor the Bank may condition an extension of credit to a customer on either (1) a
requirement that the customer obtain additional services provided by it or (2)
an agreement by the customer to refrain from obtaining other services from a
competitor.





USA
Patriot Act of 2001





The Bank
is subject to the Uniting and Strengthening America by Providing Appropriate
Tools Required to Intercept and Obstruct Terrorism (USA Patriot Act) of
2001.  Among other things, the USA Patriot Act:  (1)
prohibits banks from providing correspondent accounts directly to foreign shell
banks;  (2) imposes due diligence requirements on banks opening
or holding accounts for foreign financial institutions or wealthy foreign
individuals; (3) requires financial institutions to establish an
anti-money-laundering compliance program, and (4) eliminates civil liability for
persons who file suspicious activity reports.  The USA Patriot Act
also increases governmental powers to investigate terrorism, including expanded
government access to account records.  We do not believe that
compliance with the USA Patriot Act has had a material effect on our business
and operations.





Temporary
Liquidity Guaranty Program





On
October 14, 2008, the FDIC established a Temporary Liquidity Guarantee Program
(TLGP).  The TLGP includes a Transaction Account Guarantee Program
(TAGP), which provides unlimited deposit insurance coverage through December 31,
2009 for non-interest bearing transaction accounts, including, without
limitation, interest on lawyer trust accounts (IOLTAs) and certain negotiable
order of withdrawal (NOW) accounts.  Institutions participating in the
TAGP pay a 10 basis points fee on the balance of each covered account in excess
of $250,000.  Coverage under the TAGP is in addition to and separate
from the coverage available under the FDIC's general deposit insurance
rules.





The TLGP
also includes the Debt Guarantee Program (DGP), under which the FDIC guarantees
certain senior unsecured debt of FDIC-insured institutions and their holding
companies.  The unsecured debt must be issued on or after October 14,
2008 and not later than June 30, 2009, and the guarantee is effective through
the earlier of the maturity date or June 30, 2012.  Depending on the
term of the debt maturity, the nonrefundable DGP fee ranges from 50 to 100 basis
points for covered debt outstanding.  The TAGP and DGP are in effect
for all eligible entities, unless the entity opted out on or before December 5,
2008.  The Company and the Bank did not opt out of the
programs.




7





Real
Estate Concentration Guidance





On
December 6, 2008, the federal banking agencies issued guidance on sound risk
management practices for concentrations in commercial real estate
lending.  The particular focus was on exposure to commercial real
estate loans that are dependent on the cash flow from the real estate held as
collateral and that are likely to be sensitive to conditions in the commercial
real estate market (as opposed to real estate collateral held as a secondary
source of repayment or as an abundance of caution).  The purpose of
the guidance is not to limit a bank’s commercial real estate lending but to
guide banks in developing risk management practices and capital levels
commensurate with the level and nature of real estate
concentrations.  A bank that has experienced rapid growth in
commercial real estate lending, has notable exposure to a specific type of
commercial real estate loan, or is approaching or exceeding the following
supervisory criteria may be identified for further supervisory analysis with
respect to real estate concentration risk:





·
            Total
      reported loans for construction, land development and other land represent
      100% or more of the bank’s capital;
or





·
            Total
      commercial real estate loans represent 300% or more o the bank’s total
      capital.





The
strength of an institution’s lending and risk management practices with respect
to such concentrations will be taken into account in supervisory evaluation of
capital adequacy.





On March
17, 2008, the FDIC issued a release to re-emphasize the importance of strong
capital and loan loss allowance levels and robust credit risk management
practices for institutions with concentrated commercial real estate
exposures.  The FDIC suggested that institutions with significant
construction and development and commercial real estate loan concentrations
increase or maintain strong capital levels; ensure that loan loss allowances are
appropriately strong; manage construction and development and commercial real
estate loan portfolios closely; maintain updated financial and analytical
information on their borrowers and collateral; and bolster the loan workout
infrastructure.





The Bank


General





The Bank,
as an FDIC insured state-chartered bank, is subject to regulation and
examination by the FDIC and the Department of Financial Institutions of the
State of Washington.  The federal laws that apply to the Bank
regulate, among other things, the scope of its business, its investments, its
reserves against deposits, the timing of the availability of deposited funds and
the nature and amount of and collateral for loans.





CRA.The Community
Reinvestment Act (the CRA) requires that, in connection with examinations of
financial institutions within their jurisdiction, the FDIC evaluate the record
of the financial institutions in meeting the credit needs of their local
communities, including low and moderate income neighborhoods, consistent with
the safe and sound operation of those banks.  These factors are also
considered in evaluating mergers, acquisitions, and applications to open a
branch or facility.  In connection with the FDIC’s assessment of the
record of financial institutions under the CRA, it assigns a rating of either,
“outstanding,” “satisfactory,” “needs to improve,” or “substantial
noncompliance” following an examination.  The Bank received a CRA
rating of “satisfactory” during its most recent examination.





Insider Credit
Transactions.Banks are also
subject to certain restrictions imposed by the Federal Reserve Act on extensions
of credit to executive officers, directors, principal shareholders, or any
related interests of such persons.  Extensions of credit (i) must be
made on substantially the same terms, including interest rates and collateral,
and follow credit underwriting procedures that are not less stringent than those
prevailing at the time for comparable transactions with persons not covered
above and who are not employees and (ii) must not involve more than the normal
risk of repayment or present other unfavorable features.  Banks are
also subject to certain lending limits and restrictions on overdrafts to such
persons.  A violation of these restrictions may result in the
assessment of substantial civil monetary penalties on the affected bank or any
officer, director, employee, agent, or other person participating in the conduct
of the affairs of that bank, the imposition of a cease and desist order, and
other regulatory sanctions.




8





FDICIA.Under the
Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA), each
federal banking agency has prescribed, by regulation, noncapital safety and
soundness standards for institutions under its authority.  These
standards cover internal controls, information systems, and internal audit
systems, loan documentation, credit underwriting, interest rate exposure, asset
growth, compensation, fees and benefits, such other operational and managerial
standards as the agency determines to be appropriate, and standards for asset
quality, earnings and stock valuation.  An institution which fails to
meet these standards must develop a plan acceptable to the agency, specifying
the steps that the institution will take to meet the
standards.  Failure to submit or implement such a plan may subject the
institution to regulatory sanctions.  Management believes that the
Bank meets all such standards and, therefore, does not believe that these
regulatory standards will materially affect the Company’s business or
operations.





Interstate
Banking and Branching





The
Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (the
Interstate Act) permits nationwide interstate banking and branching under
certain circumstances.  This legislation generally authorizes
interstate branching and relaxes federal law restrictions on interstate banking.
The Interstate Act requires regulators to consult with community organizations
before permitting an interstate institution to close a branch in a low-income
area.  Washington law authorizes Washington banks to merge with
out-of-state banks subject to certain aging requirements.  Washington
law generally authorizes the acquisition of a Washington bank by an out-of-state
bank through merger with a Washington financial institution that has been in
existence for at least 5 years prior to the acquisition.  Under FDIC
regulations, banks are prohibited from using their interstate branches primarily
for deposit production.  The FDIC has accordingly implemented a
loan-to-deposit ratio screen to ensure compliance with this
prohibition.





Deposit
Insurance




The
deposits of the Bank are currently insured to a maximum of $250,000 per
depositor, and certain self-directed retirement accounts up to $250,000 per
depositor, through the Bank Insurance Fund administered by the
FDIC.  All insured banks are required to pay semi-annual deposit
insurance premium assessments to the FDIC.  In 2008, the FDIC
insurance limit was temporarily increased from $100,000 to
$250,000.  The increase expires at the end of 2009, unless otherwise
extended or made permanent.





The FDIC
may make special assessments on insured depository institutions in amounts
determined by the FDIC to be necessary to give it adequate assessment income to
repay amounts borrowed from the U.S. Treasury and other sources, or for any
other purpose the FDIC deems necessary.  The FDIC has implemented a
risk-based insurance premium system under which banks are assessed insurance
premiums based on how much risk they present to the insurance
fund.  Banks with higher levels of capital and a low degree of
supervisory concern are assessed lower premiums than banks with lower levels of
capital or a higher degree of supervisory concern.





Dividends





Dividends
from the Bank constitute the major source of liquidity for the Company, from
which the Company may cover its expenses, pay interest on its obligations,
including its debentures issued in connection with trust preferred securities,
and declare and pay dividends to shareholders.  The amount of
dividends payable by the Bank to the Company depends on the Bank’s earnings and
capital position, and is limited by federal and state laws, regulations and
policies.  In addition, the Bank is subject to certain restrictions on
the amount of dividends that it may declare without prior regulatory
approval.




9





Capital
Adequacy





Federal
bank regulatory agencies use capital adequacy guidelines in the examination and
regulation of bank holding companies and banks.  If capital falls
below minimum levels, the bank holding company or bank may be denied approval to
acquire or establish additional banks or non-bank businesses or to open new
facilities.





The FDIC
and Federal Reserve use risk-based capital guidelines for banks and bank holding
companies.  Risk-based guidelines are designed to make capital
requirements more sensitive to differences in risk profiles among banks and bank
holding companies, to account for off-balance sheet exposure and to minimize
disincentives for holding liquid low-risk assets.  Assets and
off-balance sheet items are assigned to broad risk categories, each with
appropriate weights.  The resulting capital ratios represent capital
as a percentage of total risk-weighted assets and off-balance sheet
items.  The guidelines are minimums and the Federal Reserve may
require that a banking organization maintain ratios in excess of the minimums,
particularly organizations contemplating significant
expansion.  Current guidelines require all bank holding companies and
federally-regulated banks to maintain a minimum risk-based total capital ratio
equal to 8%, of which at least 4% must be Tier I capital. Tier I capital for
bank holding companies includes common shareholders' equity, certain qualifying
preferred stock and minority interests in equity accounts of consolidated
subsidiaries, minus certain deductions, including, without limitation, goodwill,
other identifiable intangible assets, and deferred tax assets.





The
Federal Reserve also employs a leverage ratio, which is Tier I capital as a
percentage of total assets minus certain deductions, including, without
limitation, goodwill, mortgage servicing assets, other identifiable intangible
assets, and certain deferred tax assets, to be used as a supplement to
risk-based guidelines.  The principal objective of the leverage ratio
is to constrain the maximum degree to which a bank holding company may leverage
its equity capital base.  The Federal Reserve requires a minimum
leverage ratio of 3%.  However, for all but the most highly rated bank
holding companies and for bank holding companies seeking to expand, the Federal
Reserve expects an additional cushion of at least 1% to 2%.





Under
regulations adopted by the Federal Reserve and the FDIC, each bank holding
company and bank is assigned to one of five capital categories depending on,
among other things, its total risk-based capital ratio, Tier I risk-based
capital ratio, and leverage ratio, together with certain subjective factors.
Institutions which are deemed to be undercapitalized depending on the category
to which they are assigned are subject to certain mandatory supervisory
corrective actions.  Under these guidelines, the Company and the Bank
are each considered well capitalized as of the end of the fiscal
year.





Effects
of Government Monetary Policy





Banking
is a business which depends on interest rate differentials.  In
general, the major portions of a bank's earnings derives from the differences
between:  (i) interest received by a bank on loans extended to its
customers and the yield on securities held in its investment portfolio; and (ii)
the interest paid by a bank on its deposits and its other borrowings (the bank's
“cost of funds”).  Thus, our earnings and growth are constantly
subject to the influence of economic conditions generally, both domestic and
foreign, and also to the monetary, fiscal and related policies of the United
States and its agencies, particularly the Federal Reserve and the U.S.
Treasury.  The nature and timing of changes in such policies and their
impact cannot be predicted.




10




ITEM
      1A.
            Risk
      Factors





The
following are material risks that management believes are specific to our
business.  This should not be viewed as an all inclusive list or in
any particular order.





Adverse
economic conditions, particularly in Washington and Oregon, have caused and
could continue to cause us to incur losses.





Our
business is directly affected by market conditions, trends in industry and
finance, legislative and regulatory changes, and changes in governmental
monetary and fiscal policies and inflation, all of which are beyond our
control.  In 2007, the housing and real estate sectors experienced an
economic slowdown that continued and accelerated during 2008.  In
addition, the overall economy has slipped into recession and is showing signs of
significant weakness.  Further deterioration or sustained weakness in
business and economic conditions in the markets in which we do business could
have one or more of the following adverse effects on our business:




·
            An
      increase in loan delinquencies, problem assets and
      foreclosures;


·
            A
      decrease in the demand for loans and other products and
      services;


·
            An
      increase or decrease in the usage of unfunded commitments;
    or


·
            A
      decrease in the value of loan collateral, especially real estate, which in
      turn may reduce a customer’s borrowing power and significantly increase
      our exposure to particular loans.





Downturns
in real estate markets in our primary market areas could hurt our
business.





Our
business activities and credit exposure are primarily concentrated in our local
market areas of Grays Harbor, Pacific, Skagit, Whatcom and Wahkiakum counties of
Washington and Clatsop county in Oregon.  While we do not have any
sub-prime loans, our residential construction, commercial real estate and
construction, and land development loan portfolios, and a certain number of
other loans have been adversely affected by the downturn in the residential real
estate market and economy generally.  We anticipate that future
declines in the real estate markets in our primary market areas will hurt our
business.  As of December 31, 2008, 80 percent of our loan portfolio
consisted of loans secured by real estate.  If real estate values
continue to decline the collateral for our loans will provide less
security.  As a result, our ability to recover on defaulted loans by
selling the underlying real estate will be diminished, and we would be more
likely to suffer greater losses on defaulted loans.  These losses may,
in turn, result in a material adverse effect on our business, results of
operations and financial condition.





Future
loan losses may exceed our allowance for loan losses.





We are
subject to credit risk, which is the risk of losing principal or interest due to
borrowers’ failure to repay loans in accordance with their terms.  A
continued or sustained downturn in the economy or the real estate market in our
market areas or a rapid change in interest rates will have a negative effect on
borrowers’ ability to repay and on collateral values.  This
deterioration in economic conditions could result in losses to the Company in
excess of loan loss allowances.  To the extent loans are not paid
timely by borrowers, the loans are placed on non-accrual, thereby reducing
interest income or even requiring reversals of previously recorded
income.  To the extent loan charge-offs exceed our financial models,
increased amounts will be charged to the provision for loan losses, which would
further reduce income.





We
face liquidity risks in the operation of our business and our funding sources
may prove insufficient to repay deposits and support our future
growth.





Liquidity
is crucial to the operation of the Company and the Bank.  Liquidity
risk is the potential that we will be unable to fund increases in assets or
meet payment obligations, including obligations to depositors, as they
become due because of an inability to obtain adequate funding or liquidate
assets.  For example, funding illiquidity may arise if we are unable
to attract core deposits or are unable to renew at acceptable pricing
long-term borrowings or short-term borrowings.  Illiquidity may also
arise if our regulatory capital levels decrease, our lenders require additional
collateral to secure our repayment obligations, or a large amount of our
deposits are withdrawn.




11





We rely
on customer deposits and advances from the FHLB of Seattle and other borrowings
to fund our operations.  Although we have historically been able to
replace maturing deposits and advances if desired, we may not be able to replace
such funds in the future if our financial condition or the financial condition
of the FHLB of Seattle or market conditions were to change.  If we are
required to rely more heavily on more expensive funding sources to support
operations, our revenues may not increase proportionately to cover our
costs.  In this case, our net interest margin would be adversely
affected, making it even more difficult for our businesses to operate
profitably.





We
may suffer losses in our loan portfolio despite our underwriting
practices.





We seek
to mitigate the risk inherent in our loan portfolio by adhering to specific
underwriting practices.  Although we believe that our underwriting
criteria are appropriate for the various kinds of loans we make, we may incur
losses on loans that meet our underwriting criteria, and these losses may exceed
the amounts set aside as reserves in our allowance for credit
losses.





Rapidly
changing interest rate environments could reduce our net interest margin, net
interest income, fee income and net income.





Interest
and fees on loans and securities, net of interest paid on deposits and
borrowings, are a large part of our net income.  Interest rates are
key drivers of our net interest margin and subject to many factors beyond the
control of management.  As interest rates change, net interest income
is affected.  Rapid increases in interest rates in the future could
result in interest expense increasing faster than interest income because of
mismatches in financial instrument maturities.  Further, substantially
higher interest rates generally reduce loan demand and may result in slower loan
growth, particularly in commercial real estate lending, an important factor in
the Company’s revenue over the past two years.  Decreases or increases
in interest rates could reduce the spreads between the interest rates earned on
assets and the rates of interest paid on liabilities, and therefore decrease net
interest income.  See “Quantitative and Qualitative Disclosures about
Market Risk.”





We
may elect or be compelled to seek additional capital in the future, but that
capital may not be available when it is needed.





We are
required by federal and state regulatory authorities to maintain adequate levels
of capital to support our operations.  In addition, we may elect to
raise capital to support our business or to finance acquisitions, if
any.  Our ability to raise additional capital, if needed, will depend
on conditions in the capital markets, economic conditions and a number of other
factors, many of which our outside our control, and on our financial
performance.  Accordingly, we cannot assure you of our ability to
raise additional capital, if needed, on terms acceptable to us.  If we
cannot raise additional capital when needed, it may have a material adverse
effect on our financial condition, results of operations and
prospects.





The
financial services industry is very competitive.





We face
competition in attracting and retaining deposits, making loans, and providing
other financial services.  Our competitors include other community
banks, larger banking institutions, and a wide range of other financial
institutions such as credit unions, government-sponsored enterprises, mutual
fund companies, insurance companies and other non-bank
businesses.  Many of these competitors have substantially greater
resources than we have.  For a more complete discussion of our
competitive environment, see “Business-Competition” in Item 1
above.  If we are unable to compete effectively, we will lose market
share, including deposits, and face a reduction in our income from our lending
activities.




12





We
rely on dividends from subsidiaries for most of our liquidity.





The
Company is a separate and distinct legal entity from its
subsidiaries.  We receive substantially all of our liquidity from
dividends from our subsidiary.  These dividends are the principal
source of funds to pay interest and principal on our debt, other expenses, or
dividends on our common stock, if any.  Various federal and/or state
laws and regulations limit the amount of dividends that the Bank may pay to the
holding company, as may the actions of regulators.  In the event the
Bank is unable to pay dividends to us, we may not be able to service our debt,
pay any other obligations or pay dividends on our common stock.





Significant
legal or regulatory actions could subject us to uninsured liabilities and
associated reputational risk.





From time
to time, we are sued for damages or threatened with lawsuits relating to various
aspects of our operations.  We may also be subject to investigations
and possibly civil money penalties assessed by federal or state regulators in
connection with violations of applicable laws and regulations.  We may
incur substantial attorney fees and expenses in the process of defending against
lawsuits or regulatory actions and our insurance policies may not cover, or
cover adequately, the costs of adverse judgments, civil money penalties, and
attorney fees and expenses.  As a result, we may be exposed to
substantial uninsured liabilities that could adversely affect our results of
operations, capital, and financial condition.  There is also a risk
that legal or regulatory actions could harm our reputation, which, whether
successfully defended or not, could cause a decline in our customer base, stock
price, or general reputation in the markets in which we operate.





The
Company is subject to extensive regulation.





The
Company’s operations are subject to extensive regulation by federal and state
banking authorities which impose requirements and restrictions on the Company’s
operations.  The impact of changes to laws and regulations or other
actions by regulatory agencies could make regulatory compliance more difficult
or expensive for the Company and could adversely affect the Company’s financial
condition or results of operations.





Our
deposit insurance premiums are expected to increase which may adversely affect
our profits.





Our
deposit insurance premiums during fiscal 2008 totaled
$214,000.  Deposit insurance assessments will increase in 2009 due to
recent strains on the FDIC deposit insurance fund resulting from the cost of
recent bank failures and an increase in the number of banks likely to fail over
the next five years.  Effective April 1, 2009, the FDIC has updated
its regulations to:  (i) alter the way in which it assesses the risk
of loss that individual banks pose to the deposit insurance fund; (ii) revise
deposit insurance assessment rates; and (iii) allow for special assessments as
necessary to replenish the deposit insurance fund.  Each bank is
assigned to one of four risk categories based on whether the bank is well
capitalized, adequately capitalized, or undercapitalized, and based on the
bank's supervisory examination by its primary federal regulator (in our case,
the FDIC).  Based on its risk category, a bank pays a base assessment
rate for deposit insurance, ranging from 12 to 45 basis points.  The
base rate is adjusted to reflect increased or decreased risk to the deposit
insurance fund posed by unsecured debt, secured liabilities, and brokered
deposits.  After adjustment to the base assessment rate, a bank's
total base assessment rate for deposit insurance can range from 7 to 77.5 basis
points.  Changes to our risk category and applicable base rate
adjustments may significantly increase our aggregate deposit insurance premiums,
which may adversely impact our profits.




13





The FDIC
is expected to make up to a 20 basis point special assessment on June 30, 2009,
and it is expected that the FDIC will impose one or more additional special
assessments of 10 basis points if the reserve ratio of the deposit insurance
fund is estimated to fall to a level that the FDIC believes would adversely
affect public confidence.  Any such special assessments will increase
our operating costs and adversely affect our profits.





There
can be no assurance that recently enacted legislation and other measures
undertaken by the United States Treasury, the Federal Reserve and other
governmental agencies will help stabilize and provide liquidity to the U.S.
financial markets.





The
Emergency Economic Stabilization Act of 2008 (EESA) authorized the Treasury
Secretary to establish the Troubled Asset Relief Program (TARP).  As
part of EESA, TARP, and related federal programs, the Federal Reserve, the
Treasury, the FDIC, the SEC and other federal agencies have implemented measures
to stabilize and provide liquidity to the U.S. financial
markets.  These measures include:





·
            Treasury's
      program to purchase, manage, modify, sell and insure troubled mortgage
      related assets and financial
instruments;


·
            Treasury's
      capital purchase program, pursuant to which it provides Tier 1 capital to
      eligible financial institutions by acquiring preferred stock and
      warrants;


·
            homeowner
      relief that encourages loan restructuring and
  modification;


·
            the
      FDIC's temporary increase in deposit insurance coverage from $100,000 to
      $250,000 (and unlimited coverage on certain noninterest-bearing accounts)
      through December 31, 2009;


·
            the
      Federal Reserve's program to pay interest on depository institution
      balances;


·
            liquidity
      and credit facilities for financial institutions and investment
      banks;


·
            lowering
      the federal funds rate;


·
            emergency
      action against short selling
practices;


·
            a
      temporary guaranty program for money market
  funds;


·
            commercial
      paper funding facilities to provide liquidity to commercial paper
      issuers;


·
            coordinated
      international efforts to address illiquidity and other weaknesses in the
      banking sector.





The
actual impact that EESA and related measures will have on the financial markets,
including the volatility and illiquidity currently being experienced, is
unknown.  The failure of such measures to help stabilize the U.S.
financial markets and a continuation or worsening of current financial market
conditions could materially and adversely affect our business, financial
conditions, results of operations, access to credit or the trading price of our
common stock.





The
Congressional and regulatory response to the current economic and credit crisis
could have an adverse effect on our business.





Federal
and state legislators and regulators are expected to pursue increased regulation
of how banks are operated and how loans are originated, purchased, and sold as a
result of the current economic and credit crisis. Changes in the lending market
and secondary markets for loans and related congressional and regulatory
responses may impact how the Bank makes and underwrites loans, buys and sells
such loans in secondary markets, and otherwise conducts its business. We are
unable to predict whether any legislative or regulatory initiatives or actions
will be implemented, what form they will take, whether they will be directed at
the Bank, or whether such initiatives or actions, once they are initiated or
taken, will thereafter continue to change. Any such actions could affect us in
substantial and unpredictable ways and could have an adverse effect on our
business, financial condition and results of operations. For more information
regarding the regulatory environment in which we operate, see “Supervision and
Regulation” in Item 1 of this report above. The administration of President
Barack Obama recently announced a comprehensive mortgage-relief plan.  The
effects of this plan and any other similar programs or initiatives that may be
implemented are difficult to predict, but they could result in increased losses
to the Bank, either directly or indirectly through the Bank's ownership of
investment securities, including mortgage-backed securities.




14





We
may be subject to environmental and other liability risks associated with
lending activities.





If
defaults increase, we would likely foreclose on and take title to the real
estate serving as collateral for many loans.  Property ownership
increases our expenses due to the costs of managing and disposing of
properties.  There is also a risk that hazardous or toxic substances
will be found on properties, in which case we may be liable for remediation
costs and related personal injury and property damage and the value of the
property may be materially reduced.  In general, the costs and
financial liabilities associated with property ownership could have a material
adverse effect on our financial condition and results of
operations.





Inability
to hire or retain certain key professionals, management and staff could reduce
our revenues and net income.





We rely
on key personnel to manage and operate our business, including important
functions such as deposit generation and loan production.  The loss of
key staff may adversely affect our ability to maintain and manage these
functions effectively, which could negatively affect our revenues and net
income.  In addition, loss of key personnel could result in increased
recruiting and hiring expenses, which could cause higher than expected expenses
and a decrease in our net income.





Our
information systems may experience an interruption or breach in
security.





We rely
heavily on communication and information systems to conduct our
business.  Any failure, interruption or breach in security of these
systems could result in failures or disruptions in our customer relationship
management, general ledger, deposit, loan and other systems.  While we
have policies and procedures designed to prevent or limit the effect of the
possible failure, interruption or security breach of our information systems,
there can be no assurance that any such failures, interruptions or security
breaches will not occur or, if they do occur, that they will be adequately
addressed.  The occurrence of any failures, interruptions or security
breaches of our information systems could damage our reputation, result in a
loss of customer business, subject us to additional regulatory scrutiny, or
expose us to civil litigation and possible financial liability, any of which
could have a material adverse effect on our financial condition and results of
operation.





The
Company’s controls and procedures may fail or be circumvented.





Management
regularly reviews and updates the Company’s internal controls, disclosure
controls and procedures, and corporate governance policies and
procedures.  Any system of controls, however well designed and
operated, is based in part on certain assumptions and can provide only
reasonable, not absolute, assurance that the objectives of the system are
met.  Any failure or circumvention of the Company’s controls and
procedures or failure to comply with regulations related to controls and
procedures could have a material adverse effect on the Company’s business,
results of operations and financial condition.




15




ITEM
      1.B.
              Unresolved
      Staff Comments





None





ITEM
      2.
            Properties





The
Company’s administrative offices are located in Aberdeen,
Washington.  The building located at 300 East Market Street is owned
by the Bank and houses the main branch.  The administrative offices of
the Bank and the Company, which are leased from an unaffiliated third party, are
located at 1101 S. Boone Street.





Pacific
owns the land and buildings occupied by its fourteen branches in Grays
Harbor, Pacific, Skagit, Whatcom and Wahkiakum Counties, as well as its data
processing operations in Long Beach, Washington.  The remaining
locations operate in leased facilities, which are leased from unaffiliated third
parties.  The aggregate monthly lease payment for all leased space is
approximately $27,000.





In
addition to the land and buildings owned by Pacific, it also owns all of its
furniture, fixtures and equipment, including data processing equipment, at
December 31, 2008.  The net book value of the Company’s premises and
equipment was $16.6 million at that date.





Management
believes that the facilities are of sound construction and in good operating
condition, are appropriately insured and are adequately equipped for carrying on
the business of the Bank.





ITEM
      3.
            Legal
      Proceedings





The
Company and the Bank from time to time are party to various legal proceedings
arising in the ordinary course of business.  Management believes that
there are no threatened or pending proceedings against the Company or the Bank
which, if determined adversely, would have a material effect on its business,
financial condition, results of operations or cash flows.





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





No
matters were submitted to a vote of security holders in the fourth quarter of
2008.




16


PART
II





ITEM
5.  Market for Registrant’s Common Equity, Related Stockholder
Matters, and Issuer Purchases of Equity Securities





The
Company's common stock is presently traded on the OTC Bulletin BoardTM under the
trading symbol PFLC.OB.   Historically, trading in our stock has
been very limited and the trades that have occurred cannot be characterized as
amounting to an established public trading market.  As a result, the
trading prices of our common stock may not reflect the price that would result
if our stock was actively traded at high volumes.





The
following are high and low bid prices quoted on the OTC Bulletin Board during
the periods indicated.  The quotations reflect inter-dealer prices,
without retail mark-up, mark-down or commission and may not represent actual
transactions:




2008
              
              
              2007Shares
      Traded
              
              
              High
              
              
              Low
              
              
              Shares
      Traded
              
              
              High
              
              
              LowFirst
      Quarter
              
              
              78,700
              
              
              $
              14.72
              
              
              $
              10.50
              
              
              
              112,200
              
              
              $
              17.25
              
              
              $
              16.10Second
      Quarter
              
              
              42,600
              
              
              $
              14.50
              
              
              $
              11.10
              
              
              
              188,100
              
              
              $
              17.10
              
              
              $
              15.25Third
      Quarter
              
              
              55,600
              
              
              $
              12.70
              
              
              $
              8.50
              
              
              
              48,600
              
              
              $
              16.20
              
              
              $
              14.50Fourth
      Quarter
              
              
              71,700
              
              
              $
              10.00
              
              
              $
              5.75
              
              
              
              128,800
              
              
              $
              15.25
              
              
              $
              12.05


As of
December 31, 2008, there were approximately 1,139 shareholders of record of the
Company’s common stock.  Mellon Investor Services LLC serves as the
transfer agent for our common stock.





The
Company’s Board of Directors declared dividends on its common stock in December
2008 and 2007 in the amount of $.05 and $.75 per share,
respectively.  Additionally, in 2008, the Company declared a 10% stock
dividend, resulting in the issuance to our shareholders of one new share for
every 10 shares held on the record date for the stock dividend.  The
Board of Directors has adopted a dividend policy which is reviewed
annually.  There can be no assurance the Company will continue its
dividend or declare and pay dividends at historical rates.





Under
federal banking law, the payment of dividends by the Company and the Bank is
subject to capital adequacy requirements established by the Federal Reserve and
the FDIC.  In addition, payment of dividends by either entity is
subject to regulatory limitations.  Under Washington general corporate
law as it applies to the Company, no cash dividend may be declared or paid if,
after giving effect to the dividend, the Company would not be able to pay its
liabilities as they become due or its liabilities exceed its
assets.  Payment of dividends on the Common Stock is also affected by
statutory limitations, which restrict the ability of the Bank to pay upstream
dividends to the Company.  Under Washington banking law as it applies
to the Bank, no dividend may be declared or paid in an amount greater than net
profits then available, and after a portion of such net profits have been added
to the surplus funds of the Bank.





Issuer
Purchases of Equity Securities





In
January 2008, the Company approved a share repurchase program authorizing the
purchase of up to 150,000 shares of its common stock.  There were no
purchases of common stock by the Company during the quarter ended December 31,
2008.  Cumulatively, the Company has purchased 2,300 shares at an
average price of $11.50 per share under the plan.  The maximum number
of shares that may yet be purchased under the plan total 147,700 at December 31,
2008.  We have no current intention to purchase stock under our share
repurchase program during 2009.




17





STOCK
PERFORMANCE GRAPH





The
following graph compares the cumulative total shareholder return on the
Company's Common Stock with the cumulative total return on the S&P 500 and
NASDAQ Bank Index.  Total return assumes that the value of the
investment in the Company's Common Stock and each index was $100 on December 31,
2003, and that all dividends were reinvested.





COMPARISON
      OF FIVE YEAR CUMULATIVE TOTAL
RETURN







Period
      EndingIndex
            
            12/31/03
            
            
            12/31/04
            
            
            12/31/05
            
            
            12/31/06
            
            
            12/31/07
            
            
            12/31/08Pacific
      Financial Corporation
            
            $
            100.00
            
            
            $
            103.14
            
            
            $
            132.75
            
            
            $
            141.38
            
            
            $
            113.36
            
            
            $
            56.73S&P
      500
            
            
            100.00
            
            
            
            109.00
            
            
            
            114.35
            
            
            
            132.41
            
            
            
            139.68
            
            
            
            77.28NASDAQ
      Bank Index
            
            
            100.00
            
            
            
            109.72
            
            
            
            107.60
            
            
            
            122.47
            
            
            
            98.09
            
            
            
            76.96




18




ITEM
      6.
            Selected
      Financial Data





The
following selected consolidated five year financial data should be read in
conjunction with the Company’s consolidated financial statements and the
accompanying notes presented in this report.




As
      of and For the Year ended December 31,2008
              
              
              2007
              
              
              2006
              
              
              2005
              
              
              2004(dollars
      in thousands, except per share data)Operations
      DataNet
      interest income
              
              $
              21,715
              
              
              $
              24,503
              
              
              $
              23,867
              
              
              $
              22,284
              
              
              $
              19,520Provision
      for credit losses
              
              
              4,791
              
              
              
              482
              
              
              
              625
              
              
              
              1,100
              
              
              
              970Non-interest
      income
              
              
              5,057
              
              
              
              4,475
              
              
              
              4,176
              
              
              
              4,081
              
              
              
              3,162Non-interest
      expense
              
              
              21,591
              
              
              
              20,379
              
              
              
              18,118
              
              
              
              16,566
              
              
              
              13,555Provision
      (benefit) for income taxes
              
              
              (561
              )
              
              
              2,086
              
              
              
              2,749
              
              
              
              2,653
              
              
              
              2,450Net
      income
              
              
              951
              
              
              
              6,031
              
              
              
              6,551
              
              
              
              6,046
              
              
              
              5,707Net
      income per share:Basic
      (1)
              
              
              .13
              
              
              
              .83
              
              
              
              .92
              
              
              
              .86
              
              
              
              .85Diluted
      (1)
              
              
              .13
              
              
              
              .82
              
              
              
              .90
              
              
              
              .84
              
              
              
              .83Dividends
      declared
              
              
              333
              
              
              
              4,955
              
              
              
              4,893
              
              
              
              4,719
              
              
              
              4,624Dividends
      declared per share (1)
              
              
              .05
              
              
              
              .75
              
              
              
              .75
              
              
              
              .73
              
              
              
              .72Dividends
      paid ratio
              
              
              35
              %
              
              
              82
              %
              
              
              75
              %
              
              
              78
              %
              
              
              81
              %Performance
      RatiosInterest
      rate spread
              
              
              4.23
              %
              
              
              4.92
              %
              
              
              5.13
              %
              
              
              5.34
              %
              
              
              5.37
              %Net
      interest margin (2)
              
              
              4.12
              %
              
              
              4.82
              %
              
              
              5.04
              %
              
              
              5.25
              %
              
              
              5.25
              %Efficiency
      ratio (3)
              
              
              80.65
              %
              
              
              70.33
              %
              
              
              64.61
              %
              
              
              62.83
              %
              
              
              59.76
              %Return
      on average assets
              
              
              .16
              %
              
              
              1.08
              %
              
              
              1.26
              %
              
              
              1.31
              %
              
              
              1.41
              %Return
      on average equity
              
              
              1.83
              %
              
              
              11.46
              %
              
              
              13.16
              %
              
              
              12.70
              %
              
              
              14.21
              %Balance
      Sheet DataTotal
      assets
              
              $
              625,835
              
              
              $
              565,587
              
              
              $
              562,384
              
              
              $
              489,409
              
              
              $
              441,791Loans,
      net
              
              
              478,695
              
              
              
              433,904
              
              
              
              420,768
              
              
              
              393,574
              
              
              
              341,671Total
      deposits
              
              
              511,307
              
              
              
              467,336
              
              
              
              466,841
              
              
              
              399,726
              
              
              
              363,501Other
      borrowings
              
              
              60,757
              
              
              
              37,446
              
              
              
              36,809
              
              
              
              35,790
              
              
              
              25,233Shareholders’
      equity
              
              
              50,074
              
              
              
              50,699
              
              
              
              48,984
              
              
              
              46,600
              
              
              
              45,303Book
      value per share (1) (4)
              
              
              6.84
              
              
              
              6.97
              
              
              
              6.83
              
              
              
              6.55
              
              
              
              6.42Equity
      to assets ratio
              
              
              8.00
              %
              
              
              8.96
              %
              
              
              8.71
              %
              
              
              9.52
              %
              
              
              10.25
              %Asset
      Quality RatiosNonperforming
      loans to total loans
              
              
              3.40
              %
              
              
              1.41
              %
              
              
              1.76
              %
              
              
              1.67
              %
              
              
              .15
              %Allowance
      for loan lossesto
      total loans
              
              
              1.57
              %
              
              
              1.14
              %
              
              
              .95
              %
              
              
              1.33
              %
              
              
              1.23
              %Allowance
      for loan lossesto
      nonperforming loans
              
              
              44.97
              %
              
              
              78.10
              %
              
              
              52.30
              %
              
              
              78.67
              %
              
              
              901.28
              %Nonperforming
      assets tototal
      assets
              
              
              3.43
              %
              
              
              .62
              %
              
              
              1.30
              %
              
              
              1.36
              %
              
              
              .12
              %




(1)
Retroactively adjusted for a 1.1 to 1 stock split effective January 13, 2009 and
also for a 2 to 1 stock split effective April 4, 2005.


(2) Net
interest income divided by average earning assets.


(3)
Non-interest expense divided by the sum of net interest income and non-interest
income.


(4)
Shareholder equity divided by shares outstanding.




19


ITEM
      7.
            Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations





The
following discussion and analysis should be read in conjunction with Pacific's
audited consolidated financial statements and related notes appearing elsewhere
in this report.  In addition, please refer to Pacific's
forward-looking statement disclosure included in Part I of this
report.





RECENT
DEVELOPMENTS





There
have been a number of significant changes affecting the banking industry that
have been driven by deteriorating economic conditions, declines in real estate
values and illiquidity in both capital and real estate markets.  The
United States government has responded to the financial crisis with various
actions and proposals.   For instance, the U.S. Treasury
Department (UST) and the Federal Deposit Insurance Corporation (“FDIC”) have
announced various programs in an effort to provide relief to financial
institutions and ease depositor and investor concerns, including programs
providing for direct investment in banks, purchases of certain troubled assets
by the government or institutions partially financed by the government,
increases and other changes in FDIC insurance coverage, and issuances of debt
that is guaranteed by the federal government in certain
circumstances.





In
response to the challenging economic environment, management has recently
initiated a number of actions.  These measures are as
follows:





·
            For
      the near term, the Bank intends to prudently manage
      capital.  During the fourth quarter, the Company reduced the
      cash dividend to $0.05 per share as part of our efforts to preserve
      capital.





·
            The
      Company will continue efforts to align personnel expense with the reduced
      economic activity and lower volumes of real estate transactions within our
      markets.  In January 2009, the Bank completed a reduction in
      work force of approximately 10% of full-time equivalent
    staff.





·
            Closure
      of the Everson Branch during the fourth quarter of 2008, and consolidation
      of the Birch Bay branch expected during the second quarter of
      2009.





·
            Reduction
      in land and residential construction concentrations as a percentage of
      total regulatory capital.  This includes the suspension of new
      raw land and land development loans and curtailment of loans for new
      speculative home construction.





·
            With
      respect to new term commercial real estate lending activities, placing
      greater emphasis on owner occupied properties as opposed to non-owner
      occupied commercial real estate.





·
            The
      addition of an individual focusing on special assets dedicated solely to
      the resolution of problem loans primarily in the land, land development
      and residential construction
categories.





EXECUTIVE
OVERVIEW





Net
income in 2008 was $951,000, or $0.13 per diluted share compared to $6,031,000,
or $0.82 per diluted share in 2007.  The following are major factors
impacting the Company’s results of operations for 2008 as compared to
2007.





·
            Net
      interest income decreased by 11.4% or $2,788,000 to $21,715,000 as
      compared to 2007.  The decrease was primarily due to interest
      rate decreases, which were only partially offset by a larger interest
      earning asset base and improved returns on the investment
      portfolio.  Growth in earning assets was mainly driven by loan
      production and investment purchases, which were funded from wholesale
      funding sources.




20




·
            The
      net interest margin for 2008 declined to 4.12% compared to 4.82% in
      2007.  The margin compression was mainly attributable to a
      series of rate reductions in the Federal Funds rate by the Federal Open
      Market Committee (FOMC) during 2008 for a combined 400 basis points which
      caused an immediate reduction in the variable rate loan portfolio and a
      delayed reduction of the Bank’s costs of funds on its portfolio of time
      deposits.  The reversal of interest income on loans placed on
      non-accrual status also contributed to margin
  compression.





·
            The
      provision for credit losses increased $4,309,000, or 893.9%, to $4,791,000
      for 2008.  The significant increase is the result of changes in
      loan loss rates and the increase in substandard loans, primarily in the
      land acquisition and development and residential construction loan
      portfolios.





·
            In
      2008, return on average assets and return on average equity decreased to
      0.16% and 1.83%, respectively, compared to 1.08% and 11.46% in 2007 as a
      result of the aforementioned net interest margin compression and increase
      in provision for credit losses.





The
following are important factors in understanding the Company financial condition
and liquidity:





·
            Total
      assets at December 31, 2008 increased by $60,248,000, or 10.7%, to
      $625,835,000 compared to $565,587,000 at the end of 2007.  Gross
      loans (including loans held for sale) grew $41,731,000, or 9.2%, to
      $497,804,000 compared to $456,073,000 at December 31, 2007, primarily in
      the commercial real estate category.  Other contributing factors
      were an increase in the investment portfolio of $8,638,000 and an increase
      in foreclosed real estate of
$6,810,000.





·
            Non-accrual
      loans increased $11,197,000, or 321.9%, to $14,676,000 at December 31,
      2008.  The increase in non-accrual loans during the year was
      primarily related to non-performing construction and land development
      loans, which contributed $11,787,000 of the $14,676,000 outstanding
      balance at December 31, 2008.  Non-performing assets totaled
      $21,486,000, or 3.4% of total assets at December 31,
  2008.





·
            Total
      deposits increased $43,971,000, or 9.4%, compared to the prior
      year.  This increase is mostly attributable to increases in
      brokered certificates of deposits, which increased $30,305,000 to
      $35,305,000 at year-end 2008, compared to $5,000,000 at the end of
      2007.





·
            During
      the course of the year, the Company made continued investment in
      technology and delivery systems to improve electronic banking products,
      including remote deposit capture, improved data processing systems, and
      enhanced disaster recovery redundancy
      capabilities.  Additionally, we are in the process of changing
      online banking platforms which will also include electronic statement
      delivery and mobile banking services.  This conversion is
      expected to be completed by June
2009.




21




RESULTS
OF OPERATIONS





Years
ended December 31, 2008, 2007, and 2006




General.  The following
table presents condensed consolidated statements of income for the Company for
each of the years in the three-year period ended December 31, 2008.




(dollars in
      thousands)
            
            2008
            
            
            Increase
              (Decrease)
              Amount
            
            
            %
            
            
            2007
            
            
            Increase
              (Decrease)
              Amount
            
            
            %
            
            
            2006Interest
      income
            
            $
            33,713
            
            
            $
            (6,423
            )
            
            
            (16.0
            )
            
            $
            40,136
            
            
            $
            3,692
            
            
            
            10.1
            
            
            $
            36,444Interest
      expense
            
            
            11,998
            
            
            
            (3,635
            )
            
            
            (23.3
            )
            
            
            15,633
            
            
            
            3,056
            
            
            
            24.3
            
            
            
            12,577Net
      interest income
            
            
            21,715
            
            
            
            (2,788
            )
            
            
            (11.4
            )
            
            
            24,503
            
            
            
            636
            
            
            
            2.7
            
            
            
            23,867Provision
      for credit losses
            
            
            4,791
            
            
            
            4,309
            
            
            
            894.0
            
            
            
            482
            
            
            
            (143
            )
            
            
            (22.9
            )
            
            
            625Net
      interest income afterprovisions
      for credit losses
            
            
            16,924
            
            
            
            (7,097
            )
            
            
            (29.5
            )
            
            
            24,021
            
            
            
            779
            
            
            
            3.4
            
            
            
            23,242Other
      operating income
            
            
            5,057
            
            
            
            582
            
            
            
            13.0
            
            
            
            4,475
            
            
            
            299
            
            
            
            7.2
            
            
            
            4,176Other
      operating expense
            
            
            21,591
            
            
            
            1,212
            
            
            
            5.9
            
            
            
            20,379
            
            
            
            2,261
            
            
            
            12.5
            
            
            
            18,118Income
      before income taxes
            
            
            390
            
            
            
            (7,727
            )
            
            
            (95.2
            )
            
            
            8,117
            
            
            
            (1,183
            )
            
            
            (12.7
            )
            
            
            9,300Income
      taxes (benefit)
            
            
            (561
            )
            
            
            (2,647
            )
            
            
            (126.9
            )
            
            
            2,086
            
            
            
            (663
            )
            
            
            (24.1
            )
            
            
            2,749Net
      income
            
            $
            951
            
            
            $
            (5,080
            )
            
            
            (84.2
            )
            
            $
            6,031
            
            
            $
            520
            
            
            
            (7.9
            )
            
            $
            6,551




Net
Interest Income.  The Company
derives the majority of its earnings from net interest income, which is the
difference between interest income earned on interest earning assets and
interest expense incurred on interest bearing liabilities.  The
Company’s net interest income is affected by the change in the level and mix of
interest-earning assets and interest-bearing liabilities, referred to as volume
changes.  The Company’s net interest income is also affected by
changes in the yields earned on assets and rates paid on liabilities, referred
to as rate changes.  Interest rates charged on loans are affected
principally by the demand for such loans, the supply of money available for
lending purposes and competitive factors.  Those factors are, in turn,
affected by general economic conditions and other factors beyond the Company’s
control, such as federal economic policies, legislative tax policies and actions
by the FOMC.  Interest rates on deposits are affected primarily by
rates charged by competitors and actions by the FOMC.  The following
table sets forth information with regard to average balances of the interest
earning assets and interest bearing liabilities and the resultant yields or
cost, net interest income, and the net interest margin.




22




Year Ended December
      31,2008
                        
                        
                        
                        
                        
                        
                        
                        
                        2007
                        
                        
                        
                        
                        
                        
                        
                        
                        2006Interest
                        
                        
                        
                        
                        
                        
                        
                        
                        Interest
                        
                        
                        
                        
                        
                        
                        
                        
                        Interest(dollars
      in thousands)
                        
                        Average
                        
                        
                        Income
                        
                        
                        Avg
                        
                        
                        Average
                        
                        
                        Income
                        
                        
                        Avg
                        
                        
                        Average
                        
                        
                        Income
                        
                        
                        AvgBalance
                        
                        
                        (Expense)
                        
                        
                        Rate
                        
                        
                        Balance
                        
                        
                        (Expense)
                        
                        
                        Rate
                        
                        
                        Balance
                        
                        
                        (Expense)
                        
                        
                        RateAssetsEarning
      assets:Loans
      (1)
                        
                        $
                        471,338
                        
                        
                        $
                        31,385
                        
                        
                        
                        6.66
                        %
                        
                        $
                        453,940
                        
                        
                        $
                        37,823
                        
                        
                        
                        8.33
                        %
                        
                        $
                        415,695
                        
                        
                        $
                        34,002
                        
                        
                        
                        8.18
                        %Investment
      securities:Taxable
                        
                        
                        31,090
                        
                        
                        
                        1,648
                        
                        
                        
                        5.30
                        
                        
                        
                        26,522
                        
                        
                        
                        1,336
                        
                        
                        
                        5.04
                        
                        
                        
                        22,395
                        
                        
                        
                        1,021
                        
                        
                        
                        4.56Tax-Exempt
      (1)
                        
                        
                        19,440
                        
                        
                        
                        1,193
                        
                        
                        
                        6.14
                        
                        
                        
                        17,514
                        
                        
                        
                        1,074
                        
                        
                        
                        6.13
                        
                        
                        
                        16,120
                        
                        
                        
                        983
                        
                        
                        
                        6.10Total
      investmentsecurities
                        
                        
                        50,530
                        
                        
                        
                        2,841
                        
                        
                        
                        5.62
                        
                        
                        
                        44,036
                        
                        
                        
                        2,410
                        
                        
                        
                        5.47
                        
                        
                        
                        38,515
                        
                        
                        
                        2,004
                        
                        
                        
                        5.20Federal
      Home Loan Bank Stock
                        
                        
                        2,022
                        
                        
                        
                        19
                        
                        
                        
                        0.94
                        
                        
                        
                        1,858
                        
                        
                        
                        7
                        
                        
                        
                        0.38
                        
                        
                        
                        1,858
                        
                        
                        
                        —
                        
                        
                        
                        —Federal
      funds sold anddeposits
      in banks
                        
                        
                        3,787
                        
                        
                        
                        44
                        
                        
                        
                        1.16
                        
                        
                        
                        8,499
                        
                        
                        
                        426
                        
                        
                        
                        5.01
                        
                        
                        
                        17,631
                        
                        
                        
                        909
                        
                        
                        
                        5.16Total
      earning assets/interestincome
                        
                        $
                        527,677
                        
                        
                        $
                        34,289
                        
                        
                        
                        6.50
                        %
                        
                        $
                        508,333
                        
                        
                        $
                        40,666
                        
                        
                        
                        8.00
                        %
                        
                        $
                        473,699
                        
                        
                        $
                        36,915
                        
                        
                        
                        7.79
                        %Cash
      and due from banks
                        
                        
                        11,454
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        12,236
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        12,150Bank
      premises and equipment(net)
                        
                        
                        16,522
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        13,249
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        11,103Other
      assets
                        
                        
                        34,948
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        30,013
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        26,904Allowance
      for credit losses
                        
                        
                        (5,875
                        )
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        (4,618
                        )
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        (5,114
                        )Total
      assets
                        
                        $
                        584,726
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        $
                        559,213
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        $
                        518,742Liabilities
      and Shareholders’ EquityInterest
      bearing liabilities:Deposits:Savings
      and interest-bearing
      demand
                        
                        $
                        204,539
                        
                        
                        $
                        (2,903
                        )
                        
                        
                        1.42
                        %
                        
                        $
                        194,356
                        
                        
                        $
                        (4,947
                        )
                        
                        
                        2.55
                        %
                        
                        $
                        195,921
                        
                        
                        $
                        (4,650
                        )
                        
                        
                        2.37
                        %Time
                        
                        
                        186,319
                        
                        
                        
                        (6,891
                        )
                        
                        
                        3.70
                        
                        
                        
                        177,362
                        
                        
                        
                        (8,513
                        )
                        
                        
                        4.80
                        
                        
                        
                        148,055
                        
                        
                        
                        (6,196
                        )
                        
                        
                        4.18Total
      deposits
                        
                        
                        390,858
                        
                        
                        
                        (9,794
                        )
                        
                        
                        2.51
                        
                        
                        
                        371,718
                        
                        
                        
                        (13,460
                        )
                        
                        
                        3.62
                        
                        
                        
                        343,976
                        
                        
                        
                        (10,846
                        )
                        
                        
                        3.15Short-term
      borrowings
                        
                        
                        13,398
                        
                        
                        
                        (349
                        )
                        
                        
                        2.61
                        
                        
                        
                        5,961
                        
                        
                        
                        (329
                        )
                        
                        
                        5.52
                        
                        
                        
                        1,388
                        
                        
                        
                        (75
                        )
                        
                        
                        5.40Long-term
      borrowings
                        
                        
                        26,336
                        
                        
                        
                        (991
                        )
                        
                        
                        3.76
                        
                        
                        
                        21,286
                        
                        
                        
                        (820
                        )
                        
                        
                        3.85
                        
                        
                        
                        23,092
                        
                        
                        
                        (868
                        )
                        
                        
                        3.76Secured
      borrowings
                        
                        
                        1,387
                        
                        
                        
                        (94
                        )
                        
                        
                        6.78
                        
                        
                        
                        1,517
                        
                        
                        
                        (110
                        )
                        
                        
                        7.25
                        
                        
                        
                        1,981
                        
                        
                        
                        (141
                        )
                        
                        
                        7.12Junior
      subordinated debentures
                        
                        
                        13,403
                        
                        
                        
                        (770
                        )
                        
                        
                        5.74
                        
                        
                        
                        13,403
                        
                        
                        
                        (914
                        )
                        
                        
                        6.82
                        
                        
                        
                        9,539
                        
                        
                        
                        (647
                        )
                        
                        
                        6.78Total
      borrowings
                        
                        
                        54,524
                        
                        
                        
                        (2,204
                        )
                        
                        
                        4.04
                        
                        
                        
                        42,167
                        
                        
                        
                        (2,173
                        )
                        
                        
                        5.15
                        
                        
                        
                        36,000
                        
                        
                        
                        (1,731
                        )
                        
                        
                        4.81Total
      interest-bearing liabilities/Interest
      expense
                        
                        $
                        445,382
                        
                        
                        $
                        (11,998
                        )
                        
                        
                        2.69
                        %
                        
                        $
                        413,885
                        
                        
                        $
                        (15,633
                        )
                        
                        
                        3.78
                        %
                        
                        $
                        379,976
                        
                        
                        $
                        (12,577
                        )
                        
                        
                        3.31
                        %Demand
      deposits
                        
                        
                        82,620
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        87,467
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        84,846Other
      liabilities
                        
                        
                        4,750
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        5,227
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        4,133Shareholders’
      equity
                        
                        
                        51,974
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        52,634
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        49,787Total
      liabilities and shareholders’equity
                        
                        $
                        584,726
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        $
                        559,213
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        $
                        518,742Net
      interest income (1)
                        
                        
                        
                        
                        
                        $
                        22,291
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        $
                        25,033
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        $
                        24,338Net
      interest income as a percentage of average earning assetsInterest
      income
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        6.50
                        %
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        8.00
                        %
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        7.79
                        %Interest
      expense
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        2.27
                        %
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        3.08
                        %
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        2.66
                        %Net interest
      income
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        4.23
                        %
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        4.92
                        %
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        5.13
                        %Net
      interest margin (2)
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        4.12
                        %
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        4.82
                        %
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        5.04
                        %Tax
      equivalent adjustment (1)
                        
                        
                        
                        
                        
                        $
                        576
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        $
                        530
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        $
                        471




(1)  Interest
earned on tax-exempt loans and securities has been computed on a 34% tax
equivalent basis.


(2)  Net
interest income divided by average interest earning assets.





For purposes of computing the average
rate, the Company used historical cost balances which do not give effect to
changes in fair value that are reflected as a component of shareholders’
equity.  Nonaccrual loans and loans held for sale are included in
“loans.”  Interest income on loans include loan fees of $1,132,000,
$1,828,000, and $1,508,000 in 2008, 2007, and 2006,
respectively.




23




Net
interest income on a tax equivalent basis totaled $22,291,000 for the year ended
December 31, 2008, a decrease of $2,742,000, or 11.0%, compared to
2007.  Net interest income increased 2.9% to $25,033,000 in 2007
compared to 2006.  The Company’s tax equivalent interest income
decreased 15.7% to $34,289,000 from year end 2007 to year end 2008, and
increased 10.2% to $40,666,000 in 2007 from $36,915,000 in 2006.  The
decrease in 2008 was primarily due to the decline in yield earned on our loan
portfolio as a direct result of the 400 basis point reduction in the federal
funds rate by the FOMC during the year.  Additionally, higher yielding
loans were paid-off and replaced by loan production that was originated at lower
spreads over our cost of funds due to competitive pricing
pressures.  The reversal of interest income on loans placed on
non-accrual status also contributed to the decline in loan yield.  The
increase in 2007 is primarily the result of increased lending volumes, higher
loan balances and higher interest rates earned on interest earning
assets.





The
Company’s average earning assets increased $19,344,000, or 3.8%, in 2008 and was
offset by compression of its net interest margin.  The decrease in net
interest margin was due to a 400 basis point decrease by the FOMC which caused
an immediate reduction in the variable rate loan portfolio and a delayed
reduction of the Company’s costs of time deposits.  Also, as rates
move towards zero, it becomes more and more difficult to match decreases in
rates on interest earning assets with decreases in rates paid on interest
bearing liabilities.  Approximately 78% of the Company’s loan
portfolio is variable with pricing tied to indexes that are heavily influenced
by short-term interest rates.  Because of its focus on commercial
lending, the Company will continue to have a high percentage of floating rate
loans.  We anticipate that the impact of lower yields on loans and
competition for deposits will continue to put pressure on our net interest
margin.





The
Company’s average loan portfolio increased $17,398,000, or 3.8%, from year end
2007 to year end 2008, and increased $38,245,000, or 9.2%, from 2006 to
2007.  Average loan growth in 2008 was slower than in recent years
primarily as a result of lower demand for financing in the Bank’s market areas
due to a slowing economy.  The Bank also tightened its underwriting
standards, which decreased approval rates.  The increase in the
average portfolio in 2007 was largely a result of the purchase of $22 million in
variable rate loans that are fully guaranteed by U.S. government
agencies.  Excluding the purchase of loans previously mentioned,
actual loan balances were down at December 31, 2007 due to softer loan
demand.   Additionally, the Company experienced higher than
expected prepayments on the government guaranteed loan portfolio in 2008 and
2007 which contributed to a reduction in net interest income of $248,000 and
$529,000, respectively, during those years.





The
Company’s average investment portfolio increased $6,494,000, or 14.7%, from 2007
to 2008, and $5,521,000, or 14.3%, from 2006 to 2007.  During year
ended December 31, 2008, the yield on taxable securities increased from 5.04% to
5.30%, despite a declining rate environment.  These increases were
primarily related to the purchase of approximately $12.4 million of AAA rated
collateralized mortgage obligations (CMOs) during the year, which are secured by
first lien residential mortgages.  Prior to the acquisition of these
securities, the Company assessed and evaluated the risks and potential returns
over the expected life of the CMOs and in a variety of interest rate, yield
spread, financing cost, credit loss and prepayment
scenarios.  Substantially all of the purchased CMOs carry fixed
interest rates and were purchased at significant discounts.  All of
the CMOs carry credit enhancements through subordination provided by junior CMO
branches that bear the initial losses on the underlying loans.  The
Company reviews the credit quality of the securities and underlying collateral
quarterly in comparison to the initial purchase assumptions and under various
stress test scenarios.  For more information regarding the Company’s
investment portfolio, see Note 3 - “Securities” to the Company’s audited
financial statements included in Item 15 of this report and incorporated into
Item 8.  The increase in 2007 was due to management’s decision to
redistribute federal funds sold into investment securities to capture a higher
return.




24





The
Company’s average deposits increased $19,140,000, or 5.1%, from 2007 to 2008,
and increased $30,363,000, or 7.1%, in 2007 from
2006.    The Company attributes the majority of its growth
in 2008 to the success of a high-yield checking account that was introduced
during the year and an increase in brokered certificates of
deposits.  Additionally, the Company has an experienced branch staff,
a commitment to improving customer service throughout its branch delivery
system, and continues to experience success from three branches opened in
2006.  During 2008 and 2007, average deposits from branches opened in
recent years contributed $7,945,000 and $12,389,000, or 41.5% and 40.8%,
respectively, to the overall increase.  Even though the Company offers
a wide variety of retail deposit products to both consumer and commercial
customers, future deposit growth will be challenging as the Company anticipates
heightened market competition.





The
Company increased its average borrowings during 2008 by $12,357,000 or 29.3%,
and by $6,167,000, or 17.1%, during 2007.  The increase in 2008 was
used primarily to fund investment purchases.  The increase in 2007 is
primarily the result of issuing $8,248,000 in trust preferred securities in June
2006.  Total borrowings consist of advances from the Federal Home Loan
Bank of Seattle, short-term borrowings with correspondent banks, secured
borrowings and junior subordinated debentures.  The Company’s overall
cost of interest-bearing liabilities decreased to 2.69% in 2008 from 3.78% and
3.31% in 2007 and 2006, respectively.  The decrease is primarily
attributable to rate decreases on interest-bearing deposits and the downward
repricing of the variable portion of junior subordinated
debentures.  This was partially offset by the funding of the Company’s
loan growth with brokered time deposits, which are more sensitive to market rate
increases and more expensive versus funding such growth with lower cost demand,
money market, NOW or savings deposits.   The increase in cost of
interest-bearing liabilities for 2007 was primarily due to competitive deposit
pricing and higher interest rates paid during the first half of
2007.  Overall, deposit rates in the Company’s local markets have not
kept pace with the decreases in the federal funds target rate as competition has
resulted in the pressure to keep deposit rates elevated.  Increased
competition for deposits is being driven largely by financial institutions that
operate in our market area that have a particular need for
liquidity.





Net
interest margins were 4.12%, 4.82%, and 5.04%, for the years ended December 31,
2008, 2007, and 2006, respectively.





The
following table presents changes in net interest income attributable to changes
in volume or rate.  Changes not solely due to volume or rate are
allocated to volume and rate based on the absolute values of each.




2008 compared to 2007
            
            
            2007 compared to 2006Increase (decrease) due to
            
            
            Increase (decrease) due to(dollars
      in thousands)
            
            Volume
            
            
            Rate
            
            
            Net
            
            
            Volume
            
            
            Rate
            
            
            NetInterest
      earned on:Loans
            
            $
            1,403
            
            
            $
            (7,841
            )
            
            $
            (6,438
            )
            
            $
            3,177
            
            
            $
            644
            
            
            $
            3,821Securities:Taxable
            
            
            239
            
            
            
            73
            
            
            
            312
            
            
            
            201
            
            
            
            114
            
            
            
            315Tax-exempt
            
            
            118
            
            
            
            1
            
            
            
            119
            
            
            
            85
            
            
            
            6
            
            
            
            91Total
      securities
            
            
            357
            
            
            
            74
            
            
            
            431
            
            
            
            286
            
            
            
            120
            
            
            
            406Federal
      Home Loan Bank stock
            
            
            1
            
            
            
            11
            
            
            
            12
            
            
            
            —
            
            
            
            7
            
            
            
            7Fed
      funds sold and interest
              bearing
      deposits in other banks
            
            
            (160
            )
            
            
            (222
            )
            
            
            (382
            )
            
            
            (458
            )
            
            
            (25
            )
            
            
            (483
            )Total
      interest earning assets
            
            
            1,601
            
            
            
            (7,978
            )
            
            
            (6,377
            )
            
            
            3,005
            
            
            
            746
            
            
            
            3,751Interest
      paid on:Savings
      and interest bearing
              Demand
      deposits
            
            
            (247
            )
            
            
            2,291
            
            
            
            2,044
            
            
            
            37
            
            
            
            (334
            )
            
            
            (297
            )Time
      deposits
            
            
            (412
            )
            
            
            2,034
            
            
            
            1,622
            
            
            
            (1,330
            )
            
            
            (987
            )
            
            
            (2,317
            )Total
      borrowings
            
            
            (558
            )
            
            
            527
            
            
            
            (31
            )
            
            
            (312
            )
            
            
            (130
            )
            
            
            (442
            )Total
      interest bearing liabilities
            
            
            (1,217
            )
            
            
            4,852
            
            
            
            3,635
            
            
            
            (1,605
            )
            
            
            (1,451
            )
            
            
            (3,056
            )Change
      in net interest income
            
            $
            384
            
            
            $
            (3,126
            )
            
            $
            (2,742
            )
            
            $
            1,400
            
            
            $
            (705
            )
            
            $
            695




25




Non-Interest
Income.  Non-interest income was $5,057,000 for 2008, an
increase of $582,000, or 13.0%, from 2007 when it totaled
$4,475,000.  The 2007 amount increased $299,000 or 7.2%, compared to
the 2006 total of $4,176,000.





The
following table represents the principal categories of non-interest income for
each of the years in the three-year period ended December 31, 2008.





(dollars in
      thousands)
            
            2008
            
            
            Increase
              (Decrease)
              Amount
            
            
            %
            
            
            2007
            
            
            Increase
              (Decrease)
              Amount
            
            
            %
            
            
            2006Service
      charges on depositaccounts
            
            $
            1,577
            
            
            $
            83
            
            
            
            5.6
            
            
            $
            1,494
            
            
            $
            42
            
            
            
            2.9
            
            
            $
            1,452Income
      from and gains on sale of foreclosed real estate
            
            
            390
            
            
            
            390
            
            
            
            100.0
            
            
            
            —
            
            
            
            (5
            )
            
            
            (100.0
            )
            
            
            5Net
      gains on sales of loans
            
            
            1,426
            
            
            
            (558
            )
            
            
            (28.1
            )
            
            
            1,984
            
            
            
            89
            
            
            
            4.7
            
            
            
            1,895Net
      loss on sales ofsecurities
            
            
            (165
            )
            
            
            (145
            )
            
            
            (725.0
            )
            
            
            (20
            )
            
            
            (20
            )
            
            
            (100.0
            )
            
            
            —Earnings
      on bank owned lifeinsurance
            
            
            607
            
            
            
            210
            
            
            
            52.9
            
            
            
            397
            
            
            
            43
            
            
            
            12.1
            
            
            
            354Other
      operating income
            
            
            1,222
            
            
            
            602
            
            
            
            97.1
            
            
            
            620
            
            
            
            150
            
            
            
            31.9
            
            
            
            470Total
      non-interest income
            
            $
            5,057
            
            
            $
            582
            
            
            
            13.0
            
            
            $
            4,475
            
            
            $
            299
            
            
            
            (7.2
            )
            
            $
            4,176





Service
charges on deposits increased 5.6% and 2.9% during 2008 and 2007,
respectively.  The Company continues to emphasize the importance of
exceptional customer service and believes this emphasis, together with the
addition of three new full-service branches in 2006 contributed to the increase
in service charge revenue in 2008 and 2007.  Additionally, during the
fourth quarter of 2008, the Bank increased service charge per item fees,
including overdraft fees, to be more in line with competition.





Income
from sources other than service charges on deposit accounts totaled $3,556,000
in 2008, an increase of $575,000 from 2007, or 19.3%.  The largest
component is gain on sales of loans.    The market interest
rate environment heavily influences revenue from mortgage banking
activities.  Due to the deteriorating housing market in 2008, loan
sales in the secondary market were slow due to tightening of underwriting
criteria and home price depreciation both nationally and in our local market
areas.  Total origination of loans sold totaled $92,727,000 for the
year ended December 31, 2008, compared to $123,406,000 for the year ended
December 31, 2007.  The Company does not originate subprime
loans.  Management expects gains on sale of loans to increase in 2009
due to increased refinancing activity from historically low interest
rates.   Other major components of non-interest income were bank
owned life insurance income and other operating income.  The increase
in cash surrender value of life insurance was primarily the result of $5,000,000
in additional policies purchased in the fourth quarter of 2007.  Other
operating income increase for 2008 was due primarily to the gain on sale of the
Everson branch facility of $336,000.  Other operating income increases
for 2007 were attributable primarily to increased merchant card and loan
document preparation fees.




26





Non-Interest
Expense.  Total
non-interest expense in 2008 was $21,591,000, an increase of $1,212,000, or
5.9%, compared to $20,379,000 in 2007.  In 2007, non-interest expense
increased $2,261,000, or 12.5%, compared to $18,118,000 in
2006.  Changes in non-interest expense are discussed in greater detail
below.




The
following table represents the principal categories of non-interest expense for
each of the years in the three-year period ended December 31, 2008.





(dollars in
      thousands)
            
            2008
            
            
            Increase
              (Decrease)
              Amount
            
            
            %
            
            
            2007
            
            
            Increase
              (Decrease)
              Amount
            
            
            %
            
            
            2006Salaries
      and employeebenefits
            
            $
            12,381
            
            
            $
            101
            
            
            
            0.8
            
            
            $
            12,280
            
            
            $
            1,671
            
            
            
            15.8
            
            
            $
            10,609Occupancy
      and equipment
            
            
            2,855
            
            
            
            327
            
            
            
            12.9
            
            
            
            2,528
            
            
            
            110
            
            
            
            4.5
            
            
            
            2,418Marketing
      and advertising
            
            
            528
            
            
            
            (32
            )
            
            
            (5.7
            )
            
            
            560
            
            
            
            75
            
            
            
            15.5
            
            
            
            485State
      taxes
            
            
            366
            
            
            
            (70
            )
            
            
            (16.1
            )
            
            
            436
            
            
            
            61
            
            
            
            16.3
            
            
            
            375Data
      processing
            
            
            764
            
            
            
            371
            
            
            
            94.4
            
            
            
            393
            
            
            
            (29
            )
            
            
            (6.9
            )
            
            
            422Professional
      services
            
            
            828
            
            
            
            287
            
            
            
            53.0
            
            
            
            541
            
            
            
            (106
            )
            
            
            (16.4
            )
            
            
            647Other
      expense
            
            
            3,869
            
            
            
            228
            
            
            
            6.3
            
            
            
            3,641
            
            
            
            479
            
            
            
            15.1
            
            
            
            3,162Total
      non-interest expense
            
            $
            21,591
            
            
            $
            1,212
            
            
            
            5.9
            
            
            $
            20,379
            
            
            $
            2,261
            
            
            
            12.5
            
            
            $
            18,118





Salary
and employee benefits, the largest component of non-interest expense, increased
by $101,000, or 0.8%, in 2008 to $12,381,000 and increased by $1,671,000, or
15.8%, in 2007 compared to 2006.  The increase in 2008 was the result
of normal annual salary increases.  The increase in 2007 was due in
part to filling key management positions and normal salary
increases.  The number of full-time equivalent employees increased
from 212 to 221 during 2008.  Effective January 2009, the Bank
completed a reduction in force of 13 full-time equivalent
positions.  In the weeks leading up to the strategic staffing
reduction, other positions were not filled when vacated.  Accordingly,
as of March 1, 2009, we had 209 full time equivalent employees.  Also
included in salaries and benefits for 2008 and 2007 was stock option expense of
$87,000 and $97,000, respectively, in accordance with SFAS No.
123R.  For more information regarding stock options, see Note 14 -
“Stock Options” to the Company’s audited financial statements included in Item
15 of this report and incorporated into Item 8.





Occupancy
and equipment expenses increased $327,000 to $2,855,000 in 2008 compared with
$2,528,000 for 2007 due primarily to increased costs associated with two
branches that were relocated during the year.  Hannegan and Ferndale
branches were relocated from leased facilities to owned
buildings.  The new locations offer more amenities and full drive-up
facilities.  Occupancy and equipment expenses increased $110,000, or
4.5%, for 2007 compared to 2006 due primarily to equipment depreciation expense
as a result of our continued investment in the technology infrastructure needed
to support the future growth of the Company.





Marketing
and advertising expense decreased 5.7% to $528,000 in 2008 compared with
$560,000 for 2007 due to an ongoing effort to reduce controllable
expenses.  The increase in 2007 is due to the Company’s efforts to
increase awareness of its brand in the markets we serve, particularly our new
market in Whatcom county, which included a strategic brand initiative, an
evaluation of marketing materials, and ongoing customer surveys.





Data
processing expense increased 94.4% to $764,000 in 2008 compared with $393,000
for 2007.  In order to improve processing time, efficiency, technology
capabilities and support future growth of the Company, management successfully
converted its core operating system from an in-house environment to a service
bureau during 2008.  The increase in 2008 is mostly attributable to
conversion charges, as well as implementation of an automated wire platform, and
the setup of a backup site for data processing redundancy. The decrease in 2007
is attributable to a full year of savings in 2007 from the implementation of
back counter image capture which reduced item processing costs and expedited
funds availability with the Federal Reserve Bank as opposed to a partial year of
benefits in 2006.




27





Other
operating expense increased 2.1% to $4,697,000 in 2008 compared with $4,182,000
for 2007 primarily due to increased FDIC assessments and loan collection
expense, each of which were up $160,000 and $128,000,
respectively.  Other operating expenses increased 9.8% to $4,182,000
in 2007 compared to 2006 primarily due to increases in software amortization,
business travel, and training expenses, which were up $149,000, $65,000, and
$42,000, respectively.





Income
Tax Expense (Benefit).  For the years ended December 31, 2008,
2007, and 2006, the provision (benefit) for income taxes was ($561,000),
$2,086,000 and $2,749,000, respectively, representing effective tax rates of
(143.8%), 25.7% and 29.6%, respectively.  During 2008, the Company’s
pretax earnings declined sharply due to net interest margin compression and
increased provision for credit losses.  However, the Company’s tax
exempt income from investments, loans and income earned from the increase in
cash surrender value of bank owned life insurance, remained at historical
levels.  The tax exempt income offset the tax liability from earnings,
resulting in the recognition of an income tax benefit for
2008.  During 2007, the Company filed amended tax returns for the 2003
and 2004 tax years in order to capture a previously unrecognized net operating
loss benefit from the BNW acquisition.  This resulted in a $215,000
favorable tax adjustment recorded during 2007.  The effective tax
rates differ from the statutory federal tax rate of 35% largely due to tax
exempt interest income earned on certain investment securities and loans, income
earned from the increase in cash surrender value of bank owned life insurance
and tax credits from investments in low-income housing projects.





Deferred
income tax assets or liabilities reflect the estimated future tax effects
attributable to differences as to when certain items of income or expense are
reported in the financial statements versus when they are reported in the tax
returns.  As of December 31, 2008, the Company had a net deferred tax
asset of $1,340,000 compared to a net deferred tax liability of $441,000 at
December 31, 2007.





FINANCIAL
CONDITION





At
December 31, 2008 and 2007





Investment
Portfolio





The
investment portfolio provides the Company with an income alternative to
loans.  The Company’s investment securities portfolio increased
$8,638,000, or 18.3%, during 2008 to $55,879,000.  This growth in the
available-for-sale portion of its portfolio was part of a leveraging strategy in
response to the FOMC’s continued interest rate cuts.  The increase in
the portfolio was funded through Federal Home Loan Bank advances.  The
Company’s investment securities portfolio increased $4,529,000, or 10.6%, during
2007 to $47,241,000 at year end from $42,712,000 in 2006.





The
Company regularly reviews its investment portfolio to determine whether any of
its securities are other than temporarily impaired.  In addition to
accounting and regulatory guidance, in determining whether a security is other
than temporarily impaired, the Company considers duration and amount of each
unrealized loss, the financial condition of the issuer, and the prospects for a
change in market value and net asset value within a reasonable period of
time.  The Company also considers cash flow analysis for
mortgage-backed securities under various prepayment, default, and loss severity
scenarios in determining whether a mortgage-backed security is other than
temporarily impaired.  At December 31, 2008, the Company owned eight
securities in a continuous unrealized loss position for twelve months or longer,
with a carrying value of $5.8 million and fair value of $5.2
million.  These securities that have been in a continuous unrealized
loss position for twelve months or longer at December 31, 2008, had investment
grade ratings upon purchase.  The issuers of these securities have
not, to the Company’s knowledge, established any cause for default and the
various rating agencies have reaffirmed the securities’ long-term investment
grade status at December 31, 2008.  Following its evaluation of
factors deemed relevant, management determined, in part because the Company has
the ability and the intent to hold these investments until recovery of fair
value, which may be at maturity, the Company does not have any other than
temporarily impaired securities at December 31, 2008.  For more
information regarding our investment securities and analysis of the value of
securities in our investment portfolio, see Note 3 - “Securities” and Note 17 –
“Fair Value of Financial Instruments” to the Company’s audited financial
statements included in Item 15 of this report and incorporated into Item
8.




28





The
carrying values of investment securities at December 31 in each of the last
three years are as follows:





Held
      To Maturity(dollars
      in thousands)
            
            2008
            
            
            2007
            
            
            2006Obligations
      of states and political subdivisions
            
            $
            5,750
            
            
            $
            3,562
            
            
            $
            5,155Mortgage-backed
      securities
            
            
            636
            
            
            
            767
            
            
            
            949Total
            
            $
            6,386
            
            
            $
            4,329
            
            
            $
            6,104





Available
      For Sale(dollars
      in thousands)
            
            2008
            
            
            2007
            
            
            2006U.S.
      Agency securities
            
            $
            1,759
            
            
            $
            3,818
            
            
            $
            8,311Obligations
      of states and political subdivisions
            
            
            19,584
            
            
            
            16,136
            
            
            
            13,619Mortgage-backed
      securities
            
            
            27,205
            
            
            
            18,540
            
            
            
            10,232Corporate
      bonds
            
            
            945
            
            
            
            1,512
            
            
            
            1,512Mutual
      funds
            
            
            —
            
            
            
            2,906
            
            
            
            2,934Total
            
            $
            49,493
            
            
            $
            42,912
            
            
            $
            36,608





The
following table presents the maturities of investment securities at December 31,
2008.  Taxable equivalent values are used in calculating yields
assuming a tax rate of 34%.





Held
      To Maturity
              
              (dollars
      in thousands)
            
            Due
      in one year or less
            
            
            Due
      after
              one
      through five years
            
            
            Due
      after
              five
      through
              ten
      years
            
            
            Due
      after ten years
            
            
            TotalObligations
      of states andpolitical
      subdivisions
            
            $
            18
            
            
            $
            959
            
            
            $
            807
            
            
            $
            3,966
            
            
            $
            5,750Weighted
      average yield
            
            
            11.41
            %
            
            
            6.55
            %
            
            
            5.86
            %
            
            
            6.58
            %Mortgage-backed
      securities
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            636
            
            
            
            636Weighted
      average yield
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            5.59
            %Total
            
            $
            18
            
            
            $
            959
            
            
            $
            807
            
            
            $
            4,602
            
            
            $
            6,386





Available
      For Sale
              
              (dollars
      in thousands)
            
            Due
      in one year or less
            
            
            Due
      after
              one
      through five years
            
            
            Due
      after
              five
      through
              ten
      years
            
            
            Due
      after ten years
            
            
            TotalU.S.
      Agency securities
            
            $
            —
            
            
            $
            1,017
            
            
            $
            —
            
            
            $
            742
            
            
            $
            1,759Weighted
      average yield
            
            
            —
            
            
            
            5.75
            %
            
            
            —
            
            
            
            5.86
            %Obligations
      of states andpolitical
      subdivisions
            
            
            1,575
            
            
            
            4,839
            
            
            
            3,582
            
            
            
            9,588
            
            
            
            19,584Weighted
      average yield
            
            
            6.35
            %
            
            
            5.27
            %
            
            
            5.20
            %
            
            
            6.06
            %Mortgage-backed
      securities
            
            
            169
            
            
            
            97
            
            
            
            5,423
            
            
            
            21,516
            
            
            
            27,205Weighted
      average yield
            
            
            4.01
            %
            
            
            3.65
            %
            
            
            4.90
            %
            
            
            5.45
            %Other
      securities
            
            
            945
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            945Weighted
      average yield
            
            
            4.26
            %
            
            
            —
            
            
            
            —
            
            
            
            —Total
            
            $
            2,689
            
            
            $
            5,953
            
            
            $
            9,005
            
            
            $
            31,846
            
            
            $
            49,493




29




Loan
Portfolio





General.  The
Company’s strategy is to originate loans primarily in its local
markets.  Depending on the purpose of the loan, loans may be secured
by a variety of collateral, including real estate, business assets, and personal
assets.  Loans, including loans held for sale, represented 80% of
total assets as of December 31, 2008, compared to 81% at December 31,
2007.  The majority of the Company’s loan portfolio is comprised of
commercial and industrial loans (“commercial loans”) and real estate
loans.  The commercial and industrial loans are a diverse group of
loans to small, medium, and large businesses for purposes ranging from working
capital needs to term financing of equipment.





The
majority of recent growth in our overall loan portfolio has arisen out of the
commercial real estate and real estate construction loan categories, which
constitute 37.9% and 20.2%, respectively, of our loan portfolio.  Our
commercial real estate portfolio generally consists of a wide cross-section of
retail, small office, warehouse, and industrial type properties.  Loan
to value ratios for the Company’s commercial real estate loans generally did not
exceed 75% at origination and debt service ratios were generally 125% or
better.  While we have significant balances within this lending
category, we believe that our lending policies and underwriting standards are
sufficient to reduce risk even in a downturn in the commercial real estate
market.  Additionally, this is a sector in which we have significant
and long-term management experience.





Real
estate construction loans and land development loans have been significant in
our loan portfolio and have been an important source of interest income and
fees.  Conditions in the real estate markets in our market areas have
slowed considerably, and we have seen increasing delinquencies and foreclosures
in this portion of our portfolio, which have contributed to the increased
provision for credit losses in the current year.  The Company does not
originate subprime residential mortgage loans, nor does it hold any in its loan
portfolio.




Beginning
in late 2006 and continuing into 2007, the Company strengthened its underwriting
criteria for advance rates on raw land loans, land development loans,
residential lots, speculative construction for condominiums and all construction
loans as the housing market softened.  Additionally, during 2008, the
Company put in place further restrictions on loans secured by all types of real
estate properties, including home equity lines of credit and land and land
development loans, and tightened underwriting policies on hospitality
projects.  It is our strategic plan to emphasize growth in commercial
and small business loans.  We believe this will be a key contributor
to growing more low cost deposits.





The
following table sets forth the composition of the Company’s loan portfolio
(including loans held for sale) at December 31 in each of the past five
years.





(dollars in
      thousands)
            
            2008
            
            
            2007
            
            
            2006
            
            
            2005
            
            
            2004Commercial
            
            $
            91,888
            
            
            $
            128,145
            
            
            $
            132,843
            
            
            $
            124,536
            
            
            $
            111,050Real
      estate construction
            
            
            100,725
            
            
            
            93,249
            
            
            
            87,063
            
            
            
            87,621
            
            
            
            49,347Real
      estate mortgage residential
            
            
            108,420
            
            
            
            87,094
            
            
            
            91,598
            
            
            
            67,858
            
            
            
            63,268Real
      estate commercial
            
            
            188,444
            
            
            
            137,620
            
            
            
            117,608
            
            
            
            117,645
            
            
            
            112,743Installment
            
            
            7,293
            
            
            
            7,283
            
            
            
            8,668
            
            
            
            9,945
            
            
            
            9,653Credit
      cards and overdrafts
            
            
            1,959
            
            
            
            3,363
            
            
            
            1,990
            
            
            
            1,863
            
            
            
            1,979Less
      unearned income
            
            
            (925
            )
            
            
            (681
            )
            
            
            (601
            )
            
            
            (487
            )
            
            
            (281
            )Total
            
            $
            497,804
            
            
            $
            456,073
            
            
            $
            439,169
            
            
            $
            408,981
            
            
            $
            347,759




30




Loan
Maturities and Sensitivity in Interest Rates.The following table
presents information related to maturity distribution and interest rate
sensitivity of commercial and real estate construction loans outstanding, based
on scheduled repayments at December 31, 2008.




Due
      afterDue
      in one
                        
                        
                        one
      through
                        
                        
                        Due
      after(dollars in thousands)
                        
                        year or less
                        
                        
                        five years
                        
                        
                        five years
                        
                        
                        TotalCommercial
                        
                        $
                        30,024
                        
                        
                        $
                        27,995
                        
                        
                        $
                        33,869
                        
                        
                        $
                        91,888Real
      estate construction
                        
                        
                        81,190
                        
                        
                        
                        10,736
                        
                        
                        
                        8,799
                        
                        
                        
                        100,725Real
      estate mortgage residential
                        
                        
                        12,104
                        
                        
                        
                        15,088
                        
                        
                        
                        81,228
                        
                        
                        
                        108,420Real
      estate commercial
                        
                        
                        14,274
                        
                        
                        
                        28,587
                        
                        
                        
                        145,583
                        
                        
                        
                        188,444Installment
                        
                        
                        1,687
                        
                        
                        
                        3,860
                        
                        
                        
                        1,746
                        
                        
                        
                        7,293Credit
      cards and overdrafts
                        
                        
                        1,959
                        
                        
                        
                        —
                        
                        
                        
                        —
                        
                        
                        
                        1,959Total
                        
                        $
                        141,238
                        
                        
                        $
                        86,266
                        
                        
                        $
                        271,225
                        
                        
                        $
                        498,729Less
      unearned income
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        (925
                        )Total
      loans
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        $
                        497,804Total
      loans maturing after one year withPredetermined
      interest rates (fixed)
                        
                        
                        
                        
                        
                        $
                        42,507
                        
                        
                        $
                        91,035
                        
                        
                        $
                        133,542Floating
      or adjustable rates (variable)
                        
                        
                        
                        
                        
                        
                        125,993
                        
                        
                        
                        4,636
                        
                        
                        
                        130,629Total
                        
                        
                        
                        
                        
                        $
                        168,500
                        
                        
                        $
                        95,671
                        
                        
                        $
                        264,171
  At
December 31, 2008, 27.9% of the total loan portfolio presented above was due in
one year or less.





Nonperforming
Assets.  Nonperforming assets are defined as loans on
non-accrual status, loans past due ninety days or more and still accruing
interest, loans which have been restructured to provide reduction or deferral of
interest or principal for reasons related to the debtor’s financial
difficulties, and foreclosed real estate.  The Company’s policy for
placing loans on non-accrual status is based upon management’s evaluation of the
ability of the borrower to meet both principal and interest payments as they
become due.  Generally, loans with interest or principal payments
which are ninety or more days past due are placed on non-accrual (unless they
are well-secured and in the process of collection) and previously accrued
interest is reversed against income.





The
following table presents information related to the Company’s non-accrual loans
and other non-performing assets at December 31 in each of the last five
years.





(dollars
      in thousands)
              
              2008
              
              
              2007
              
              
              2006
              
              
              2005
              
              
              2004Non-accrual
      loans
              
              $
              14,676
              
              
              $
              3,479
              
              
              $
              7,335
              
              
              $
              6,650
              
              
              $
              470Accruing
      loans past due 90days
      or more
              
              
              2,274
              
              
              
              2,932
              
              
              
              376
              
              
              
              82
              
              
              
              —Restructured
      loans
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              —Foreclosed
      real estate
              
              
              6,810
              
              
              
              —
              
              
              
              —
              
              
              
              37
              
              
              
              40







31




Non-accrual
loans totaled $14,676,000 at December 31, 2008, an increase of $11,197,000 as
compared to $3,479,000 at December 31, 2007.  The balance of
non-accrual loans at year end is equal to 2.95% of total loans including loans
held for sale, compared to 0.76% at December 31, 2007.  The totals are
net of charge-offs based on the difference between carrying value on our books
and management’s estimate of fair market value after taking into account the
result of appraisals and other factors.  The increase in non-accrual
loans during the year was primarily related to non-performing construction and
land development loans, which contributed $11,787,000 of the $14,676,000 balance
outstanding at December 31, 2008.  Of the non-accrual loans at year
end 2006 and 2005, $5,603,000 and $5,817,000 related to one borrower involved in
the forest products industry.  The improvement in non-accrual loans in
2007 resulted from the resolution of this loan.  Loans past due ninety
days or more and still accruing interest of $2,274,000 and $2,932,000 at
December 31, 2008 and 2007, respectively, were made up entirely of loans that
were fully guaranteed by the United States Department of
Agriculture.





Foreclosed
real estate at December 31, 2008 totaled $6,810,000 and is made up as
follows:  seven land or land development properties totaling
$4,187,000; one partially completed commercial warehouse building totaling
$1,256,000, and two spec houses totaling $1,367,000.  The Company has
updated appraisals on all foreclosed real estate properties.  The
balances are recorded at the estimated net realizable value less selling
costs.  Sales of foreclosed real estate owned totaled $1,109,000, $0,
and $42,000 during 2008, 2007 and 2006, respectively.





Interest
income on non-accrual loans that would have been recorded had those loans
performed in accordance with their initial terms, as of December 31, was
$1,090,000, $270,000, and $306,000 for 2008, 2007, and 2006,
respectively.  Interest income recognized on impaired loans was
$34,000, $457,000, and $272,000 for 2008, 2007, and 2006,
respectively.





Loan
Concentrations.  The Company has credit risk exposure related
to real estate loans.  The Company makes loans for acquisition,
construction and other purposes that are secured by real estate.  At
December 31, 2008, loans secured by real estate totaled $397,589,000, which
represents 79.8% of the total loan portfolio.  Real estate
construction loans comprised $100,725,000 of that amount, while real estate
loans secured by residential properties totaled $108,420,000.  As a
result of these concentrations of loans, the loan portfolio is susceptible to
deteriorating economic and market conditions in the Company’s market
areas.  The Company generally requires collateral on all real estate
exposures and typically originates loans at loan-to-value ratios of no greater
than 80%.





Allowance
and Provision for Credit Losses.  The allowance for credit
losses reflects management's current estimate of the amount required to absorb
losses on existing loans and commitments to extend credit.  Loans deemed
uncollectible are charged against and reduce the
allowance.  Periodically, a provision for credit losses is charged to
current expense.  This provision acts to replenish the allowance for
credit losses and to maintain the allowance at a level that management deems
adequate.  There is no precise method of predicting specific loan
losses or amounts that ultimately may be charged off on segments of the loan
portfolio.  The determination that a loan may become uncollectible, in
whole or in part, is a matter of judgment.  Similarly, the adequacy of
the allowance for credit losses can be determined only on a judgmental basis,
after full review, including (a) consideration of economic conditions and the
effect on particular industries and specific borrowers; (b) a review of
borrowers’ financial data, together with industry data, the competitive
situation, the borrowers’ management capabilities and other factors; (c) a
continuing evaluation of the loan portfolio, including monitoring by lending
officers and staff credit personnel of all loans which are identified as being
of less than acceptable quality; (d) an in-depth appraisal, on a monthly basis,
of all loans judged to present a possibility of loss (if, as a result of such
monthly appraisals, the loan is judged to be not fully collectible, the carrying
value of the loan is reduced to that portion considered collectible); and (e) an
evaluation of the underlying collateral for secured lending, including the use
of independent appraisals of real estate properties securing loans.  A
formal analysis of the adequacy of the allowance is conducted quarterly and is
reviewed by the Board of Directors.  See “Risk Factors” above for a
discussion of certain risks faced by the Company.




32





Periodic
provisions for loan losses are made to maintain the allowance for credit losses
at an appropriate level.  The provisions are based on an analysis of
various factors including historical loss experience by volumes and types of
loans, volumes and trends in delinquencies and non-accrual loans, trends in
portfolio volume, results of internal and independent external credit reviews,
and anticipated economic conditions.





Transactions
in the allowance for credit losses for the five years ended December 31, 2008
are as follows:




(dollars
      in thousands)
            
            2008
            
            
            2007
            
            
            2006
            
            
            2005
            
            
            2004Balance
      at beginning of year
            
            $
            5,007
            
            
            $
            4,033
            
            
            $
            5,296
            
            
            $
            4,236
            
            
            $
            2,238Charge-offs:Commercial
            
            
            18
            
            
            
            —
            
            
            
            1,925
            
            
            
            41
            
            
            
            235Real
      estate loans
            
            
            2,053
            
            
            
            40
            
            
            
            —
            
            
            
            —
            
            
            
            18Credit
      card
            
            
            66
            
            
            
            18
            
            
            
            16
            
            
            
            7
            
            
            
            11Installment
            
            
            89
            
            
            
            93
            
            
            
            4
            
            
            
            17
            
            
            
            11Total
      charge-offs
            
            
            2,226
            
            
            
            151
            
            
            
            1,945
            
            
            
            65
            
            
            
            275Recoveries:Commercial
            
            
            —
            
            
            
            619
            
            
            
            —
            
            
            
            3
            
            
            
            7Real
      estate loans
            
            
            40
            
            
            
            21
            
            
            
            51
            
            
            
            19
            
            
            
            123Credit
      card
            
            
            2
            
            
            
            2
            
            
            
            5
            
            
            
            1
            
            
            
            1Installment
            
            
            9
            
            
            
            1
            
            
            
            1
            
            
            
            2
            
            
            
            —Total
      recoveries
            
            
            51
            
            
            
            643
            
            
            
            57
            
            
            
            25
            
            
            
            131Net
      charge-offs (recoveries)
            
            
            2,175
            
            
            
            (492
            )
            
            
            1,888
            
            
            
            40
            
            
            
            144Provision
      for credit losses
            
            
            4,791
            
            
            
            482
            
            
            
            625
            
            
            
            1,100
            
            
            
            970BNW
      Bancorp, Inc. acquisition
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            1,172Balance
      at end of year
            
            $
            7,623
            
            
            $
            5,007
            
            
            $
            4,033
            
            
            $
            5,296
            
            
            $
            4,236Ratio
      of net charge-offs (recoveries)to
      average loans outstanding
            
            
            .46
            %
            
            
            (.11
            %)
            
            
            .45
            %
            
            
            .01
            %
            
            
            .05
            %





During
the year ended December 31, 2008, provision for credit losses totaled $4,791,000
compared to $482,000 for the same period in 2007.  The significant
increase in provision for credit losses in the current year is the result of
changes in loan loss rates and the increase in substandard loans primarily
within our land acquisition and development and residential construction loan
portfolios.  In addition, we have experienced increasing levels of
delinquent and nonperforming loans.  The increasing risk profile of
the Company’s land acquisition and development portfolio reflects unfavorable
conditions in the residential real estate market that have affected the ability
of home builders and developers to repay loans due to reduced cash flows from
sluggish sales.  In addition, the value of collateral for many of
these loans has declined and the market is significantly less
liquid.





For the
year ended December 31, 2008, net charge-offs were $2,175,000 compared to net
recoveries of $492,000 for the same period in 2007.  The increase in
charge-offs for the period was primarily attributable to write-downs totaling
$1,904,000 on five construction and/or land development loans as the result of
re-appraisals on the properties.  Net recoveries for the twelve months
ended December 31, 2007 were $492,000 which included a single recovery of
$619,000 on the $1,925,000 charge-off in 2006 that was attributable to one
commercial borrower.




33




The
allowance for credit losses was $7,623,000 at year-end 2008, compared with
$5,007,000 at year-end 2007, an increase of $2,616,000 or 52.2%.  The
increase from December 31, 2007 is attributable to additional credit loss
provision and is reflective of deteriorating economic conditions in our
markets.  The increase in 2007 was due to increased recoveries and
provision expense.  The increased level of allowance for credit losses
in 2006 and 2005 was primarily due to the growth of the loan
portfolio.





Estimated
loss factors used in the allowance for credit loss analysis are established
based in part on historic charge-off data by loan category and economic
conditions.  During the year ended December 31, 2008, the loss factors
used in the allowance for credit losses were updated based on trends in
historical charge-offs, portfolio migration analysis, and other qualitative
factors.  Although the adequacy of the allowance is reviewed
quarterly, management performs an ongoing assessment of the risks inherent in
the portfolio.  As of December 31, 2008, management deems the
allowance for credit losses of $7,623,000 (1.57% of total loans outstanding and
44.97% of non-performing loans) adequate to provide for probable losses in our
loan portfolio based on an evaluation of known and inherent risks in the loan
portfolio at that date.  The Company’s loan portfolio contains a
significant portion of government guaranteed loans which are fully guaranteed by
the United States Government.  Government guaranteed loans were
$49,934,000 and $49,948,000 at December 31, 2008 and 2007,
respectively.  The ratio of allowance for credit losses to total loans
outstanding excluding the government guaranteed loans was 1.70% and 1.23%,
respectively.





The
Financial Accounting Standards Board (FASB) has issued SFAS No. 114, “Accounting
by Creditors for Impairment of a Loan” and SFAS No. 118, “Accounting by
Creditors for Impairment of a Loan—Income Recognition Disclosures, an amendment
to SFAS No. 114”.  The Company measures impaired loans based on the present
value of expected future cash flows discounted at the loan’s effective interest
rate or, as a practical expedient, at the loan’s observable market price or the
fair market value of the collateral if the loan is collateral dependent. 
The Company excludes loans that are currently measured at fair value or at the
lower of cost or fair value, and certain large groups of smaller balance
homogeneous loans that are collectively measured for impairment.





The
following table summarizes the Bank’s impaired loans at December
31:





(dollars
      in thousands)
            
            2008
            
            
            2007
            
            
            2006
            
            
            2005
            
            
            2004Total
      impaired loans
            
            $
            22,117
            
            
            $
            6,431
            
            
            $
            7,379
            
            
            $
            6,650
            
            
            $
            7,934Total
      impaired loans withvaluation
      allowance
            
            
            462
            
            
            
            3,052
            
            
            
            51
            
            
            
            4,917
            
            
            
            7,464Valuation
      allowance related toimpaired
      loans
            
            
            118
            
            
            
            72
            
            
            
            17
            
            
            
            924
            
            
            
            200





No
valuation allowance for credit losses was considered necessary for the remaining
impaired loans.  The balance of the allowance for credit losses in
excess of these specific reserves is available to absorb losses from all
loans.





It is the
Company’s policy to charge-off any loan or portion of a loan that is deemed
uncollectible in the ordinary course of business.  The entire allowance for
credit losses is available to absorb such charge-offs.





The
Company allocates its allowance for credit losses among major loan
categories primarily on the basis of historical data.  Based on certain
characteristics of the portfolio and management’s analysis, losses can be
estimated for major loan categories.  The following table presents the
allocation of the allowance for credit losses among the major loan categories
based primarily on historical net charge-off experience and other business
considerations at December 31 in each of the last five years.




34




%
      of
              
              
              
              
              
              %
      of
              
              
              
              
              
              %
      of
              
              
              
              
              
              %
      of
              
              
              
              
              
              %
      of2008
              
              
              Total
              
              
              2007
              
              
              Total
              
              
              2006
              
              
              Total
              
              
              2005
              
              
              Total
              
              
              2004
              
              
              Total(dollars in thousands)
              
              Reserve
              
              
              Loans
              
              
              Reserve
              
              
              Loans
              
              
              Reserve
              
              
              Loans
              
              
              Reserve
              
              
              Loans
              
              
              Reserve
              
              
              LoansCommercial
      loans
              
              $
              1,392
              
              
              
              18
              %
              
              $
              1,780
              
              
              
              36
              %
              
              $
              1,705
              
              
              
              42
              %
              
              $
              1,589
              
              
              
              32
              %
              
              $
              1,680
              
              
              
              32
              %Real
      estate loans
              
              
              5,975
              
              
              
              79
              %
              
              
              3,016
              
              
              
              60
              %
              
              
              2,167
              
              
              
              54
              %
              
              
              3,548
              
              
              
              65
              %
              
              
              2,432
              
              
              
              65
              %Consumer
      loans
              
              
              256
              
              
              
              3
              %
              
              
              211
              
              
              
              4
              %
              
              
              161
              
              
              
              4
              %
              
              
              159
              
              
              
              3
              %
              
              
              124
              
              
              
              3
              %Total
      allowance
              
              $
              7,623
              
              
              
              100
              %
              
              $
              5,007
              
              
              
              100
              %
              
              $
              4,033
              
              
              
              100
              %
              
              $
              5,296
              
              
              
              100
              %
              
              $
              4,236
              
              
              
              100
              %Ratio
      of allowance for creditlosses
      to loans outstandingat
      end of year
              
              
              1.57
              %
              
              
              
              
              
              
              1.14
              %
              
              
              
              
              
              
              .95
              %
              
              
              
              
              
              
              1.33
              %
              
              
              
              
              
              
              1.23
              %


The table
indicates an increase of $2,959,000 in the allowance related to real estate
loans from December 31, 2007 to December 31, 2008.  The primary reason
for the increases and changes in percentage allocations are due to the
deterioration in the housing market in our market areas, as well as an increase
in the loan loss rates relative to real estate loans.





Deposits





The
Company’s primary source of funds has historically been customer
deposits.  A variety of deposit products are offered to attract
customer deposits.  These products include non-interest bearing demand
accounts, negotiable order of withdrawal (NOW) accounts, savings accounts, and
time deposits.  Interest-bearing accounts earn interest at rates
established by management, based on competitive market factors and the need to
increase or decrease certain types of maturities of deposits.  The
Company has succeeded in growing its deposit base over the last three years
despite increasing competition for deposits in our markets.  The
Company believes that it has benefited from its local identity and superior
customer service.  Attracting deposits remains integral to the
Company’s business as it is the primary source of funds for loans and a major
decline in deposits or failure to attract deposits in the future could have an
adverse effect on operations.  The Company relies primarily on its
branch staff and current customer relationships to attract and retain
deposits.  The Company’s strategic plan contemplates and focuses on
continued growth in non-interest bearing accounts which contribute to higher
levels of non-interest income and net interest margin.  We expect
significant competition for deposits of this nature to continue for the
foreseeable future.  As noted in the table below, our balance of
non-interest bearing demand deposits declined from $87,467,000 at December 31,
2007 to $82,620,000 at December 31, 2008.





The
following table sets forth the average balances for each major category of
deposits and the weighted average interest rate paid for deposits for the
periods indicated.





(dollars
      in thousands)
            
            2008
            
            
            Rate
            
            
            2007
            
            
            Rate
            
            
            2006
            
            
            RateNon-interest
      bearing demanddeposits
            
            $
            82,620
            
            
            
            0.00
            %
            
            $
            87,467
            
            
            
            0.00
            %
            
            $
            84,846
            
            
            
            0.00
            %Interest
      bearing demand deposits
            
            
            53,816
            
            
            
            0.81
            %
            
            
            42,803
            
            
            
            0.48
            %
            
            
            48,140
            
            
            
            0.57
            %Savings
      deposits
            
            
            150,723
            
            
            
            1.64
            %
            
            
            151,553
            
            
            
            3.13
            %
            
            
            147,781
            
            
            
            2.96
            %Time
      deposits
            
            
            186,319
            
            
            
            3.70
            %
            
            
            177,362
            
            
            
            4.80
            %
            
            
            148,055
            
            
            
            4.18
            %Total
            
            $
            473,478
            
            
            
            2.07
            %
            
            $
            459,185
            
            
            
            2.93
            %
            
            $
            428,822
            
            
            
            2.53
            %




35




Maturities
of time certificates of deposit as of December 31, 2008 are summarized as
follows:




(dollars
      in thousands)
            
            Under
              $100,000
            
            
            Over
              $100,000
            
            
            Total3
      months or less
            
            $
            20,397
            
            
            $
            71,745
            
            
            $
            92,142Over
      3 through 6 months
            
            
            12,253
            
            
            
            14,894
            
            
            
            27,147Over
      6 through 12 months
            
            
            19,375
            
            
            
            29,177
            
            
            
            48,552Over
      12 months
            
            
            21,948
            
            
            
            28,175
            
            
            
            50,123Total
            
            $
            73,973
            
            
            $
            143,991
            
            
            $
            217,964





Total
deposits increased 9.4% to $511.3 million at December 31, 2008 compared to
$467.3 million at December 31, 2007, due to the launch of a high-yield retail
checking account which was introduced to attract new deposits, and an increase
in brokered time certificates of deposits.  The Dream Checking account
pays a high rate of interest upon meeting certain electronic requirements such
as debit card and automated clearing house transactions.  At December
31, 2008, the balances in Dream Checking accounts totaled $15,264,000, of which
$6,658,000 was new money.





To
further attract deposits, the Company has increased its emphasis on enhancing
its cash management product line.  During the fourth quarter of 2008,
the Company began offering remote deposit captures services and is in the
process of migrating to a new online banking platform that will enhance
electronic services including e-statements and mobile
banking.  Additionally, during the fourth quarter of 2008, the Company
began offering Certificate of Deposit Registry Service (CDARSTM)
deposits.  Through the CDARSTM program, customers can now access FDIC
insurance up to $50 million.





The ratio
of non-interest bearing deposits to total deposits was 15.7% and 18.6% at
December 31, 2008 and 2007, respectively.  Total deposits of $467.3
million at December 31, 2007, were relatively flat compared to $466.8 million at
December 31, 2006.  Year over year we primarily experienced a shift in
total deposits with increases in money market accounts from a business
investment sweep product launched in 2007, that were almost entirely offset by
decreases in non-interest bearing demand deposits.





The
Company obtains deposits from the communities it serves.  In addition,
management’s strategy for funding asset growth is to make use of brokered and
other wholesale deposits on an as-needed basis.  Brokered deposits
totaled $35,305,000 and $5,000,000 at December 31, 2008 and 2007,
respectively.  The Bank believes that its brokered deposits and its
jumbo certificates, which represented 6.9% and 28.2% of total deposits at
December 31, 2008, respectively, present similar interest rate risk compared to
its other deposits.





Short-Term
Borrowings





The
following is information regarding the Company’s short-term borrowings for the
years ended December 31, 2008, 2007 and 2006.





(dollars in
      thousands)
            
            2008
            
            
            2007
            
            
            2006Amount
      outstanding at end of period
            
            $
            23,500
            
            
            $
            10,125
            
            
            $
            —Weighted
      average interest rate thereon
            
            
            2.37
            %
            
            
            4.26
            %
            
            
            —
            %Maximum
      month-end balance during the year
            
            
            34,290
            
            
            
            18,695
            
            
            
            6,500Average
      balance during the year
            
            
            13,398
            
            
            
            5,961
            
            
            
            1,388Average
      interest rate during the year
            
            
            2.61
            %
            
            
            5.52
            %
            
            
            5.40
            %




36




CONTRACTUAL
OBLIGATIONS





The
Company is party to many contractual financial obligations at December 31, 2008,
including without limitation, borrowings from the Federal Home Loan Bank of
Seattle, Junior Subordinated Debentures and operating leases for branch
locations.  The following is information regarding the dates payments
of such obligations are due.





Payments
      due by PeriodContractual
      obligations
              
              Less
      than
                1
      year
              
              
              1
      – 3 years
              
              
              3
      – 5 years
              
              
              More
      than
                5
      years
              
              
              TotalOperating
      leases
              
              $
              304
              
              
              $
              355
              
              
              $
              117
              
              
              $
              —
              
              
              $
              776Total
      deposits
              
              
              461,184
              
              
              
              41,099
              
              
              
              9,024
              
              
              
              —
              
              
              
              511,307Federal
      Home Loan Bank borrowings
              
              
              —
              
              
              
              15,000
              
              
              
              7,500
              
              
              
              —
              
              
              
              22,500Secured
      borrowings
              
              
              330
              
              
              
              163
              
              
              
              861
              
              
              
              —
              
              
              
              1,354Junior
      subordinated debentures
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              13,403
              
              
              
              13,403Total
      long-term obligations
              
              $
              461,818
              
              
              $
              56,617
              
              
              $
              17,502
              
              
              $
              13,403
              
              
              $
              549,340





COMMITMENTS
AND CONTINGENCIES AND OFF-BALANCE SHEET ARRANGEMENTS





The Bank
is party to financial instruments with off-balance-sheet risk in the normal
course of business to meet the financing needs of its
customers.  These financial instruments include commitments to extend
credit and standby letters of credit, and involve, to varying degrees, elements
of credit risk in excess of the amount recognized on the consolidated balance
sheets.





The
Bank’s exposure to credit loss in the event of nonperformance by the other party
to the financial instrument for commitments to extend credit and standby letters
of credit is represented by the contractual amount of those
instruments.  The Bank uses the same credit policies in making
commitments and conditional obligations as they do for on-balance-sheet
instruments.  A summary of the Bank’s commitments at December 31 is as
follows:




2008
              
              
              2007Commitments
      to extend credit
              
              $
              101,459
              
              
              $
              108,095Standby
      letters of credit
              
              
              1,519
              
              
              
              3,489




KEY
FINANCIAL RATIOS





Year
      ended December 31,
            
            2008
            
            
            2007
            
            
            2006
            
            
            2005
            
            
            2004Return
      on average assets
            
            
            .16
            %
            
            
            1.08
            %
            
            
            1.26
            %
            
            
            1.31
            %
            
            
            1.41
            %Return
      on average equity
            
            
            1.83
            %
            
            
            11.46
            %
            
            
            13.16
            %
            
            
            12.70
            %
            
            
            14.21
            %Average
      equity to average assets ratio
            
            
            8.89
            %
            
            
            9.41
            %
            
            
            9.60
            %
            
            
            10.30
            %
            
            
            9.91
            %Dividend
      payout ratio
            
            
            35
            %
            
            
            82
            %
            
            
            75
            %
            
            
            78
            %
            
            
            81
            %





LIQUIDITY
AND CAPITAL RESOURCES





Liquidity.  The
primary concern of depositors, creditors and regulators is the Company’s ability
to have sufficient funds readily available to repay liabilities as they
mature.  In order to evaluate whether adequate funds are and will be
available at all times, the Company monitors and projects the amount of funds
required on a daily basis.  The Bank's primary source of liquidity is
deposits from its customer base, which has historically provided a stable source
of “core” demand and consumer deposits.  Other sources of liquidity
are available, including borrowings from the Federal Home Loan Bank of Seattle
and from correspondent banks.  Liquidity requirements can also be met
through disposition of short-term assets.  In management’s opinion,
the Company maintains an adequate level of liquid assets for its known and
reasonably foreseeable liquidity requirements, consisting of cash and amounts
due from banks, interest bearing deposits and federal funds sold to support the
daily cash flow requirements.




37





Management
expects to continue to rely on customer deposits as the primary source of
liquidity, but may also obtain liquidity from maturity of its investment
securities, sale of securities currently available for sale, loan sales,
brokered deposits, government sponsored programs, loan repayments, net income,
and other borrowings.  Although deposit balances have shown historical
growth, deposit habits of customers may be influenced by changes in the
financial services industry, interest rates available on other investments,
general economic conditions, consumer confidence, and
competition.  Competition for deposits is presently quite intense,
even in our traditional markets of operations, making deposit retention
challenging and new deposit growth quite difficult.  Borrowings may be
used on a short-term basis to compensate for reductions in deposits, but are
generally not considered a long term solution to liquidity
issues.  Therefore, reductions in deposits could adversely affect the
Company’s financial condition, results of operations, and
liquidity.  See “Risk Factors” under Item 1A. above.





The
holding company specifically relies on dividends from the Bank, proceeds from
the exercise of stock options, and proceeds from the issuance of trust preferred
securities for its funds, which are used for various corporate
purposes.  Dividends are the holding Company's most important source
of funds, and are subject to regulatory restrictions and the capital needs of
the Bank, which are always primary.  Sales of trust preferred
securities have historically also been a source of liquidity for the holding
company and capital for both the holding company and the Bank.  We do
not anticipate trust preferred securities will be a source of liquidity in 2009
due to market conditions.





On July
2, 2003, the Federal Reserve issued Supervisory Letter SR 03-13 clarifying that
Bank Holding Companies should continue to report trust preferred securities in
accordance with current Federal Reserve Bank instructions which allows trust
preferred securities to be counted in Tier 1 capital subject to certain
limitations.  The Federal Reserve has indicated it will review the
implications of any accounting treatment changes and, if necessary or warranted,
will provide appropriate guidance.  For additional information
regarding trust preferred securities, this discussion and analysis should be
read in conjunction with our consolidated financial statements and related notes
included elsewhere in this report including Note 8 – “Junior Subordinated
Debentures”.





Capital.  The
Company conducts its business through the Bank.  Thus, the Company
needs to be able to provide capital and financing to the Bank should the need
arise.  The primary sources for obtaining capital are additional stock
sales and retained earnings.  Total shareholders’ equity averaged
$51,974,000 in 2008, which includes $11,282,000 of goodwill associated with the
BNW acquisition.  Shareholders’ equity averaged $52,634,000 in 2007,
compared to $49,787,000 in 2006.





The
Company’s Board of Directors considers financial results, growth plans, and
anticipated capital needs in formulating its dividend policy.  The
payment of dividends is subject to adequate financial resources at the Bank,
which depend in part on operating results, and limitations imposed by law and
governmental regulations or actions of regulators.





The
Federal Reserve has established guidelines that mandate risk-based capital
requirements for bank holding companies.  Under the guidelines, one of
four risk weights is applied to balance sheet assets, each with different
capital requirements based on the credit risk of the asset.  The
Company’s capital ratios include the assets of the Bank on a consolidated basis
in accordance with the requirements of the Federal Reserve.   The
Company’s capital ratios have exceeded the minimum required to be classified
“well capitalized” at the close of each of the past three years.




38





The
following table sets forth the minimum required capital ratios and actual ratios
for December 31, 2008 and 2007.





Actual
            
            
            
            
            
            Capital
      Adequacy Purposes(dollars
      in thousands)
            
            Amount
            
            
            Ratio
            
            
            Amount
            
            
            RatioDecember
      31, 2008Tier
      1 capital (to average assets)Consolidated
            
            $
            53,011
            
            
            
            8.87
            %
            
            $
            23,905
            
            
            
            4.00
            %Bank
            
            
            52,181
            
            
            
            8.75
            %
            
            
            23,858
            
            
            
            4.00
            %Tier
      1 capital (to risk-weighted assets)Consolidated
            
            
            53,011
            
            
            
            10.54
            %
            
            
            20,117
            
            
            
            4.00
            %Bank
            
            
            52,181
            
            
            
            10.40
            %
            
            
            20,068
            
            
            
            4.00
            %Total
      capital (to risk-weighted assets)Consolidated
            
            
            59,315
            
            
            
            11.79
            %
            
            
            40,233
            
            
            
            8.00
            %Bank
            
            
            58,470
            
            
            
            11.65
            %
            
            
            40,137
            
            
            
            8.00
            %December
      31, 2007Tier
      1 capital (to average assets)Consolidated
            
            $
            50,825
            
            
            
            9.28
            %
            
            $
            21,906
            
            
            
            4.00
            %Bank
            
            
            50,210
            
            
            
            9.19
            %
            
            
            21,860
            
            
            
            4.00
            %Tier
      1 capital (to risk-weighted assets)Consolidated
            
            
            50,825
            
            
            
            11.37
            %
            
            
            17,887
            
            
            
            4.00
            %Bank
            
            
            50,210
            
            
            
            11.26
            %
            
            
            17,840
            
            
            
            4.00
            %Total
      capital (to risk-weighted assets)Consolidated
            
            
            55,832
            
            
            
            12.49
            %
            
            
            35,774
            
            
            
            8.00
            %Bank
            
            
            55,217
            
            
            
            12.38
            %
            
            
            35,679
            
            
            
            8.00
            %





New
Accounting Pronouncements.  For a discussion
of new accounting pronouncements and their impact on the Company, see Note 1 of
the Notes to the Consolidated Financial Statements included in Item 15 of this
report and incorporated into Item 8 of this Form 10-K.





CRITICAL
ACCOUNTING POLICIES





The
Company’s consolidated financial statements are prepared in accordance with
accounting principles generally accepted in the United States of
America.  The financial information contained within these statements
is, to a significant extent, financial information that is based on approximate
measures of the financial effects of transactions and events that have already
occurred.  Based on its evaluation of accounting policies that involve
the most complex and subjective decisions and assessments, management has
identified the following as its most critical accounting policies.




39





Allowance
for Credit Losses





The
Company’s allowance for credit losses methodology incorporates a variety of risk
considerations, both quantitative and qualitative, in establishing an allowance
for credit losses that management believes is appropriate at each reporting
date.  Quantitative factors include the Company’s historical loss
experience, delinquency and charge-off trends, collateral values, changes in
nonperforming loans, and other factors.  Quantitative factors also
incorporate known information about individual loans, including borrowers’
sensitivity to interest rate movements.  Qualitative factors include
the general economic environment in the Company’s markets, including economic
conditions and, in particular, the state of certain industries.  Size
and complexity of individual credits in relation to loan structure, existing
loan policies and pace of portfolio growth are other qualitative factors that
are considered in the methodology.  As the Company adds new products
and increases the complexity of its loan portfolio, it intends to enhance its
methodology accordingly.  A materially different amount could be
reported for the provision for credit losses in the statement of operations to
change the allowance for credit losses if management’s assessment of the above
factors were different.  This discussion and analysis should be read
in conjunction with the Company’s financial statements and the accompanying
notes presented elsewhere herein, as well as the portion of this Management’s
Discussion and Analysis section entitled “Allowance and Provision for Credit
Losses.”  See “Risk Factors” above for a discussion of certain risks
faced by the Company.





Goodwill





Goodwill
is initially recorded when the purchase price paid for an acquisition exceeds
the estimated fair value of the net identified tangible and intangible assets
acquired.  Goodwill is presumed to have an indefinite useful life and
is tested, at least annually, for impairment at the reporting unit
level.  The Company performs an annual review each year, or more
frequently if indicators of potential impairment exist, to determine if the
recorded goodwill is impaired.  The Company’s impairment review
process compares the fair value of the Company to its carrying value, including
the goodwill related to the Company.  If the fair value exceeds the
carrying value, goodwill of the Company is not considered impaired and no
additional analysis is necessary.  Due to poor overall economic
conditions, declines in financial stocks, and a challenging operating
environment for the financial services industry, we assessed whether it was
more-likely-than-not that these factors have reduced the fair value of the
Company, which represents one reporting unit, below its carrying amount, and
whether an interim test of goodwill was necessary.  Based on the
results of this analysis, it was determined that it was not more-likely-than-not
that the fair value of the Company has fallen below its carrying amount at
December 31, 2008.





Investment
Valuation and Other-Than-Temporary-Impairment





The
Company records investments in securities available-for-sale at fair value and
securities held-to-maturity at amortized cost.  Fair value is
determined based on quoted prices for similar assets and liabilities traded in
the same market; 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 drivers are observable.  Declines in fair
value below amortized cost are reviewed to determine if they are other than
temporary.  If the decline in fair value is judged to be other than
temporary, the impairment loss is charged to earnings.  Factors
considered in evaluating whether a decline in value is other than temporary
include: (1) the length of time and extent to which the fair value has been less
than amortized cost, (2) the financial condition and near-term prospectus of the
issuer, and (3) the intent and ability of the Company to retain the investment
for a period of time sufficient to allow for any anticipate recovery in fair
value.  The Company regularly reviews its investment portfolio to
determine whether any of its securities are other-than-temporarily
impaired.




40




ASSET
AND LIABILITY MANAGEMENT





The
largest component of the Company’s earnings is net interest
income.  Interest income and interest expense are affected by general
economic conditions, competition in the market place, market interest rates and
repricing and maturity characteristics of the Company’s assets and
liabilities.  Exposure to interest rate risk is primarily a function
of differences between the maturity and repricing schedules of assets
(principally loans and investment securities) and liabilities (principally
deposits).  Assets and liabilities are described as interest
sensitivity for a given period of time when they mature or can reprice within
that period.  The difference between the amount of interest sensitive
assets and interest sensitive liabilities is referred to as the interest
sensitivity “GAP” for any given period.  The “GAP” may be either
positive or negative.  If positive, more assets reprice than
liabilities.   If negative, the reverse is true.





Certain
shortcomings are inherent in the interest sensitivity “GAP” method of
analysis.  Complexities such as prepayment risk and customer responses
to interest rate changes are not taken into account in the “GAP”
analysis.  Accordingly, management also utilizes a net interest income
simulation model to measure interest rate sensitivity.  Simulation
modeling gives a broader view of net interest income variability, by providing
various rate shock exposure estimates.  Management regularly reviews
the interest rate risk position and provides measurement reports to the Board of
Directors.





The
following table shows the dollar amount of interest sensitive assets and
interest sensitive liabilities at December 31, 2008 and differences between them
for the maturity or repricing periods indicated.




(dollars in
      thousands)
                
                Due
      in one year or less
                
                
                Due
      after one through five years
                
                
                Due
      after five years
                
                
                TotalInterest
      earning assetsLoans,
      including loans held for sale
                
                $
                234,412
                
                
                $
                167,618
                
                
                $
                95,774
                
                
                $
                497,804Investment
      securities
                
                
                2,707
                
                
                
                6,912
                
                
                
                46,260
                
                
                
                55,879Fed
      Funds sold and interest bearingbalances
      with banks
                
                
                1,357
                
                
                
                —
                
                
                
                —
                
                
                
                1,357Federal
      Home Loan Bank stock
                
                
                —
                
                
                
                —
                
                
                
                2,170
                
                
                
                2,170Total
      interest earning assets
                
                $
                238,476
                
                
                $
                174,530
                
                
                $
                144,204
                
                
                $
                557,210Interest
      bearing liabilitiesInterest
      bearing demand deposits
                
                $
                68,113
                
                
                $
                —
                
                
                $
                —
                
                
                $
                68,113Savings
      deposits
                
                
                145,164
                
                
                
                —
                
                
                
                —
                
                
                
                145,164Time
      deposits
                
                
                167,841
                
                
                
                50,123
                
                
                
                —
                
                
                
                217,964Short
      term borrowings
                
                
                23,500
                
                
                
                —
                
                
                
                —
                
                
                
                23,500Long
      term borrowings
                
                
                —
                
                
                
                22,500
                
                
                
                —
                
                
                
                22,500Secured
      borrowings
                
                
                330
                
                
                
                1,024
                
                
                
                —
                
                
                
                1,354Junior
      subordinated debentures
                
                
                8,248
                
                
                
                5,155
                
                
                
                —
                
                
                
                13,403Total
      interest bearing liabilities
                
                $
                413,196
                
                
                $
                78,802
                
                
                $
                —
                
                
                $
                491,998Net
      interest rate sensitivity GAP
                
                $
                (174,720
                )
                
                $
                95,728
                
                
                $
                144,204
                
                
                $
                65,212Cumulative
      interest rate sensitivity GAP
                
                
                
                
                
                
                (78,992
                )
                
                
                65,212
                
                
                
                65,212Cumulative
      interest rate sensitivity GAPas
      a % of earning assets
                
                
                
                
                
                
                (14.2
                )%
                
                
                11.7
                %
                
                
                11.7
                %





Effects
of Changing Prices.  The results of operations and financial
condition presented in this report are based on historical cost information, and
are unadjusted for the effects of inflation.  Since the assets and
liabilities of financial institutions are primarily monetary in nature, the
performance of the Company is affected more by changes in interest rates than by
inflation.  Interest rates generally increase as the rate of inflation
increases, but the magnitude of the change in rates may not be the
same.




41





The
effects of inflation on financial institutions are normally not as significant
as its influence on businesses which have investments in plants and
inventories.  During periods of high inflation there are normally
corresponding increases in the money supply, and financial institutions will
normally experience above-average growth in assets, loans and
deposits.  Inflation does increase the price of goods and services,
and therefore operating expenses increase during inflationary
periods.





ITEM
      7A.
            Quantitative
      and Qualitative Disclosures About Market
Risk





The
Company’s results of operations are largely dependent upon its ability to manage
interest rate risk.  Management considers interest rate risk to be a
significant market risk that could have a material effect on the Company’s
financial condition and results of operations.  The Company does not
currently use derivatives to manage market and interest rate
risks.  All of the Company’s transactions are denominated in U.S.
dollars.  Approximately 78% of the Company’s loans have interest rates
that float with the Company’s reference rate.  Fixed rate loans
generally are made with a term of five years or less.





In the
Asset and Liability Management section of the Management’s Discussion and
Analysis in Item 7 is a table presenting estimated maturity or pricing
information indicating the Company’s exposure to interest rate
changes.  The following table discloses the balances of financial
instruments held by the Company, including their fair value, as of December 31,
2008.





The
expected maturities are disclosed based on contractual
schedules.  Principal repayments are not considered.  The
expected maturities for financial liabilities with no stated maturity reflect
estimated future roll-off rates.  The roll-off rates for non-interest
bearing deposits, interest bearing demand deposits, money market accounts, and
savings deposits are 15%, 25%, 25% and 20%, respectively.  The
interest rates disclosed are based on rates in effect at December 31,
2008.  Fair values are estimated in accordance with generally accepted
accounting principles as disclosed in the financial statements.





Expected
      MaturityYear
      ended December 31, 2008
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            There-
            
            
            
            
            
            Fair(dollars
      in thousands)
            
            2009
            
            
            2010
            
            
            2011
            
            
            2012
            
            
            2013
            
            
            after
            
            
            Total
            
            
            ValueFinancial
      AssetsCash
      and cash equivalentsNon-interest
      bearing
            
            $
            16,182
            
            
            $
            —
            
            
            $
            —
            
            
            $
            —
            
            
            $
            —
            
            
            $
            —
            
            
            $
            16,182
            
            
            $
            16,182Interest
      bearing deposits in banks
            
            
            582
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            582
            
            
            
            582Weighted
      average interest rate
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —Federal
      fund sold
            
            
            775
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            775
            
            
            
            775Weighted
      average interest rate
            
            
            .24
            %
            
            
            
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —Securities
      available for saleFixed
      rate
            
            
            2,689
            
            
            
            407
            
            
            
            2,272
            
            
            
            1,499
            
            
            
            758
            
            
            
            30,004
            
            
            
            37,629
            
            
            
            37,629Weighted
      average interest rate
            
            
            5.47
            %
            
            
            6.75
            %
            
            
            4.95
            %
            
            
            5.24
            %
            
            
            5.26
            %
            
            
            5.55
            %Variable
      rate
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            1,017
            
            
            
            10,847
            
            
            
            11,864
            
            
            
            11,864Weighted
      average interest rate
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            5.75
            %
            
            
            5.40
            %Securities
      held to maturityFixed
      rate
            
            
            18
            
            
            
            735
            
            
            
            —
            
            
            
            —
            
            
            
            224
            
            
            
            5,409
            
            
            
            6,386
            
            
            
            6,418Weighted
      average interest rate
            
            
            9.29
            %
            
            
            6.93
            %
            
            
            —
            
            
            
            —
            
            
            
            5.64
            %
            
            
            6.36
            %Loans
      receivableFixed
      rate
            
            
            21,882
            
            
            
            7,775
            
            
            
            9,121
            
            
            
            8,931
            
            
            
            14,680
            
            
            
            47,323
            
            
            
            109,712
            
            
            
            96,931Weighted
      average interest rate
            
            
            7.03
            %
            
            
            6.00
            %
            
            
            7.05
            %
            
            
            7.09
            %
            
            
            5.76
            %
            
            
            6.28
            %Adjustable
      rate
            
            
            319,284
            
            
            
            24,398
            
            
            
            23,777
            
            
            
            9,300
            
            
            
            16,936
            
            
            
            2,172
            
            
            
            388,092
            
            
            
            343,666Weighted
      average interest rate
            
            
            6.21
            %
            
            
            8.15
            %
            
            
            6.69
            %
            
            
            8.06
            %
            
            
            6.86
            %
            
            
            7.33
            %Federal
      Home Loan Bank stock
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            2,170
            
            
            
            2,170
            
            
            
            2,170Weighted
      average interest rate
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —Financial
      LiabilitiesNon-interest
      bearing deposits
            
            $
            12,010
            
            
            $
            10,208
            
            
            $
            8,677
            
            
            $
            7,376
            
            
            $
            6,269
            
            
            $
            35,526
            
            
            $
            80,066
            
            
            $
            80,066Interest
      bearing checking accounts
            
            
            17,028
            
            
            
            12,771
            
            
            
            9,578
            
            
            
            7,184
            
            
            
            5,388
            
            
            
            16,164
            
            
            
            68,113
            
            
            
            68,113Weighted
      average interest rate
            
            
            1.03
            %
            
            
            1.03
            %
            
            
            1.03
            %
            
            
            1.03
            %
            
            
            1.03
            %
            
            
            1.03
            %Money
      Market accounts
            
            
            23,304
            
            
            
            17,478
            
            
            
            13,108
            
            
            
            9,831
            
            
            
            7,373
            
            
            
            22,121
            
            
            
            93,215
            
            
            
            93,215Weighted
      average interest rate
            
            
            1.12
            %
            
            
            1.12
            %
            
            
            1.12
            %
            
            
            1.12
            %
            
            
            1.12
            %
            
            
            1.12
            %Savings
      accounts
            
            
            10,390
            
            
            
            8,312
            
            
            
            6,649
            
            
            
            5,320
            
            
            
            4,256
            
            
            
            17,022
            
            
            
            51,949
            
            
            
            51,949Weighted
      average interest rate
            
            
            .79
            %
            
            
            .79
            %
            
            
            .79
            %
            
            
            .79
            %
            
            
            .79
            %
            
            
            .79
            %Certificates
      of depositFixed
      rate
            
            
            165,881
            
            
            
            27,709
            
            
            
            12,926
            
            
            
            4,538
            
            
            
            4,486
            
            
            
            —
            
            
            
            215,540
            
            
            
            217,159Weighted
      average interest rate
            
            
            2.89
            %
            
            
            3.78
            %
            
            
            4.40
            %
            
            
            4.62
            %
            
            
            3.75
            %
            
            
            —Variable
      rate
            
            
            1,960
            
            
            
            464
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            2,424
            
            
            
            2,424Weighted
      average interest rate
            
            
            2.19
            %
            
            
            2.24
            %
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —Short
      Term borrowings
            
            
            23,500
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            23,500
            
            
            
            23,779Weighted
      average interest rate
            
            
            2.37
            %
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —Long
      Term BorrowingsFixed
      rate
            
            
            —
            
            
            
            4,500
            
            
            
            10,500
            
            
            
            5,000
            
            
            
            2,500
            
            
            
            —
            
            
            
            22,500
            
            
            
            23,033Weighted
      average interest rate
            
            
            —
            
            
            
            3.77
            %
            
            
            3.85
            %
            
            
            3.76
            %
            
            
            3.45
            %
            
            
            —Secured
      borrowings
            
            
            330
            
            
            
            —
            
            
            
            163
            
            
            
            861
            
            
            
            —
            
            
            
            —
            
            
            
            1,354
            
            
            
            1,354Weighted
      average interest rate
            
            
            6.81
            %
            
            
            —
            
            
            
            6.66
            %
            
            
            6.56
            %
            
            
            —Junior
      subordinated debentures
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            13,403
            
            
            
            13,403
            
            
            
            7,113Weighted
      average interest rate
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            6.67
            %




42




As
illustrated in the table above, our balance sheet is currently sensitive to
decreasing interest rates, meaning that more interest bearing assets mature or
re-price than interest earning liabilities.  Therefore, if our asset
and liability mix were to remain unchanged, and there was a decrease in market
rates of interest, the Company would expect that its net income would be
adversely affected.  In contrast, an increasing interest rate
environment would positively affect income.  While the table presented
above provides information about the Company’s interest rate sensitivity, it
does not predict the trends of future earnings.  For this reason,
financial modeling is used to forecast earnings under varying interest rate
projections.  While this process assists in managing interest rate
risk, it does require significant assumptions for the projection of loan
prepayments, loan origination volumes and liability funding sources that may
prove to be inaccurate.





ITEM
      8.
            Financial
      Statements and Supplementary Data





Information
required for this item is included in Item 15 of this report.





ITEM
      9.
            Changes
      in and disagreements with accountants on accounting and financial
      disclosure





None.





ITEM
      9A.
            Controls
      and Procedures





Disclosure Controls and Procedures.Our management has evaluated, with the participation and under the
supervision of our chief executive officer (CEO) and chief financial officer
(CFO), the effectiveness of our disclosure controls and procedures (as defined
in Rules 13a-15(e) and 15d-15(e) of the Exchange Act) as of the end of the
period covered by this report.  Based on this evaluation, our CEO and
CFO have concluded that, as of such date, the Company’s disclosure controls and
procedures are effective in ensuring that information relating to the Company,
including its consolidated subsidiaries, required to be disclosed in reports
that it files under the Exchange Act is (1) recorded, processed, summarized and
reported within the time periods specified in the SEC’s rules and forms, and (2)
accumulated and communicated to our management, including our CEO and CFO, as
appropriate to allow timely decisions regarding required
disclosures.




43





Management’s Report on Internal
Control Over Financial Reporting.The Company’s management is
responsible for establishing and maintaining adequate internal control over
financial reporting.  The Company’s internal control system is
designed to provide reasonable assurance to our management and the board of
directors regarding the preparation and fair presentation of published financial
statements.  Nonetheless, all internal control systems, no matter how
well designed, have inherent limitations.  Because of these inherent
limitations, including the possibility of collusion or improper management
override of controls, material misstatements due to error or fraud may occur and
not be detected.  Even systems determined to be effective as of a
particular date can provide only reasonable assurance with respect to financial
statement preparation and presentation and may not eliminate the need for
restatements.





The
Company’s management assessed the effectiveness of the Company’s internal
control over financial reporting as of December 31, 2008.  In making
this assessment, management used the criteria set forth by the Committee of
Sponsoring Organizations of the Treadway Commission in Internal Control – Integrated
Framework.  Based on our assessment, we believe that, as of
December 31, 2008, the Company’s internal control over financial reporting is
effective based on those criteria.





Report
Of Independent Registered Public Accounting Firm





To the
Board of Directors and Shareholders of


Pacific
Financial Corporation


Aberdeen,
Washington





We have
audited the internal control over financial reporting of Pacific Financial
Corporation and subsidiary (the “Company”) as of December 31, 2008, based
on criteria established in Internal Control — Integrated Framework issued
by the Committee of Sponsoring Organizations of the Treadway Commission. 
The Company’s management is responsible for maintaining effective internal
control over financial reporting and for its assessment of the effectiveness of
internal control over financial reporting, included in the accompanying
Management’s Report on Internal Control Over Financial Reporting.  Our
responsibility is to express an opinion on the Company’s internal control over
financial reporting based on our audit.





We
conducted our audit in accordance with the standards of the Public Company
Accounting Oversight Board (United States).  Those standards require that
we plan and perform the audit to obtain reasonable assurance about whether
effective internal control over financial reporting was maintained in all
material respects.  Our audit included obtaining an understanding of
internal control over financial reporting, assessing the risk that a material
weakness exists, testing and evaluating the design and operating effectiveness
of internal control based on the assessed risk, and performing such other
procedures as we considered necessary in the circumstances.  We believe
that our audit provides a reasonable basis for our opinion.





A
company’s internal control over financial reporting is a process designed by, or
under the supervision of, the company’s principal executive and principal
financial officers, or persons performing similar functions, and effected by the
company’s board of directors, management, and other personnel to provide
reasonable assurance regarding the reliability of financial reporting and the
preparation of financial statements for external purposes in accordance with
generally accepted accounting principles.  A company’s internal control
over financial reporting includes those policies and procedures that
(1) pertain to the maintenance of records that, in reasonable detail,
accurately and fairly reflect the transactions and dispositions of the assets of
the company; (2) provide reasonable assurance that transactions are
recorded as necessary to permit preparation of financial statements in
accordance with generally accepted accounting principles, and that receipts and
expenditures of the company are being made only in accordance with
authorizations of management and directors of the company; and (3) provide
reasonable assurance regarding prevention or timely detection of unauthorized
acquisition, use, or disposition of the company’s assets that could have a
material effect on the financial statements.




44





Because
of the inherent limitations of internal control over financial reporting,
including the possibility of collusion or improper management override of
controls, material misstatements due to error or fraud may not be prevented or
detected on a timely basis.  Also, projections of any evaluation of the
effectiveness of the internal control over financial reporting to future periods
are subject to the risk that the controls may become inadequate because of
changes in conditions, or that the degree of compliance with the policies or
procedures may deteriorate.





In our
opinion, the Company maintained, in all material respects, effective internal
control over financial reporting as of December 31, 2008, based on the
criteria established in Internal Control — Integrated Framework issued by
the Committee of Sponsoring Organizations of the Treadway
Commission.





We have
also audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), the consolidated financial statements as of and
for the year ended December 31, 2008 of the Company and our report dated
March 20, 2009 expressed an unqualified opinion on those financial
statements.






Portland,
Oregon


March 20,
2009







Changes in Internal Control Over
Financial Reporting. There have not been any changes in the Company’s
internal control over financial reporting, as such term is defined in Rules
13a-15(f) and 15d-15(f) under the Exchange Act, during the Company’s fiscal
quarter ended December 31, 2008 that have materially affected, or are reasonable
likely to materially affect, the Company’s internal control over financial
reporting.





ITEM 9B.
            Other
      Information





None.


Part
III





ITEM
      10.
            Directors
      and Executive Officers of the
Registrant





Information
concerning directors and executive officers requested by this item is contained
in the Company’s 2009 Proxy Statement for its annual meeting of shareholders to
be held on April 22, 2009 (“2009 Proxy Statement”), in the sections entitled
“CURRENT EXECUTIVE OFFICERS,” “PROPOSAL NO. 1 – ELECTION OF DIRECTORS,” and
“SECTION 16(a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE” and is incorporated
into this report by reference.




45





The Board
of Directors adopted a Code of Ethics for the Company’s executive officers that
requires the Company’s officers to maintain the highest standards of
professional conduct.  A copy of the Executive Officer Code of Ethics
is available on the Company’s Web site www.thebankofpacific.com
under the link for Stockholder Info and CEO’s Newsletter.





The
Company has a separately designated Audit Committee established in accordance
with Section 3(a)(58)(A) of the Exchange Act.  The committee is
composed of Directors Gary C. Forcum, Joseph A. Malik, John Ferlin and G. Dennis
Archer, each of whom is independent.  In determining independence of
audit committee members, the Company’s Board of Directors applied the definition
of independence for audit committee members found in the Nasdaq listing
standards.





The
Company’s Board of Directors has determined that Gary C.  Forcum,
Joseph A. Malik, John Ferlin and G. Dennis Archer are audit committee financial
experts as defined in Item 401(h) of the SEC’s Regulation
S-K.  Directors Forcum, Malik, Ferlin and Archer are independent as
that term is used for audit committee members in the Nasdaq listing
standards.





ITEM
      11.
            Executive
      Compensation





Information
concerning executive and director compensation and certain matters regarding
participation in the Company’s compensation committee required by this item is
contained in the registrant’s 2009 Proxy Statement in the sections entitled
“DIRECTOR COMPENSATION FOR 2008” and “EXECUTIVE COMPENSATION,” and is
incorporated into this report by reference.





ITEM
      12.
            Security
      Ownership of Certain Beneficial Owners and Management and
      RelatedStockholder
      Matters





Information
concerning security ownership of certain beneficial owners and management
requested by this item is incorporated by reference to the material contained in
the registrant’s 2009 Proxy Statement in the section entitled “SECURITY
OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT” and under the caption
“Equity Compensation Plan Information” in the section entitled “EXECUTIVE
COMPENSATION.”





ITEM
      13.
            Certain
      Relationships and Related Transactions, and Director
      Independence





Information
concerning certain relationships and related transactions requested by this item
is contained in the registrant’s 2009 Proxy Statement in the sections entitled
“COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION” and “RELATED
PERSON TRANSACTIONS” and is incorporated into this report by
reference.





Information
concerning director independence requested by this item is contained in the
registrant’s 2009 Proxy Statement in the section entitled “PROPOSAL NO. 1 –
ELECTION OF DIRECTORS” and is incorporated into this report by
reference





ITEM
      14.
            Principal
      Accountant Fees and Services





Information
concerning fees paid to our independent public accountants required by this item
is included under the heading “AUDITORS – Fees Paid to Auditors” in the
registrant’s 2009 Proxy Statement and is incorporated into this report by
reference.




46





Part
IV





ITEM
      15.
            Exhibits
      and Financial Statement Schedules








(a)
            (1)  The
      following financial statements are filed below:Report
      of Independent Registered Public Accounting Firm – Deloitte & Touche
      LLP
            F-1Consolidated
      Balance Sheets
            F-2Consolidated
      Statements of Income
            F-3Consolidated
      Statements of Shareholders’ Equity
            F-4Consolidated
      Statements of Cash Flows
            F-5Notes
      to Consolidated Financial Statements
            F-7(a)
            (2)  Schedules:  None(a)
            (3)  Exhibits:  See
      Exhibit Index immediately following the signature page.




47
 
 REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 
 
 To the
Board of Directors and Shareholders of
 Pacific
Financial Corporation
 Aberdeen,
Washington
 
 We have
audited the accompanying consolidated balance sheets of Pacific Financial
Corporation and subsidiary (the “Company”) as of December 31, 2008 and
2007, and the related consolidated statements of income, shareholders’ equity,
and cash flows for each of the three years in the period ended December 31,
2008.  These financial statements are the responsibility of the Company’s
management.  Our responsibility is to express an opinion on these financial
statements based on our audits.
 
 We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States).  Those standards require that
we plan and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement.  An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements.  An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation.  We believe that
our audits provide a reasonable basis for our opinion.
 
 In our
opinion, such consolidated financial statements present fairly, in all material
respects, the financial position of Pacific Financial Corporationand subsidiary as of
December 31, 2008 and 2007, and the results of their operations and their
cash flows for each of the three years in the period ended December 31,
2008, in conformity with accounting principles generally accepted in the United
States of America.
 
 We have
also audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), the Company’s internal control over financial
reporting as of December 31, 2008, based on the criteria established in
Internal Control—Integrated
Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission and our report dated March 20, 2009 expressed an
unqualified opinion on the Company’s internal control over financial
reporting.
 
  
 Portland,
Oregon
 March 20,
2009
  F-1
  Pacific
Financial Corporation and Subsidiary
 December
31, 2008 and 2007
 Consolidated
Balance Sheets
 (Dollars
in Thousands)
  2008
                
                
                2007AssetsCash
      and due from banks
                
                $
                16,182
                
                
                $
                15,044Interest
      bearing deposits in banks
                
                
                582
                
                
                
                253Federal
      funds sold
                
                
                775
                
                
                
                —Securities
      available for sale, at fair value (amortized cost of $52,930 and
      $43,323)
                
                
                49,493
                
                
                
                42,912Securities
      held to maturity (fair value of $6,418 and $4,368)
                
                
                6,386
                
                
                
                4,329Federal
      Home Loan Bank stock, at cost
                
                
                2,170
                
                
                
                1,858Loans
      held for sale
                
                
                11,486
                
                
                
                17,162Loans
                
                
                486,318
                
                
                
                438,911Allowance
      for credit losses
                
                
                7,623
                
                
                
                5,007Loans
      - net
                
                
                478,695
                
                
                
                433,904Premises
      and equipment
                
                
                16,631
                
                
                
                15,427Foreclosed
      real estate
                
                
                6,810
                
                
                
                —Accrued
      interest receivable
                
                
                2,772
                
                
                
                3,165Cash
      surrender value of life insurance
                
                
                15,718
                
                
                
                15,111Goodwill
                
                
                11,282
                
                
                
                11,282Other
      intangible assets
                
                
                1,587
                
                
                
                1,728Other
      assets
                
                
                5,266
                
                
                
                3,412Total
      assets
                
                $
                625,835
                
                
                $
                565,587Liabilities
      and Shareholders’ EquityLiabilitiesDeposits:Demand,
      non-interest bearing
                
                $
                80,066
                
                
                $
                86,883Savings
      and interest-bearing demand
                
                
                213,277
                
                
                
                204,775Time,
      interest-bearing
                
                
                217,964
                
                
                
                175,678Total
      deposits
                
                
                511,307
                
                
                
                467,336Accrued
      interest payable
                
                
                1,002
                
                
                
                1,399Secured
      borrowings
                
                
                1,354
                
                
                
                1,418Short-term
      borrowings
                
                
                23,500
                
                
                
                10,125Long-term
      borrowings
                
                
                22,500
                
                
                
                12,500Junior
      subordinated debentures
                
                
                13,403
                
                
                
                13,403Other
      liabilities
                
                
                2,695
                
                
                
                8,707Total
      liabilities
                
                
                575,761
                
                
                
                514,888Commitments
      and Contingencies (See note 12)
                
                
                —
                
                
                
                —Shareholders’
      EquityCommon
      stock (par value $1); authorized:  25,000,000
      shares;
                  issued
      and outstanding:  2008 – 7,317,430 shares; 2007 – 6,606,545
      shares
                
                
                7,318
                
                
                
                6,607Additional
      paid-in capital
                
                
                31,626
                
                
                
                27,163Retained
      earnings
                
                
                13,937
                
                
                
                17,807Accumulated
      other comprehensive loss
                
                
                (2,807
                )
                
                
                (878
                )Total
      shareholders’ equity
                
                
                50,074
                
                
                
                50,699Total
      liabilities and shareholders’ equity
                
                $
                625,835
                
                
                $
                565,587
 
 
 See
notes to consolidated financial statements.
  F-2
  Pacific
Financial Corporation and Subsidiary
 Years
Ended December 31, 2008, 2007 and 2006
 Consolidated
Statements of Income
 (Dollars
in Thousands, Except Per Share Amounts)
 
 2008
                
                
                2007
                
                
                2006Interest
      and Dividend IncomeLoans
                
                $
                31,215
                
                
                $
                37,658
                
                
                $
                33,883Federal
      funds sold and deposits in banks
                
                
                44
                
                
                
                426
                
                
                
                909Securities
      available for sale:Taxable
                
                
                1,610
                
                
                
                1,290
                
                
                
                946Tax-exempt
                
                
                609
                
                
                
                528
                
                
                
                434Securities
      held to maturity:Taxable
                
                
                38
                
                
                
                46
                
                
                
                57Tax-exempt
                
                
                178
                
                
                
                181
                
                
                
                215Federal
      Home Loan Bank stock dividends
                
                
                19
                
                
                
                7
                
                
                
                —Total
      interest and dividend income
                
                
                33,713
                
                
                
                40,136
                
                
                
                36,444Interest
      ExpenseDeposits
                
                
                9,794
                
                
                
                13,460
                
                
                
                10,846Short-term
      borrowings
                
                
                349
                
                
                
                329
                
                
                
                75Long-term
      borrowings
                
                
                991
                
                
                
                820
                
                
                
                868Secured
      borrowings
                
                
                94
                
                
                
                110
                
                
                
                141Junior
      subordinated debentures
                
                
                770
                
                
                
                914
                
                
                
                647Total
      interest expense
                
                
                11,998
                
                
                
                15,633
                
                
                
                12,577Net
      interest income
                
                
                21,715
                
                
                
                24,503
                
                
                
                23,867Provision
      for Credit Losses
                
                
                4,791
                
                
                
                482
                
                
                
                625Net
      interest income after provision for credit losses
                
                
                16,924
                
                
                
                24,021
                
                
                
                23,242Non-Interest
      IncomeService
      charges on deposit accounts
                
                
                1,577
                
                
                
                1,494
                
                
                
                1,452Income
      from and gains on sale of foreclosed real estate
                
                
                390
                
                
                
                —
                
                
                
                5Net
      gains from sales of loans
                
                
                1,426
                
                
                
                1,984
                
                
                
                1,895Net
      loss on sales of securities available for sale
                
                
                (165
                )
                
                
                (20
                )
                
                
                —Earnings
      on bank owned life insurance
                
                
                607
                
                
                
                397
                
                
                
                354Other
      operating income
                
                
                1,222
                
                
                
                620
                
                
                
                470Total
      non-interest income
                
                
                5,057
                
                
                
                4,475
                
                
                
                4,176Non-Interest
      ExpenseSalaries
      and employee benefits
                
                
                12,381
                
                
                
                12,280
                
                
                
                10,609Occupancy
                
                
                1,565
                
                
                
                1,336
                
                
                
                1,266Equipment
                
                
                1,290
                
                
                
                1,192
                
                
                
                1,152State
      taxes
                
                
                366
                
                
                
                436
                
                
                
                375Data
      processing
                
                
                764
                
                
                
                393
                
                
                
                422Professional
      services
                
                
                828
                
                
                
                541
                
                
                
                647Other
                
                
                4,397
                
                
                
                4,201
                
                
                
                3,647Total
      non-interest expense
                
                
                21,591
                
                
                
                20,379
                
                
                
                18,118Income
      before income taxes
                
                
                390
                
                
                
                8,117
                
                
                
                9,300Income
      Taxes
                
                
                (561
                )
                
                
                2,086
                
                
                
                2,749Net
      income
                
                $
                951
                
                
                $
                6,031
                
                
                $
                6,551Earnings
      Per ShareBasic
                
                $
                0.13
                
                
                $
                0.83
                
                
                $
                0.92Diluted
                
                $
                0.13
                
                
                $
                0.82
                
                
                $
                0.90Weighted
      Average Shares Outstanding:Basic
                
                
                7,311,611
                
                
                
                7,239,323
                
                
                
                7,131,707Diluted
                
                
                7,328,168
                
                
                
                7,334,846
                
                
                
                7,244,388
 
 
 See
notes to consolidated financial statements.
  F-3
  Pacific
Financial Corporation and Subsidiary
 Years
Ended December 31, 2008, 2007 and 2006
 Consolidated
Statements of Shareholders’ Equity
 (Dollars
in Thousands, Except Per Share Amounts)
 
 AccumulatedShares
      of
                
                
                
                
                
                Additional
                
                
                
                
                
                OtherCommon
                
                
                Common
                
                
                Paid-in
                
                
                Retained
                
                
                ComprehensiveStock
                
                
                Stock
                
                
                Capital
                
                
                Earnings
                
                
                Loss
                
                
                TotalBalance
      at January 1, 2006
                
                
                6,464,536
                
                
                $
                6,464
                
                
                $
                25,386
                
                
                $
                15,073
                
                
                $
                (323
                )
                
                $
                46,600Comprehensive
      income:Net
      income
                
                
                —
                
                
                
                —
                
                
                
                —
                
                
                
                6,551
                
                
                
                —
                
                
                
                6,551Other
      comprehensive income, net of tax:Change
      in fair value of
                  securities
      available for sale
                
                
                —
                
                
                
                —
                
                
                
                —
                
                
                
                —
                
                
                
                5
                
                
                
                5Comprehensive
      income
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                6,556Stock
      options exercised
                
                
                44,945
                
                
                
                45
                
                
                
                364
                
                
                
                —
                
                
                
                —
                
                
                
                409Issuance
      of common stock
                
                
                14,926
                
                
                
                15
                
                
                
                218
                
                
                
                —
                
                
                
                —
                
                
                
                233Stock
      compensation expense
                
                
                —
                
                
                
                —
                
                
                
                36
                
                
                
                —
                
                
                
                —
                
                
                
                36Cash
      dividends declared ($0.75 per share)
                
                
                —
                
                
                
                —
                
                
                
                —
                
                
                
                (4,893
                )
                
                
                —
                
                
                
                (4,
      893
                )Tax
      benefit from exercies of stock options
                
                
                —
                
                
                
                —
                
                
                
                43
                
                
                
                —
                
                
                
                —
                
                
                
                43Balance
      at December 31, 2006
                
                
                6,524,407
                
                
                $
                6,524
                
                
                $
                26,047
                
                
                $
                16,731
                
                
                $
                (318
                )
                
                $
                48,984Comprehensive
      income:Net
      income
                
                
                —
                
                
                
                —
                
                
                
                —
                
                
                
                6,031
                
                
                
                —
                
                
                
                6,031Other
      comprehensive income, net of tax:Change
      in fair value ofsecurities
      available for sale
                
                
                —
                
                
                
                —
                
                
                
                —
                
                
                
                —
                
                
                
                46
                
                
                
                46Prior
      service cost at initiation ofdefined
      benefit plan
                
                
                —
                
                
                
                —
                
                
                
                —
                
                
                
                —
                
                
                
                (704
                )
                
                
                (704
                )Amortization
      of unrecognized priorservice
      costs and net gains/losses
                
                
                —
                
                
                
                —
                
                
                
                —
                
                
                
                —
                
                
                
                98
                
                
                
                98Comprehensive
      income
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                5,471Stock
      options exercised
                
                
                74,026
                
                
                
                74
                
                
                
                775
                
                
                
                —
                
                
                
                —
                
                
                
                849Issuance
      of common stock
                
                
                25,012
                
                
                
                25
                
                
                
                395
                
                
                
                —
                
                
                
                —
                
                
                
                420Common
      stock repurchased and retired
                
                
                (16,900
                )
                
                
                (16
                )
                
                
                (203
                )
                
                
                
                
                
                
                
                
                
                
                (219
                )Stock
      compensation expense
                
                
                —
                
                
                
                —
                
                
                
                97
                
                
                
                —
                
                
                
                —
                
                
                
                97Cash
      dividends declared ($0.75 per share)
                
                
                —
                
                
                
                —
                
                
                
                —
                
                
                
                (4,955
                )
                
                
                —
                
                
                
                (4,955
                )Tax
      benefit from exercise of stock options
                
                
                —
                
                
                
                —
                
                
                
                52
                
                
                
                —
                
                
                
                —
                
                
                
                52Balance
      at December 31, 2007
                
                
                6,606,545
                
                
                $
                6,607
                
                
                $
                27,163
                
                
                $
                17,807
                
                
                $
                (878
                )
                
                $
                50,699Comprehensive
      income (loss):Net
      income
                
                
                —
                
                
                
                —
                
                
                
                —
                
                
                
                951
                
                
                
                —
                
                
                
                951Other
      comprehensive income, net of tax:Change
      in fair value ofsecurities
      available for sale
                
                
                —
                
                
                
                —
                
                
                
                —
                
                
                
                —
                
                
                
                (1,997
                )
                
                
                (1,997
                )Amortization
      of unrecognized priorservice
      costs and net gains/losses
                
                
                —
                
                
                
                —
                
                
                
                —
                
                
                
                —
                
                
                
                68
                
                
                
                68Comprehensive
      income (loss)
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                (978
                )Stock
      options exercised
                
                
                6,656
                
                
                
                6
                
                
                
                52
                
                
                
                —
                
                
                
                —
                
                
                
                58Issuance
      of common stock
                
                
                41,672
                
                
                
                42
                
                
                
                524
                
                
                
                —
                
                
                
                —
                
                
                
                566Common
      stock repurchased and retired
                
                
                (2,300
                )
                
                
                (2
                )
                
                
                (24
                )
                
                
                
                
                
                
                
                
                
                
                (26
                )Stock
      compensation expense
                
                
                —
                
                
                
                —
                
                
                
                87
                
                
                
                —
                
                
                
                —
                
                
                
                87Cash
      dividends declared ($0.05 per share)
                
                
                —
                
                
                
                —
                
                
                
                —
                
                
                
                (333
                )
                
                
                —
                
                
                
                (333
                )Stock
      dividends declared (10%)
                
                
                664,857
                
                
                
                665
                
                
                
                3,823
                
                
                
                (4,488
                )
                
                
                —
                
                
                
                —Tax
      benefit from exercise of stock options
                
                
                —
                
                
                
                —
                
                
                
                1
                
                
                
                —
                
                
                
                —
                
                
                
                1Balance
      at December 31, 2008
                
                
                7,317,430
                
                
                $
                7,318
                
                
                $
                31,626
                
                
                $
                13,937
                
                
                $
                (2,807
                )
                
                $
                50,074
 
 
 See notes to consolidated financial
statements.
  F-4
  Pacific
Financial Corporation and Subsidiary
 Years
Ended December 31, 2008, 2007 and 2006
 Consolidated
Statements of Cash Flows
 (Dollars
in Thousands)
 
 2008
                
                
                2007
                
                
                2006Cash
      Flows from Operating ActivitiesNet
      income
                
                $
                951
                
                
                $
                6,031
                
                
                $
                6,551Adjustments
      to reconcile net income to net cashprovided
      by operating activities:Depreciation
      and amortization
                
                
                1,604
                
                
                
                1,476
                
                
                
                1,257Provision
      for credit losses
                
                
                4,791
                
                
                
                482
                
                
                
                625Deferred
      income taxes
                
                
                (752
                )
                
                
                (305
                )
                
                
                759Originations
      of loans held for sale
                
                
                (96,986
                )
                
                
                (123,406
                )
                
                
                (109,444
                )Proceeds
      from sales of loans held for sale
                
                
                99,709
                
                
                
                122,549
                
                
                
                107,082Net
      gains on sales of loans
                
                
                (1,426
                )
                
                
                (1,984
                )
                
                
                (1,895
                )Loss
      on sales of securities available for sale
                
                
                165
                
                
                
                20
                
                
                
                —Gain
      on sales of foreclosed real estate
                
                
                (390
                )
                
                
                —
                
                
                
                (5
                )(Gain)
      loss on sale of premises and equipment
                
                
                (301
                )
                
                
                18
                
                
                
                3Earnings
      on bank owned life insurance
                
                
                (607
                )
                
                
                (397
                )
                
                
                (354
                )(Increase)
      decrease in accrued interest receivable
                
                
                393
                
                
                
                (159
                )
                
                
                (642
                )Increase
      (decrease) in accrued interest payable
                
                
                (397
                )
                
                
                (16
                )
                
                
                868Write-down
      of foreclosed real estate
                
                
                73
                
                
                
                —
                
                
                
                —Other
      - net
                
                
                (1,151
                )
                
                
                1,129
                
                
                
                (864
                )Net
      cash provided by operating activities
                
                
                5,676
                
                
                
                5,438
                
                
                
                3,941Cash
      Flows from Investing ActivitiesNet
      (increase) decrease in interest bearing deposits in banks
                
                
                (329
                )
                
                
                5,226
                
                
                
                (5,196
                )Net
      (increase) decrease in federal funds sold
                
                
                (775
                )
                
                
                20,345
                
                
                
                (20,345
                )Activity
      in securities available for sale:Sales
                
                
                5,208
                
                
                
                805
                
                
                
                —Maturities,
      prepayments and calls
                
                
                5,921
                
                
                
                8,807
                
                
                
                4,822Purchases
                
                
                (21,254
                )
                
                
                (15,090
                )
                
                
                (11,783
                )Activity
      in securities held to maturity:Maturities
                
                
                828
                
                
                
                943
                
                
                
                392Purchases
                
                
                (2,888
                )
                
                
                —
                
                
                
                —Investment
      in PFC Statutory Trust II
                
                
                —
                
                
                
                —
                
                
                
                (248
                )Proceeds
      from sales of SBA loan pools
                
                
                —
                
                
                
                1,139
                
                
                
                —Increase
      in loans made to customers, net of principal collections
                
                
                (53,408
                )
                
                
                (14,821
                )
                
                
                (27,959
                )Purchases
      of premises and equipment
                
                
                (2,933
                )
                
                
                (5,191
                )
                
                
                (2,718
                )Proceeds
      from sales of premises and equipment
                
                
                668
                
                
                
                190
                
                
                
                4Proceeds
      from sales of foreclosed real estate
                
                
                1,499
                
                
                
                —
                
                
                
                42Purchase
      of bank owned life insurance
                
                
                —
                
                
                
                (5,000
                )
                
                
                —Deposit
      assumption and transfer
                
                
                —
                
                
                
                —
                
                
                
                (1,268
                )Net
      cash used in investing activities
                
                
                (67,463
                )
                
                
                (2,647
                )
                
                
                (64,257
                )
 
 
 (continued)
   See
notes to consolidated financial statements.
  F-5
  Pacific
Financial Corporation and Subsidiary
 Years
Ended December 31, 2008, 2007 and 2006
 Consolidated
Statements of Cash Flows
 (concluded) (Dollars in
Thousands)
 
 2008
                
                
                2007
                
                
                2006Cash
      Flows from Financing ActivitiesNet
      increase in deposits
                
                $
                43,971
                
                
                $
                495
                
                
                $
                67,115Net
      increase (decrease) in short-term borrowings
                
                
                6,875
                
                
                
                3,125
                
                
                
                (3,985
                )Decrease
      in secured borrowings
                
                
                (64
                )
                
                
                (488
                ))
                
                
                (244
                )Proceeds
      from issuance of long-term borrowings
                
                
                23,500
                
                
                
                —
                
                
                
                2,000Repayments
      of long-term borrowings
                
                
                (7,000
                )
                
                
                (2,000
                )
                
                
                (5,000
                )Proceeds
      from junior subordinated debentures
                
                
                —
                
                
                
                —
                
                
                
                8,248Common
      stock issued
                
                
                624
                
                
                
                1,269
                
                
                
                642Repurchase
      and retirement of common stock
                
                
                (26
                )
                
                
                (219
                )
                
                
                —Cash
      dividends paid
                
                
                (4,955
                )
                
                
                (4,893
                )
                
                
                (4,719
                )Net
      cash provided by (used in) financing activities
                
                
                62,925
                
                
                
                (2,711
                )
                
                
                64,057Net
      change in cash and due from banks
                
                
                1,138
                
                
                
                80
                
                
                
                3,741Cash
      and Due from BanksBeginning
      of year
                
                
                15,044
                
                
                
                14,964
                
                
                
                11,223End
      of year
                
                $
                16,182
                
                
                $
                15,044
                
                
                $
                14,964Supplemental
      Disclosures of Cash Flow InformationInterest
      paid
                
                $
                12,395
                
                
                $
                15,649
                
                
                $
                11,709Income
      taxes paid
                
                
                1,091
                
                
                
                2,297
                
                
                
                1,667Supplemental
      Disclosures of Non-Cash Investing ActivitiesFair
      value adjustment of securities available for sale, net of
    tax
                
                $
                (1,997
                )
                
                $
                46
                
                
                $
                5Transfer
      of securities held to maturity to available for sale
                
                
                —
                
                
                
                825
                
                
                
                —Transfer
      of loans held for sale to loans held for investment
                
                
                4,259
                
                
                
                —
                
                
                
                —Foreclosed
      real estate acquired in settlement of loans
                
                
                (7,992
                )
                
                
                —
                
                
                
                —Reclass
      of long-term borrowings to short-term borrowings
                
                
                6,500
                
                
                
                —
                
                
                
                —
 
 
 See
notes to consolidated financial statements.
  F-6
 Pacific
Financial Corporation and Subsidiary
 December
31, 2008 and 2007 and for the three years ended December 31, 2008
 Notes
to Consolidated Financial Statements, Dollars in Thousands Except Per Share
Amounts
 
   Note
1 - Summary of Significant Accounting Policies
 
 Principles
of Consolidation
 
 The
consolidated financial statements include the accounts of Pacific Financial
Corporation (the Company), and its wholly owned subsidiary, The Bank of the
Pacific (the Bank), after elimination of intercompany transactions and
balances.  The Company has two wholly owned subsidiaries, PFC
Statutory Trust I and II (the Trusts), which do not meet the criteria for
consolidation under Financial Accounting Standards Board Interpretation No. 46
(revised), “Consolidation of Variable Interest Entities,” and therefore, are not
consolidated in the Company’s financial statements.
 
 Nature
of Operations
 
 The
Company is a holding company which operates primarily through its subsidiary
bank.  The Bank operates seventeen branches located in Grays Harbor,
Pacific, Skagit, Whatcom and Wahkiakum Counties in western Washington and one in
Clatsop County, Oregon.  The Bank provides loan and deposit services
to customers, who are predominately small- and middle-market businesses and
middle-income individuals in western Washington and the north coast of
Oregon.
 
 On June
23, 2006, the Bank completed a deposit transfer and assumption transaction with
an Oregon-based bank for a $1,268 premium.  In connection with completion
of the transaction, the Oregon Department of Consumer and Business Services
issued a Certificate of Authority to the Bank authorizing it to conduct a
banking business in the State of Oregon.  The premium, and the resultant
right to conduct business in Oregon, has been recorded as an indefinite-lived
intangible asset.
 
 Consolidated
Financial Statement Presentation
 
 The
consolidated financial statements have been prepared in accordance with
accounting principles generally accepted in the United States of America and
practices within the banking industry.  The preparation of
consolidated financial statements requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities, and the
disclosure of contingent assets and liabilities, as of the date of the balance
sheet, and the reported amounts of revenues and expenses during the reporting
period.  Actual results could differ from those
estimates.  Material estimates that are particularly susceptible to
significant change in the near term relate to the determination of the allowance
for credit losses, the valuation of deferred tax assets, the valuation of
investments, and the evaluation of goodwill and investments for
impairment.
 
 Stock
Dividend
 
 On
December 31, 2008, the Company declared a 1.1 to 1 stock split in the form of a
10% stock dividend, payable to shareholders on January 13, 2009.  Each
shareholder of record received one additional share for every ten shares
owned.  All per share amounts (including stock options) in the
consolidated financial statements and accompanying notes were restated to
reflect the split.
 
 Securities
Available for Sale
 
 Securities
available for sale consist of debt securities, marketable equity securities and
mutual funds that the Company intends to hold for an indefinite period, but not
necessarily to maturity.  Securities available for sale are reported
at fair value.  Unrealized gains and losses, net of the related
deferred tax effect, are reported as a net amount in a separate component of
shareholders' equity entitled “accumulated other comprehensive income
(loss).”  Realized gains and losses on securities available for sale,
determined using the specific identification method, are included in
earnings.  Amortization of premiums and accretion of discounts are
recognized in interest income over the period to maturity. For mortgage-backed
securities, actual maturity may differ from contractual maturity due to
principal payments and amortization of premiums and accretion of discounts may
vary due to prepayment speed assumptions.
 
 F-7
 
  Pacific
Financial Corporation and Subsidiary
 December
31, 2008 and 2007 and for the three years ended December 31, 2008
 Notes
to Consolidated Financial Statements, Dollars in Thousands Except Per Share
Amounts
 Securities
Held to Maturity
 
 Debt
securities for which the Company has the positive intent and ability to hold to
maturity are reported at cost, adjusted for amortization of premiums and
accretion of discounts, which are recognized in interest income over the period
to maturity.
 
 Declines
in the fair value of individual securities held to maturity and available for
sale below their cost that are other than temporary result in write-downs of the
individual securities to their fair value.  Such write-downs are
included in earnings as realized losses.  Management evaluates
individual securities for other than temporary impairment on a quarterly basis
based on the securities’ current credit quality, interest rates, term to
maturity and management’s intent and ability to hold the securities until the
net book value is recovered.
 
 Federal
Home Loan Bank Stock
 
 The
Company’s investment in Federal Home Loan Bank (“FHLB”) stock is carried at par
value.  The Company is required to maintain a minimum level of
investment in FHLB stock based on specific percentages of its outstanding
mortgages, total assets or FHLB advances.  Stock redemptions are at
the discretion of the FHLB.
 
 Loans
Held for Sale
 
 Mortgage
loans originated for sale in the foreseeable future in the secondary market are
carried at the lower of aggregatecost or estimated fair
value.  Gains and losses on sales of loans are recognized at
settlement date and are determined by the difference between the sales proceeds
and the carrying value of the loans.  Net unrealized losses are
recognized through a valuation allowance established by charges to
income.
 
 Loans
Receivable
 
 Loans
receivable that management has the intent and ability to hold for the
foreseeable future or until maturity or pay-off are reported at their
outstanding principal balances adjusted for any charge-offs, the allowance for
credit losses, and any deferred fees or costs on originated loans, and
unamortized premiums or discounts on purchased loans.  Loan fees and
certain direct loan origination costs are deferred, and the net fee or cost is
recognized as an adjustment of yield over the contractual life of the related
loans using the effective interest method.
 
 Interest
income on loans is accrued over the term of the loans based upon the principal
outstanding.  The accrual of interest on loans is discontinued when,
in management’s opinion, the borrower may be unable to meet payments as they
come due.  When interest accrual is discontinued, all unpaid accrued
interest is reversed against interest income.  Interest income is
subsequently recognized only to the extent that cash payments are received
until, in management’s judgment, the borrower has the ability to make
contractual interest and principal payments, in which case the loan is returned
to accrual status.
  F-8
 
  Pacific
Financial Corporation and Subsidiary
 December
31, 2008 and 2007 and for the three years ended December 31, 2008
 Notes
to Consolidated Financial Statements, Dollars in Thousands Except Per Share
Amounts
   Allowance
for Credit Losses
 
 The
allowance for credit losses is established as losses are estimated to have
occurred through a provision for credit losses charged to
earnings.  Losses are charged against the allowance when management
believes the collectibility of a loan balance is unlikely.  Subsequent
recoveries, if any, are credited to the allowance.
 
 The
allowance for credit losses is evaluated on a regular basis by management and is
based upon management’s periodic review of the collectability of the loans in
light of historical experience, the nature and volume of the loan portfolio,
adverse situations that may affect the borrower’s ability to repay, estimated
value of any underlying collateral and prevailing economic
conditions.  The evaluation is inherently subjective, as it requires
estimates that are susceptible to significant revision as more information
becomes available.  The Company’s methodology for assessing the
appropriateness of the allowance consists of several key elements, which include
the formula allowance and impaired allowances.  The formula portion of
the general credit loss allowance is established by applying a loss percentage
factor to the different loan types based on historical loss experience adjusted
for qualitative factors.
 
 A loan is
considered impaired when, based on current information and events, it is
probable the Company will be unable to collect the scheduled payments of
principal or interest when due according to the contractual terms of the loan
agreement.  Factors considered by management in determining impairment
include payment status, collateral value, and the probability of collecting
scheduled principal and interest payments when due.  Loans that
experience insignificant payment delays and payment shortfalls are generally not
classified as impaired.  Management determines the significance of
payment delays and payment shortfalls on a case-by-case basis, taking into
considerations all of the circumstances surrounding the loan and the borrowers,
including the length of the delay, the reasons for the delay, the borrower’s
prior payment record, and the amount of the shortfall in relation to the
principal and interest owed.  Impairment is measured on a loan by loan
basis for commercial, construction and real estate loans by either the present
value of the expected future cashflows discounted at the loan’s effective
interest rate, the loan’s obtainable market price, or the fair value of the
collateral less estimated selling costs if the loan is collateral
dependent.  Large groups of smaller balance homogeneous loans are
collectively evaluated for impairment.
 
 Premises
and Equipment
 
 Premises
and equipment are stated at cost less accumulated depreciation, which is
computed on the straight-line method over the estimated useful lives of the
assets.  Asset lives range from 3 to 39 years.  Leasehold
improvements are amortized over the terms of the respective leases or the
estimated useful lives of the improvements, whichever is less.  Gains
or losses on dispositions are reflected in earnings.
 
 Foreclosed
Real Estate
 
 Real
estate properties acquired through, or in lieu of, foreclosure are to be sold
and are initially recorded at the lower of cost or fair value of the properties
less estimated costs of disposal.  Any write-down to fair value at the
time of transfer to other real estate owned is charged to the allowance for
credit losses.  Properties are evaluated regularly to ensure that the
recorded amounts are supported by their current fair values, and that valuation
allowances to reduce the carrying amounts to fair value less estimated costs to
dispose are recorded as necessary. Any subsequent reductions in carrying values,
and revenue and expense from the operations of properties, are charged to
operations.
 
 F-9
 
  Pacific
Financial Corporation and Subsidiary
 December
31, 2008 and 2007 and for the three years ended December 31, 2008
 Notes
to Consolidated Financial Statements, Dollars in Thousands Except Per Share
Amounts
 
 
 Goodwill
and other intangible assets
 
 At
December 31, 2008 the Company had $12,869 in goodwill and other intangible
assets.  Goodwill and other intangibles with indefinite lives are
tested, at least annually on June 30, or more frequently if indicators of
potential impairment exist, for impairment.  The Company’s impairment
review process compares the fair value of the Company to its carrying
value.  If the fair value exceeds the carrying value, goodwill of the
Company is not considered impaired and no additional analysis is
necessary.Due to poor overall economic conditions, declines
in financial stocks, and a challenging operating environment for the financial
services industry, we assessed whether it was more-likely-than-not that these
factors have reduced the fair value of the Company, which represents one
reporting unit, below its carrying amount, and whether an interim test of
goodwill was necessary.  Based on the results of this analysis, it was
determined that it was not more-likely-than-not that the fair value of the
Company has fallen below its carrying amount at December 31, 2008.
 
 Core
deposit intangibles are amortized to non-interest expense using a straight line
method over seven years.  Net unamortized core deposit intangible
totaled $319 and $461 at December 31, 2008 and 2007,
respectively.  Amortization expense related to core deposit intangible
totaled $142 during each of the years ended December 31, 2008, 2007, and
2006.  Amortization expense for the core deposit intangible for future
years is estimated as follows:  2009 - $142; 2010 - $142; and 2011 -
$35.
 
 Impairment
of long-lived assets
 
 Management
periodically reviews the carrying value of its long-lived assets to determine if
an impairment has occurred or whether changes in circumstances have occurred
that would require a revision to the remaining useful life, of which there have
been none.  In making such determination, management evaluates the
performance, on an undiscounted basis, of the underlying operations or assets
which give rise to such amount.
 
 Transfers
of Financial Assets
 
 Transfers
of financial assets, including cash, investment securities, loans and loans held
for sale, are accounted for as sales when control over the assets has been
surrendered.  Control over transferred assets is deemed to be
surrendered when (1) the assets have been isolated from the Bank, (2) the
transferee obtains the right (free of conditions that constrain it from taking
advantage of that right) to pledge or exchange the transferred assets, and (3)
the Bank does not maintain effective control over the transferred assets through
either an agreement to repurchase them before their maturity, or the ability to
cause the buyer to return specific assets.
 
 Income
Taxes
 
 Deferred
tax assets and liabilities result from differences between the financial
statement carrying amounts and the tax bases of assets and liabilities, and are
reflected at currently enacted income tax rates applicable to the period in
which the deferred tax assets or liabilities are expected to be realized or
settled.  Deferred tax assets are reduced by a valuation allowance
when management determines that it is more likely than not that some portion or
all of the deferred tax assets will not be realized.  As changes in
tax laws or rates are enacted, deferred tax assets and liabilities are adjusted
through the provision for income taxes.
 
 The
Company files a consolidated federal income tax return.  The Bank
provides for income taxes separately and remits to the Company amounts currently
due in accordance with a Tax Allocation Agreement between the Company and the
Bank.
  F-10
 
  Pacific
Financial Corporation and Subsidiary
 December
31, 2008 and 2007 and for the three years ended December 31, 2008
 Notes
to Consolidated Financial Statements, Dollars in Thousands Except Per Share
Amounts
 
 In June
2006, the Financial Accounting Standards Board (FASB) issued Interpretation No.
48, Accounting for Uncertainty
in Income Taxes – an Interpretation of FASB Statement No. 109(“FIN
48”).  The interpretation prescribes a recognition threshold and
measurement attribute for the financial statement recognition and measurement of
a tax position taken or expected to be taken in a tax return.  The
Company adopted the provisions of FIN 48 on January 1, 2007.  As of
December 31, 2008, the Company had no unrecognized tax benefits.  The
Company’s policy is to recognize interest and penalties on unrecognized tax
benefits in “Provision for income taxes” in the consolidated statements of
income.  There were no amounts related to interest and penalties
recognized for the year ended December 31, 2008.  The tax years that
remain subject to examination by federal and state taxing authorities are the
years ended December 31, 2007, 2006 and 2005.
 
 Stock-Based
Compensation
 
 The
Company accounts for stock based compensation in accordance with Statement of
Financial Accounting Standards (SFAS) No. 123R, Share Based Payment, which
requires measurement of compensation cost for all stock based awards based on
the grant date fair value and recognition of compensation cost over the service
period of stock based awards.  The fair value of stock options is
determined using the Black-Scholes valuation model, which is consistent with the
Company’s valuation methodology previously utilized in footnote disclosure
required under SFAS No. 123, Accounting for Stock Based
Compensation.
 
 The
Company’s stock compensation plans are described more fully in Note
14.
 
 Cash
Equivalents and Cash Flows
 
 The
Company considers all amounts included in the balance sheet caption “Cash and
due from banks” to be cash equivalents.  Cash flows from loans,
interest bearing deposits in banks, federal funds sold, short-term borrowings,
secured borrowings and deposits are reported net.
 
 The
Company maintains balances in depository institution accounts which, at times,
may exceed federally insured limits.  The Company has not experienced
any losses in such accounts.
 
 Earnings
Per Share
 
 Basic
earnings per share excludes dilution and is computed by dividing net income by
the weighted average number of common shares outstanding.  Diluted
earnings per share reflect the potential dilution that could occur if common
shares were issued pursuant to the exercise of options under the Company’s stock
option plans.  Stock options excluded from the calculation of diluted
earnings per share because they are antidilutive, were 504,988, 235,070 and
277,805 in 2008, 2007 and 2006, respectively.
 
 Comprehensive
Income
 
 Accounting
principles generally require that recognized revenue, expenses, gains and losses
be included in net income.  Certain changes in assets and liabilities,
such as prior service costs and amortization of prior service costs related to
defined benefit plans and unrealized gains and losses on securities available
for sale, are reported as a separate component of the equity section of the
consolidated balance sheets, such items, along with net income, are components
of comprehensive income.  Gains and losses on securities available for
sale are reclassified to net income as the gains or losses are realized upon
sale of the securities.  Other-than-temporary impairment charges are
reclassified to net income at the time of the charge.
  F-11
  Pacific
Financial Corporation and Subsidiary
 December
31, 2008 and 2007 and for the three years ended December 31, 2008
 Notes
to Consolidated Financial Statements, Dollars in Thousands Except Per Share
Amounts
 
 Business
Segment
 
 The
Company operates a single business segment.  The financial information
that is used by the chief operating decision maker in allocating resources and
assessing performance is only provided for one reportable segment as of December
31, 2008, 2007 and 2006.
 
 Recent
Accounting Pronouncements
 
 In
September 2006, the FASB issued SFAS No. 157, Fair Value Measurements,
which establishes a framework for reporting fair value and expands disclosures
about fair value measurements.  SFAS No. 157 became effective for the
Company on January 1, 2008, as required for financial assets and financial
liabilities.  In February 2008, FASB issued FSP FAS 157-2, Effective Date of FASB Statement No.
157, which delayed the effective date of SFAS No. 157 to fiscal years
beginning after November 15, 2008 for nonfinancial assets and nonfinancial
liabilities that are recognized or disclosed at fair value on a nonrecurring
basis.  In October 2008, FASB issued FSP 157-3, Determining Fair Value of a
Financial Asset When the Market for That Asset is Not Active,and was
effective upon issuance, including reporting for prior periods for which
financial statements have not been issued.   FSP 157-3 clarifies
the application of SFAS 157 when the market for a financial asset is not
active.  The adoption of SFAS 157 for financial assets and liabilities
did not have a material impact on the Company’s consolidated financial
statements.  The Company is currently evaluating the effect of FSP FAS
157-2 and its impact, if any, on its consolidated financial
statements.
 
 In
February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial
Assets and Financial Liabilities.  SFAS No. 159 permits
entities to choose to measure financial assets and liabilities at fair
value.  The election to measure a financial asset or liability at fair
value can be made on an instrument-by-instrument basis and is
irrevocable.  The difference between carrying value and fair value at
the election date is recorded as a transition adjustment to opening retained
earnings.  Subsequent changes in fair value are recognized in
earnings.  The Company adopted SFAS No. 159 effective January 1,
2008.  The Company did not elect to adopt the fair value option for
any financial assets or liabilities on January 1, 2008 or during the year ended
2008.  The adoption of this standard did not have a material effect on
the Company’s consolidated financial statements.
 
 In
December 2007, the FASB issued SFAS No. 141(R), Business
Combinations.  SFAS No. 141(R) requires the acquiring entity in
a business combination to recognize the full fair value of assets acquired and
liabilities assumed in the transaction (whether a full or partial acquisition);
establishes the acquisition date fair value as the measurement objective for all
assets acquired and liabilities assumed; requires expensing most transaction and
restructuring costs; and requires the acquirer to disclose to investors and
other users all of the information needed to evaluate and understand the nature
and financial effect of the business combination.  SFAS No. 141(R)
applies prospectively to business combinations for which the acquisition date is
on or after January 1, 2009.
 
 In March
2008, FASB issued SFAS No. 161, Disclosures about Derivative
Instruments and Hedging Activities – an amendment of FASB Statement No. 133(SFAS No. 161).  SFAS No. 161 requires enhanced disclosures to
provide a better understanding of how and why an entity uses derivative
instruments, how derivative instruments and related hedge items are accounted
for, and their effect on an entity’s financial position, financial performance,
and cash flows.  SFAS No. 161 is effective for fiscal years beginning
after November 15, 2008.  The Company does not expect SFAS 161 to have
a material effect on the Company’s consolidated financial
statements.
 
 In June
2008, the FASB issued FASB Staff Position (“FSP”) No. EITF 03-6-1, Determining Whether Instruments
Granted in Share-Base Payment Transactions Are Participating
Securities.  Under this FSP, unvested share-based payment
awards that contain nonforfeitable rights to dividends will be considered to be
a separate class of common stock and will be included in the basic EPS
calculation using the two-class method that is described in FASB Statement No.
128, Earnings per
Share.  This FSP will be effective for the Company on January
1, 2009, and will require retrospective adjustment of all prior periods
presented.
  F-12
  Pacific
Financial Corporation and Subsidiary
 December
31, 2008 and 2007 and for the three years ended December 31, 2008
 Notes
to Consolidated Financial Statements, Dollars in Thousands Except Per Share
Amounts
  Note
2 - Restricted Assets
 
 Federal
Reserve Board regulations require that the Bank maintain certain minimum reserve
balances in cash on hand and on deposit with the Federal Reserve Bank, based on
a percentage of deposits.  The average amount of such balances for the
years ended December 31, 2008 and 2007 was approximately $673 and $653,
respectively.
 
 Note
3 - Securities
 
 Investment
securities have been classified according to management’s intent.  The
amortized cost of securities and their approximate fair value are as
follows:
 
 Gross
                
                
                GrossAmortized
                
                
                Unrealized
                
                
                Unrealized
                
                
                FairSecurities
      Available for Sale
                
                Cost
                
                
                Gains
                
                
                Losses
                
                
                ValueDecember
      31, 2008U.S.
      Government agency securities
                
                $
                1,671
                
                
                $
                88
                
                
                $
                —
                
                
                $
                1,759Obligations
      of states and political subdivisions
                
                
                19,876
                
                
                
                158
                
                
                
                450
                
                
                
                19,584Mortgage-backed
      securities
                
                
                30,370
                
                
                
                330
                
                
                
                3,495
                
                
                
                27,205Corporate
      bonds
                
                
                1,013
                
                
                
                —
                
                
                
                68
                
                
                
                945Mutual
      funds
                
                
                —
                
                
                
                —
                
                
                
                —
                
                
                
                —Total
                
                $
                52,930
                
                
                $
                576
                
                
                $
                4,013
                
                
                $
                49,493December
      31, 2007U.S.
      Government agency securities
                
                $
                3,796
                
                
                $
                22
                
                
                $
                —
                
                
                $
                3,818Obligations
      of states and political subdivisions
                
                
                16,248
                
                
                
                83
                
                
                
                195
                
                
                
                16,136Mortgage-backed
      securities
                
                
                18,706
                
                
                
                23
                
                
                
                189
                
                
                
                18,540Corporate
      bonds
                
                
                1,532
                
                
                
                —
                
                
                
                20
                
                
                
                1,512Mutual
      funds
                
                
                3,041
                
                
                
                —
                
                
                
                135
                
                
                
                2,906Total
                
                $
                43,323
                
                
                $
                128
                
                
                $
                539
                
                
                $
                42,912Securities
      Held to MaturityDecember
      31, 2008State
      and municipal securities
                
                $
                5,750
                
                
                $
                40
                
                
                $
                12
                
                
                $
                5,778Mortgage-backed
      securities
                
                
                636
                
                
                
                5
                
                
                
                1
                
                
                
                640Total
                
                $
                6,386
                
                
                $
                45
                
                
                $
                13
                
                
                $
                6,418December
      31, 2007State
      and municipal securities
                
                $
                3,562
                
                
                $
                48
                
                
                $
                5
                
                
                $
                3,605Mortgage-backed
      securities
                
                
                767
                
                
                
                —
                
                
                
                4
                
                
                
                763Total
                
                $
                4,329
                
                
                $
                48
                
                
                $
                9
                
                
                $
                4,368
  F-13
  Pacific
Financial Corporation and Subsidiary
 December
31, 2008 and 2007 and for the three years ended December 31, 2008
 Notes
to Consolidated Financial Statements, Dollars in Thousands Except Per Share
Amounts
 
 
 Note 3 – Securities(continued)
 
 Unrealized
losses and fair value, aggregated by investment category and length of time that
individual securities have been in continuous unrealized loss position, as of
December 31, 2008 and 2007 are summarized as follows:
 
 Less
      than 12
      Months
                      
                      
                      More
      than 12
      Months
                      
                      
                      TotalFair
                      
                      
                      Unrealized
                      
                      
                      Fair
                      
                      
                      Unrealized
                      
                      
                      Fair
                      
                      
                      UnrealizedValue
                      
                      
                      Loss
                      
                      
                      Value
                      
                      
                      Loss
                      
                      
                      Value
                      
                      
                      LossDecember
      31, 2008Available
      for SaleObligations
      of states andpolitical
      subdivisions
                      
                      $
                      8,756
                      
                      
                      $
                      349
                      
                      
                      $
                      889
                      
                      
                      $
                      101
                      
                      
                      $
                      9,645
                      
                      
                      $
                      450Mortgage-backed
      securities
                      
                      
                      10,522
                      
                      
                      
                      3,006
                      
                      
                      
                      4,302
                      
                      
                      
                      489
                      
                      
                      
                      14,824
                      
                      
                      
                      3,495Corporate
      bonds
                      
                      
                      945
                      
                      
                      
                      68
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      945
                      
                      
                      
                      68Mutual
      funds
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      —Total
                      
                      $
                      20,223
                      
                      
                      $
                      3,423
                      
                      
                      $
                      5,191
                      
                      
                      $
                      590
                      
                      
                      $
                      25,414
                      
                      
                      $
                      4,013Held
      to MaturityState
      and municipal securities
                      
                      $
                      378
                      
                      
                      $
                      12
                      
                      
                      $
                      —
                      
                      
                      $
                      —
                      
                      
                      $
                      378
                      
                      
                      $
                      12Mortgage-backed
      securities
                      
                      
                      160
                      
                      
                      
                      1
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      160
                      
                      
                      
                      1Total
                      
                      $
                      538
                      
                      
                      $
                      13
                      
                      
                      $
                      —
                      
                      
                      $
                      —
                      
                      
                      $
                      538
                      
                      
                      $
                      13December
      31, 2007Available
      for SaleObligations
      of states andpolitical
      subdivisions
                      
                      $
                      2,984
                      
                      
                      $
                      38
                      
                      
                      $
                      6,460
                      
                      
                      $
                      157
                      
                      
                      $
                      9,444
                      
                      
                      $
                      195Mortgage-backed
      securities
                      
                      
                      10,582
                      
                      
                      
                      88
                      
                      
                      
                      4,435
                      
                      
                      
                      101
                      
                      
                      
                      15,017
                      
                      
                      
                      189Corporate
      bonds
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      1,512
                      
                      
                      
                      20
                      
                      
                      
                      1,512
                      
                      
                      
                      20Mutual
      funds
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      2,906
                      
                      
                      
                      135
                      
                      
                      
                      2,906
                      
                      
                      
                      135Total
                      
                      $
                      13,566
                      
                      
                      $
                      126
                      
                      
                      $
                      15,313
                      
                      
                      $
                      413
                      
                      
                      $
                      28,879
                      
                      
                      $
                      539Held
      to MaturityState
      and municipal securities
                      
                      $
                      83
                      
                      
                      $
                      —
                      
                      
                      $
                      980
                      
                      
                      $
                      5
                      
                      
                      $
                      1,063
                      
                      
                      $
                      5Mortgage-backed
      securities
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      763
                      
                      
                      
                      4
                      
                      
                      
                      763
                      
                      
                      
                      4Total
                      
                      $
                      83
                      
                      
                      $
                      —
                      
                      
                      $
                      1,743
                      
                      
                      $
                      9
                      
                      
                      $
                      1,826
                      
                      
                      $
                      9
 
 The
mortgage-backed securities (“MBS”) portfolio consists of $11,669 of agency MBS
and $19,337 of non-agency MBS, with fair values of $11,913 and $15,932,
respectively.  All of the non-agency MBS are rated above investment
grade, with the majority secured by prime collateral.
 
 At
December 31, 2008, there were 32 investment securities in an unrealized loss
position, of which 8 were in a continuous loss position for 12 months or
more.  The unrealized losses on these securities were caused by
changes in interest rates, widening credit spreads and market illiquidity,
causing a decline in the fair value subsequent to their
purchase.  Management monitors published credit ratings on these
securities for adverse changes.  As of December 31, 2008, all of these
securities with published ratings remained above investment
grade.  The Company has evaluated the securities shown above and
anticipates full recovery of amortized cost with respect to these securities at
maturity or sooner in the event of a more favorable market interest rate
environment.  Based on management’s evaluation and because the Company
has the ability and intent to hold these securities until their values recover,
which may be at maturity, the Company does not consider these investments to be
other-than-temporarily impaired at December 31, 2008.
 
 F-14
 
  Pacific
Financial Corporation and Subsidiary
 December
31, 2008 and 2007 and for the three years ended December 31, 2008
 Notes
to Consolidated Financial Statements, Dollars in Thousands Except Per Share
Amounts
 Note 3 – Securities(concluded)
 
 The
Company did not engage in originating subprime mortgage loans and it does not
believe that it has exposure to subprime mortgage loans or subprime mortgage
backed securities.  Additionally, the Company does not have any
investment in or exposure to collateralized debt obligations or structured
investment vehicles.
 
 The
contractual maturities of investment securities held to maturity and available
for sale at December 31, 2008 are shown below.  Investments in
mortgage-backed securities are shown separately as maturities may differ from
contractual maturities because borrowers have the right to call or prepay
obligations, with or without call or prepayment
penalties.  Investments in mutual funds are shown separately due to
the short-term nature of the investments and because mutual funds do not have a
stated maturity date.
 
 Held
      to Maturity
                
                
                Available
      for SaleAmortized
                
                
                Fair
                
                
                Amortized
                
                
                FairCost
                
                
                Value
                
                
                Cost
                
                
                ValueDue
      in one year or less
                
                $
                17
                
                
                $
                17
                
                
                $
                2,583
                
                
                $
                2,520Due
      from one year to five years
                
                
                960
                
                
                
                974
                
                
                
                5,730
                
                
                
                5,856Due
      from five to ten years
                
                
                807
                
                
                
                824
                
                
                
                3,576
                
                
                
                3,582Due
      after ten years
                
                
                3,966
                
                
                
                3,963
                
                
                
                10,671
                
                
                
                10,330Mortgage-backed
      securities
                
                
                636
                
                
                
                640
                
                
                
                30,370
                
                
                
                27,205Total
                
                $
                6,386
                
                
                $
                6,418
                
                
                $
                52,930
                
                
                $
                49,493
 
 Gross
gains realized on sales of securities were $12, $0 and $0 and gross losses
realized were $177, $20 and $0 in 2008, 2007 and 2006,
respectively.  In 2007, the Bank transferred $825 in municipal bonds
from held to maturity to available for sale as a result of significant
deterioration in the credit quality of the bond issuer.  The bonds
were subsequently sold and the Bank realized a loss on sale of $20.
 
 Securities
carried at approximately $­­­­27,668 at December 31, 2008 and
$17,708 at December 31, 2007 were pledged to secure public deposits, commercial
deposits, borrowings at the Federal Home Loan Bank of Seattle, and for other
purposes required or permitted by law.
 
 Note
4 - Loans
 
 Loans
(including loans held for sale) at December 31 consist of the
following:
 
 2008
                
                
                2007Commercial
      and agricultural
                
                $
                91,888
                
                
                $
                128,145Real
      estate:Construction
                
                
                100,725
                
                
                
                93,249Residential
      1-4 family
                
                
                82,468
                
                
                
                60,616Multi-family
                
                
                7,860
                
                
                
                6,353Commercial
                
                
                188,444
                
                
                
                137,620Farmland
                
                
                18,092
                
                
                
                20,125Consumer
                
                
                9,252
                
                
                
                10,646498,729
                
                
                
                456,754Less
      unearned income
                
                
                (925
                )
                
                
                (681
                )Total
                
                $
                497,804
                
                
                $
                456,073
 
 F-15
 Pacific
Financial Corporation and Subsidiary
 December
31, 2008 and 2007 and for the three years ended December 31, 2008
 Notes
to Consolidated Financial Statements, Dollars in Thousands Except Per Share
Amounts
 
 
 Note 4 – Loans(concluded)
 
 Changes
in the allowance for credit losses for the years ended December 31 are as
follows:
 
 2008
                
                
                2007
                
                
                2006Balance
      at beginning of year
                
                $
                5,007
                
                
                $
                4,033
                
                
                $
                5,296Provision
      for credit losses
                
                
                4,791
                
                
                
                482
                
                
                
                625Charge-offs
                
                
                (2,226
                )
                
                
                (151
                )
                
                
                (1,945
                )Recoveries
                
                
                51
                
                
                
                643
                
                
                
                57Net
      (charge-offs) recoveries
                
                
                (2,175
                )
                
                
                492
                
                
                
                (1,888
                )Balance
      at end of year
                
                $
                7,623
                
                
                $
                5,007
                
                
                $
                4,033
 
 Following
is a summary of information pertaining to impaired loans:
 
 2008
                
                
                2007
                
                
                2006December
      31Impaired
      loans without a valuation allowance
                
                $
                21,655
                
                
                $
                3,379
                
                
                $
                7,328Impaired
      loans with a valuation allowance
                
                
                462
                
                
                
                3,052
                
                
                
                51Total
      impaired loans
                
                $
                22,117
                
                
                $
                6,431
                
                
                $
                7,739Valuation
      allowance related to impaired loans
                
                $
                118
                
                
                $
                72
                
                
                $
                17Years
      Ended December 31Average
      investment in impaired loans
                
                $
                16,915
                
                
                $
                2,938
                
                
                $
                6,475Interest
      income recognized on a cash basis on impaired loans
                
                
                34
                
                
                
                457
                
                
                
                272
 
 At
December 31, 2008, there were no commitments to lend additional funds to
borrowers whose loans have been modified.  Loans 90 days and over past
due and still accruing interest at December 31, 2008 and 2007 were $2,274 and
$2,932, respectively.
 
 Certain
related parties of the Company, principally directors and their affiliates, were
loan customers of the Bank in the ordinary course of business during 2008 and
2007.  Total related party loans outstanding at December 31, 2008 and
2007 to executive officers and directors were $1,146 and $1,223,
respectively.  During 2008 and 2007, new loans of $676 and $43,
respectively, were made, and repayments totaled $753 and $892,
respectively.  In management’s opinion, these loans and transactions
were on the same terms as those for comparable loans and transactions with
non-related parties.  No loans to related parties were on non-accrual,
past due or restructured at December 31, 2008.
 
 Note
5 - Premises and Equipment
 
 The
components of premises and equipment at December 31 are as follows:
  2008
                
                
                2007Land
      and premises
                
                $
                16,546
                
                
                $
                12,261Equipment,
      furniture and fixtures
                
                
                7,585
                
                
                
                7,569Construction
      in progress
                
                
                835
                
                
                
                4,46224,966
                
                
                
                24,292Less
      accumulated depreciation and amortization
                
                
                8,335
                
                
                
                8,865Total
      premises and equipment
                
                $
                16,631
                
                
                $
                15,427
  F-16
  Pacific
Financial Corporation and Subsidiary
 December
31, 2008 and 2007 and for the three years ended December 31, 2008
 Notes
to Consolidated Financial Statements, Dollars in Thousands Except Per Share
Amounts
 
 
 Note 5 - Premises and Equipment(concluded)
 
 Depreciation
expense was $1,152, $975, and $844 for 2008, 2007 and 2006,
respectively.  The Bank leases premises under operating
leases.  Rental expense of leased premises was $369, $426 and $378 for
2008, 2007 and 2006, respectively, which is included in occupancy
expense.
 
 Minimum
net rental commitments under noncancelable operating leases having an original
or remaining term of more than one year for future years ending December 31 are
as follows:
 
 2009
                
                $
                3042010
                
                
                2292011
                
                
                1262012
                
                
                632013
                
                
                54Total
      minimum payments required
                
                $
                776
 
 Certain
leases contain renewal options from five to ten years and escalation clauses
based on increases in property taxes and other costs.
 
 Note
6 - Deposits
 
 The
composition of deposits at December 31 is as follows:
  2008
                
                
                2007Demand
      deposits, non-interest bearing
                
                $
                80,066
                
                
                $
                86,883NOW
      and money market accounts
                
                
                161,329
                
                
                
                149,565Savings
      deposits
                
                
                51,948
                
                
                
                55,210Time
      certificates, $100,000 or more
                
                
                143,991
                
                
                
                99,540Other
      time certificates
                
                
                73,973
                
                
                
                76,138Total
                
                $
                511,307
                
                
                $
                467,336
 
 Scheduled
maturities of time certificates of deposit are as follows for future years
ending December 31:
 
 2009
                
                $
                167,8412010
                
                
                28,1732011
                
                
                12,9262012
                
                
                4,5382013
                
                
                4,486Total
                
                $
                217,964
 
 Note
7 - Borrowings
 
 Long-term
borrowings at December 31, 2008 and 2007 represent advances from the Federal
Home Loan Bank of Seattle.  Advances at December 31, 2008 bear
interest at 3.45% to 4.12% and mature in various years as follows: 2010 -
$4,500; 2011 - $10,500; 2012 - $5,000 and 2013 - $2,500.  The Bank has
pledged $100,745 of securities and loans as collateral for these borrowings at
December 31, 2008.
  F-17
 Pacific
Financial Corporation and Subsidiary
 December
31, 2008 and 2007 and for the three years ended December 31, 2008
 Notes
to Consolidated Financial Statements, Dollars in Thousands Except Per Share
Amounts
 
 Note 7 – Borrowings(concluded)
 
 Secured
borrowings at December 31, 2008 and 2007 represent borrowings collateralized by
participation interests in loans originated by the Bank.  These
borrowings are repaid as payments (normally monthly) are made on the underlying
loans, bearing interest ranging from 6.38% to 7.00%.  Original
maturities range from May 2009 to May 2012.
 
 Short-term
borrowings represent federal funds purchased that generally mature within one to
four days from the transaction date and term borrowings with scheduled maturity
dates within one year.  The following is a summary of short-term
borrowings for the years ended:
 
 2008
                
                
                2007
                
                
                2006Amount
      outstanding at end of year
                
                $
                23,500
                
                
                $
                10,125
                
                
                $
                —Weighted
      average interest rate at December 31
                
                
                2.37
                %
                
                
                4.26
                %
                
                
                —Maximum
      month-end balance during the year
                
                
                34,290
                
                
                
                18,695
                
                
                
                6,500Average
      balance during the year
                
                
                13,398
                
                
                
                5,961
                
                
                
                1,388Average
      interest rate during the year
                
                
                2.61
                %
                
                
                5.52
                %
                
                
                5.40
                %
 
 Note
8 – Junior Subordinated Debentures
 
 At
December 31, 2008, two wholly-owned subsidiary grantor trusts established by the
Company had outstanding $13,000 of pooled Trust Preferred Securities (“trust
preferred securities”).  Trust preferred securities accrue and pay
distributions periodically at specified annual rates as provided in the
indentures.  The trusts used the net proceeds from the offering of
trust preferred securities to purchase a like amount of Junior Subordinated
Debentures (the “Debentures”) of the Company.  The Debentures are the
sole assets of the trusts.  The Company’s obligations under the
Debentures and the related documents, taken together, constitute a full and
unconditional guarantee by the Company of the obligations of the
trusts.  The trust preferred securities are mandatory redeemable upon
the maturity of the Debentures, or upon earlier redemption as provided in the
indentures.  The Company has the right to redeem the Debentures in
whole or in part on or after specified dates, at a redemption price specified in
the indentures plus any accrued but unpaid interest to the redemption
date.
 
 The
following table is a summary of the trust preferred securities and debentures at
December 31, 2008:
 
 Issuance
                
                
                Preferred
                
                Rate
                
                Initial
                
                
                Rate
      at
                
                
                MaturityIssuance
      Trust
                
                Date
                
                
                Security
                
                Type
                
                Rate
                
                
                12/31/08
                
                
                DatePFC
      Statutory Trust I
                
                
                12/2005
                
                
                $
                5,000
                
                Fixed
                (1)
                
                6.39
                %
                
                
                6.39
                %
                
                
                3/2036PFC
      Statutory Trust II
                
                
                6/2006
                
                
                $
                8,000
                
                Variable
                (2)
                
                7.02
                %
                
                
                6.42
                %
                
                
                7/2036
 
 (1)
                  Fixed
      rate until March 15, 2011, at which time becomes a variable rate, adjusted
      quarterly, equal to 145 basis points over the three month LIBOR
      rate.
 (2)
                  The
      variable rate preferred securities reprice
  quarterly.
 
 The total
amount of trust preferred securities outstanding at both December 31, 2008 and
2007 was $13,000.  The interest rate on the trust preferred securities
issued in June 2006 resets quarterly and is tied to the London Interbank Offered
Rate (“LIBOR”).  The Company has the right to redeem the debentures
issued in the December 2005 offering in March 2011, and the June 2006 offering
in July 2011.
 
 The
Debentures issued by the Company to the grantor trusts totaling $13,000 are
reflected in the consolidated balance sheet in the liabilities section under the
caption “junior subordinated debentures.”  The Company records
interest expense on the corresponding junior subordinated debentures in the
consolidated statements of income.
  F-18
  Pacific
Financial Corporation and Subsidiary
 December
31, 2008 and 2007 and for the three years ended December 31, 2008
 Notes
to Consolidated Financial Statements, Dollars in Thousands Except Per Share
Amounts
  Note 8 – Junior Subordinated
Debentures(concluded)
 
 The
Company recorded $403 in the consolidated balance sheet at December 31, 2008 and
2007 respectively, for the common capital securities issued by the issuer
trusts.
 
 On July
2, 2003, the Federal Reserve Board (“Federal Reserve”) issued Supervisory Letter
SR 03-13 clarifying that Bank Holding Companies should continue to report trust
preferred securities in accordance with current Federal Reserve Bank
instructions which allows trust preferred securities to be counted in Tier 1
capital subject to certain limitations.  The Federal Reserve has
indicated it will review the implications of any accounting treatment changes
and, if necessary or warranted, will provide appropriate guidance.
 
 
 Note
9 - Income Taxes
 
 Income
taxes for the years ended December 31 is as follows:
  2008
                
                
                2007
                
                
                2006Current
                
                $
                191
                
                
                $
                2,391
                
                
                $
                1,990Deferred
      provision (benefit)
                
                
                (752
                )
                
                
                (305
                )
                
                
                759Total
      income taxes (benefit)
                
                $
                (561
                )
                
                $
                2,086
                
                
                $
                2,749
 
 The tax
effects of temporary differences that give rise to significant portions of
deferred tax assets and liabilities at December 31 are:
  2008
                
                
                2007Deferred
      Tax AssetsAllowance
      for credit losses
                
                $
                2,521
                
                
                $
                1,579Deferred
      compensation
                
                
                136
                
                
                
                160Supplemental
      executive retirement plan
                
                
                341
                
                
                
                275Unrealized
      loss on securities available for sale
                
                
                1,169
                
                
                
                140Loan
      fees/costs
                
                
                274
                
                
                
                242Other
                
                
                145
                
                
                
                132Total
      deferred tax assets
                
                
                4,586
                
                
                
                2,528Deferred
      Tax LiabilitiesDepreciation
                
                $
                251
                
                
                $
                88Loan
      fees/costs
                
                
                2,447
                
                
                
                2,346Core
      deposit intangible
                
                
                109
                
                
                
                157Other
                
                
                439
                
                
                
                378Total
      deferred tax liabilities
                
                
                3,246
                
                
                
                2,969Net
      deferred tax assets (liabilities)
                
                $
                1,340
                
                
                $
                (441
                )
 
 Net
deferred tax assets are recorded in other assets and net deferred tax
liabilities are recorded in other liabilities in the consolidated financial
statements.
 
 F-19
 Pacific
Financial Corporation and Subsidiary
 December
31, 2008 and 2007 and for the three years ended December 31, 2008
 Notes
to Consolidated Financial Statements, Dollars in Thousands Except Per Share
Amounts
 
 
 Note 9 - Income Taxes(concluded)
 
 The
following is a reconciliation between the statutory and effective federal income
tax rate for the years ended December 31:
  2008
                
                
                2007
                
                
                2006Percent
                
                
                
                
                
                Percent
                
                
                
                
                
                Percentof
      Pre-tax
                
                
                
                
                
                of
      Pre-tax
                
                
                
                
                
                Pre-taxAmount
                
                
                Income
                
                
                Amount
                
                
                Income
                
                
                Amount
                
                
                IncomeIncome
      tax at statutory rate
                
                $
                137
                
                
                
                35.0
                %
                
                $
                2,841
                
                
                
                35.0
                %
                
                $
                3,255
                
                
                
                35.0
                %Adjustments
      resulting from:Tax-exempt
      income
                
                
                (371
                )
                
                
                (95.1
                )
                
                
                (316
                )
                
                
                (3.9
                )
                
                
                (275
                )
                
                
                (2.9
                )Net
      earnings on life insurance policies
                
                
                (199
                )
                
                
                (51.0
                )
                
                
                (139
                )
                
                
                (1.7
                )
                
                
                (112
                )
                
                
                (1.2
                )Other
                
                
                (128
                )
                
                
                (32.8
                )
                
                
                (300
                )
                
                
                (3.7
                )
                
                
                (119
                )
                
                
                (1.3
                )Total
      income tax expense(benefit)
                
                $
                (561
                )
                
                
                (143.8
                )%
                
                $
                2,086
                
                
                
                25.7
                %
                
                $
                2,749
                
                
                
                29.6
                %
 
 Note
10 - Employee Benefits
 
 Incentive
Compensation Plan
 
 The Bank
has a plan that provides incentive compensation to key employees if the Bank
meets certain performance criteria established by the Board of
Directors.  The cost of this plan was $66, $943, and $1,016 in 2008,
2007 and 2006, respectively.
 
 401(k)
Plans
 
 The Bank
has established a 401(k) profit sharing plan for those employees who meet the
eligibility requirements set forth in the plan.  Eligible employees
may contribute up to 15% of their compensation.  Matching
contributions by the Bank are at the discretion of the Board of
Directors.  Contributions totaled $279, $398 and $334 for 2008, 2007
and 2006, respectively.
 
 Director
and Employee Deferred Compensation Plans
 
 The
Company has director and employee deferred compensation plans.  Under
the terms of the plans, a director or employee may participate upon approval by
the Board.  The participant may then elect to defer a portion of his
or her earnings (directors’ fees or salary) as designated at the beginning of
each plan year.  Payments begin upon retirement, termination, death or
permanent disability, sale of the Company, the ten-year anniversary of the
participant’s participation date, or at the discretion of the
Company.  There are currently two participants in the
plans.  Total deferrals plus earnings were $75, $145 and $149 at
December 31, 2008, 2007 and 2006, respectively.  There is no ongoing
expense to the Company for this plan.
 
 The
directors of a bank acquired by the Company in 1999 adopted two deferred
compensation plans for directors - one plan providing retirement income benefits
for all directors and the other, a deferred compensation plan, covering only
those directors who have chosen to participate in the plan.  At the
time of adopting these plans, the Bank purchased life insurance policies on
directors participating in both plans which may be used to fund payments to them
under these plans.  Cash surrender values on these policies were
$3,346 and $3,232 at December 31, 2008 and 2007, respectively.  In
2008, 2007 and 2006, the net benefit recorded from these plans, including the
cost of the related life insurance, was $353, $371 and $306,
respectively.  Both of these plans were fully funded and frozen as of
September 30, 2001.  Plan participants were given the option to either
remain in the plan until reaching the age of 70 or to receive a lump-sum
distribution.  Participants electing to remain in the plan will
receive annual payments over a ten-year period upon reaching 70 years of
age.  The liability associated with these plans totaled $325 and $326
at December 31, 2008 and 2007, respectively.
  F-20
  Pacific
Financial Corporation and Subsidiary
 December
31, 2008 and 2007 and for the three years ended December 31, 2008
 Notes
to Consolidated Financial Statements, Dollars in Thousands Except Per Share
Amounts
  Note 10 - Employee Benefits(continued)
 
 Executive
Long-Term Compensation Agreements
 
 During
2008, the Company issued executive long-term compensation agreements to selected
employees that provide incentive for those covered employees to remain employed
with the Company for a defined period of time.  The cost of this plan
was $54 in 2008.
 
 Supplemental
Executive Retirement Plan
 
 Effective
January 1, 2007, the Company adopted a non-qualified Supplemental Executive
Retirement Plan (SERP) that provides retirement benefits to its executive
officers.  The SERP is unsecured and unfunded and there are no plan
assets.  The post-retirement benefit provided by the SERP is designed
to supplement a participating officer’s retirement benefits from social
security, in order to provide the officer with a certain percentage of final
average income at retirement age.  The benefit is generally based on
average earnings, years of service and age at retirement.  At the
inception of the SERP, the Company recorded a prior service cost to accumulated
other comprehensive income of $634.  The Company has purchased bank
owned life insurance covering all participants in the SERP.  The cash
surrender value of these policies totaled $5,229 and $5,058 at December 31, 2008
and 2007, respectively.
 
 The
following table sets forth the net periodic pension cost and obligation
assumptions used in the measurement of the benefit obligation for the years
ended December 31:
  2008
                
                
                2007Net periodic pension
      cost:Service
      Cost
                
                $
                93
                
                
                $
                91Interest
      Cost
                
                
                48
                
                
                
                41Amortization
      of prior service cost
                
                
                70
                
                
                
                70Amortization
      of net (gain)/loss
                
                
                (2
                )
                
                
                —Net
      periodic pension cost
                
                $
                209
                
                
                $
                202Weighted
      average assumptions:Discount
      rate
                
                
                6.38
                %
                
                
                5.94
                %Rate
      of compensation increases
                
                
                3.00
                
                
                
                5.00
 
 The
following table sets forth the change in benefit obligation at December
31:
 
 2008
                
                
                2007Change
      in Benefit Obligation:Benefit
      obligation at beginning of year
                
                $
                808
                
                
                $
                704Service
      cost
                
                
                93
                
                
                
                91Interest
      cost
                
                
                48
                
                
                
                41Actuarial
      gain
                
                
                —
                
                
                
                (28
                )Benefit
      obligation at end of year
                
                $
                949
                
                
                $
                808
 
 F-21
  Pacific
Financial Corporation and Subsidiary
 December
31, 2008 and 2007 and for the three years ended December 31, 2008
 Notes
to Consolidated Financial Statements, Dollars in Thousands Except Per Share
Amounts
 
 Note 10 - Employee Benefits(concluded)
 
 Amounts
recognized in accumulated other comprehensive loss at December 31 are as
follows:
 
 2008
                
                
                2007Net
      gain
                
                $
                (25
                )
                
                $
                (28
                )Prior
      service cost
                
                
                564
                
                
                
                634Total
      recognized in accumulative other comprehensive loss
                
                $
                538
                
                
                $
                606
 
 The
following table summarizes the projected and accumulated benefit obligations at
December 31:
 
 2008
                
                
                2007Projected
      benefit obligation
                
                $
                949
                
                
                $
                808Accumulated
      benefit obligation
                
                
                765
                
                
                
                633
 
 Estimated
future benefit payments as of December 31, 2008 are as follows:
  2009
      – 2013
                
                $
                02014
      – 2018
                
                
                397
 
 Note
11 – Dividend Reinvestment Plan
 
 In
November 2005, the Company instituted a dividend reinvestment plan which allows
for all or part of cash dividends to be reinvested in shares of Company common
stock based upon participant elections.  Under the plan, 1,100,000
shares are authorized for dividend reinvestment, of which 89,771 shares have
been issued through December 31, 2008.
 
 Note
12 - Commitments and Contingencies
 
 The Bank
is party to financial instruments with off-balance-sheet risk in the normal
course of business to meet the financing needs of its
customers.  These financial instruments include commitments to extend
credit and standby letters of credit, and involve, to varying degrees, elements
of credit risk in excess of the amount recognized on the consolidated balance
sheets.
 
 The
Bank’s exposure to credit loss in the event of nonperformance by the other party
to the financial instrument for commitments to extend credit and standby letters
of credit is represented by the contractual amount of those
instruments.  The Bank uses the same credit policies in making
commitments and conditional obligations as they do for on-balance-sheet
instruments.  A summary of the Bank’s commitments at December 31 is as
follows:
 
 2008
                
                
                2007Commitments
      to extend credit
                
                $
                101,459
                
                
                $
                108,095Standby
      letters of credit
                
                
                1,519
                
                
                
                3,489
 
 F-22
  Pacific
Financial Corporation and Subsidiary
 December
31, 2008 and 2007 and for the three years ended December 31, 2008
 Notes
to Consolidated Financial Statements, Dollars in Thousands Except Per Share
Amounts
 
 Note 12 - Commitments and
Contingencies(concluded)
 
 Commitments
to extend credit are agreements to lend to a customer as long as there is no
violation of any condition established in the contract.  Since many of
the commitments are expected to expire without being drawn
upon, the total commitment amounts do not necessarily represent future cash
requirements.  The Bank’s experience has been that approximately 67%
of loan commitments are drawn upon by customers.  The Bank evaluates
each customer’s creditworthiness on a case-by-case basis.  The amount
of collateral obtained, if deemed necessary by the Bank upon extension of
credit, is based on management’s credit evaluation of the party.
 
 Collateral
held varies, but may include accounts receivable, inventory, property and
equipment, residential real estate, and income-producing commercial
properties.
 
 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.  The credit risk involved in issuing letters of credit
is essentially the same as that involved in extending loan facilities to
customers.  Collateral held varies as specified above and is required
in instances where the Bank deems necessary.
 
 Certain
executive officers have entered into employment contracts with the Bank which
provide for contingent payments subject to future events.
 
 The Bank
has agreements with commercial banks for lines of credit totaling $30,000, of
which $0 was used at December 31, 2008.  In addition, the Bank has a
credit line with the Federal Home Loan Bank of Seattle totaling 20% of assets,
$46,000 of which was used at December 31, 2008.  These borrowings are
collateralized under blanket pledge and custody agreements.
 
 Because
of the nature of its activities, the Company is subject to various pending and
threatened legal actions which arise in the ordinary course of
business.  In the opinion of management, liabilities arising from
these claims, if any, will not have a material effect on the financial
condition, results of operations or cash flows of the Company.
 
 Note
13 - Significant Concentrations of Credit Risk
 
 Most of
the Bank’s business activity is with customers and governmental entities located
in the state of Washington, including investments in state and municipal
securities.  Loans are generally limited by state banking regulations
to 20% of the Bank’s shareholder’s equity, excluding accumulated other
comprehensive income (loss).  Standby letters of credit were granted
primarily to commercial borrowers.  The Bank, as a matter of practice,
generally does not extend credit to any single borrower or group of borrowers in
excess of $7,500.
 
 Note
14 - Stock Options
 
 The
Company’s three stock incentive plans, adopted in 1995, 1997 and 2000, provide
for granting incentive stock options, as defined under current tax laws, to key
personnel.  The plan adopted in 2000 also provides for non-qualified
stock options and other types of stock based awards.  Under the first
plan, options are exercisable 90 days from the date of grant.  These
options terminate if not exercised within ten years from the date of
grant.  If after six years from the date of grant fewer than 20% of
the options have been exercised, they will expire at a rate of 20%
annually.  Under the second plan, the options become exercisable one
year from the date of grant, at a rate of 10% annually.  Options
terminate if not exercised when they become available.  No additional
grants will be made under these two plans.  The 2000 plan authorizes
the issuance of up to a total of 1,100,000 shares (305,195 shares are available
for grant at December 31, 2008).  Under the 2000 plan, options either
become exercisable ratably over five years or vest fully five years from the
date of grant.  Under the 2000 plan, the Company may grant up to
150,000 options for its common stock to a single individual in a calendar
year.
  F-23
  Pacific
Financial Corporation and Subsidiary
 December
31, 2008 and 2007 and for the three years ended December 31, 2008
 Notes
to Consolidated Financial Statements, Dollars in Thousands Except Per Share
Amounts
 
 Note 14 - Stock Options(continued)
 
 The
Company uses the Black-Scholes option pricing model to calculate the fair value
of stock-based awards based on assumptions noted in the following
table.  Expected volatility is based on historical volatility of the
Company’s common shares.  The expected term of stock options granted
is based on the simplified method, which is
the simple average between contractual term and vesting period.  The
risk-free rate is based on the expected term of stock options and the applicable
U.S. Treasury yield in effect at the time of grant.
 
 Grant
      period ended
                
                Expected
      Life
                
                Risk
      Free
                  Interest
      Rate
                
                
                Expected
                  Volatility
                
                
                Dividend
                  Yield
                
                
                Average
                  Fair
      ValueDecember
      31, 2008
                
                6.5
      years
                
                
                3.75
                %
                
                
                16.19
                %
                
                
                6.05
                %
                
                $
                0.83December
      31, 2007
                
                6.5
      years
                
                
                4.59
                %
                
                
                15.66
                %
                
                
                4.92
                %
                
                $
                1.54December
      31, 2006
                
                6.5
      years
                
                
                4.97
                %
                
                
                16.53
                %
                
                
                4.83
                %
                
                $
                1.71
 
 A summary
of the status of the Company’s stock option plans as of December 31, 2008, 2007
and 2006, and changes during the years ending on those dates, is presented
below:
 
 2008
                
                
                2007
                
                
                2006Weighted
                
                
                
                
                
                Weighted
                
                
                
                
                
                WeightedAverage
                
                
                
                
                
                Average
                
                
                
                
                
                AverageExercise
                
                
                
                
                
                Exercise
                
                
                
                
                
                ExerciseShares
                
                
                Price
                
                
                Shares
                
                
                Price
                
                
                Shares
                
                
                PriceOutstanding
      at beginning of year
                
                
                689,868
                
                
                $
                12.55
                
                
                
                769,702
                
                
                $
                12.45
                
                
                
                756,442
                
                
                $
                12.07Granted
                
                
                8,250
                
                
                
                11.27
                
                
                
                106,975
                
                
                
                13.93
                
                
                
                62,700
                
                
                
                13.75Exercised
                
                
                (7,321
                )
                
                
                7.93
                
                
                
                (81,429
                )
                
                
                10.43
                
                
                
                (49,440
                )
                
                
                8.30Expired
                
                
                —
                
                
                
                —
                
                
                
                (1,870
                )
                
                
                5.35
                
                
                
                —
                
                
                
                —Forfeited
                
                
                (6,270
                )
                
                
                12.42
                
                
                
                (103,510
                )
                
                
                15.09
                
                
                
                —
                
                
                
                —Outstanding
      at end of year
                
                
                684,527
                
                
                $
                12.58
                
                
                
                689,868
                
                
                $
                12.55
                
                
                
                769,702
                
                
                $
                12.45Exercisable
      at end of year
                
                
                557,587
                
                
                $
                12.32
                
                
                
                495,985
                
                
                $
                12.24
                
                
                
                627,575
                
                
                $
                12.42
 
 F-24
 
 Pacific
Financial Corporation and Subsidiary
 December
31, 2008 and 2007 and for the three years ended December 31, 2008
 Notes
to Consolidated Financial Statements, Dollars in Thousands Except Per Share
Amounts
 
 
 Note 14 - Stock Options(concluded)
 
 A summary
of the status of the Company’s nonvested options as of December 31, 2008 and
2007 and changes during the period then ended are presented below:
 
 2008
                  
                  
                  2007Shares
                  
                  
                  Weighted
      Average Fair Value
                  
                  
                  Shares
                  
                  
                  Weighted
      Average Fair ValueNon-vested
      beginning of period
                  
                  
                  193,884
                  
                  
                  $
                  1.80
                  
                  
                  
                  142,127
                  
                  
                  $
                  2.15Granted
                  
                  
                  8,250
                  
                  
                  
                  0.83
                  
                  
                  
                  106,975
                  
                  
                  
                  1.54Vested
                  
                  
                  (73,984
                  )
                  
                  
                  2.02
                  
                  
                  
                  (36,188
                  )
                  
                  
                  2.37Forfeited
                  
                  
                  (1,210
                  )
                  
                  
                  1.85
                  
                  
                  
                  (19,030
                  )
                  
                  
                  1.84Non-vested
      end of period
                  
                  
                  126,940
                  
                  
                  $
                  1.62
                  
                  
                  
                  193,884
                  
                  
                  $
                  1.80
 
 The
following information summarizes information about stock options outstanding and
exercisable at December 31, 2008:
  Options Outstanding
                
                
                Options ExercisableRange
      of exercise prices
                
                Number
                
                
                Weighted
      average remaining contractual life (years)
                
                
                Weighted
      average exercise price
                
                
                Number
                
                
                Weighted
      average remaining contractual life (years)
                
                
                Weighted
      average exercise price0.00
      – 11.10
                
                
                263,447
                
                
                
                2.7
                
                
                $
                10.25
                
                
                
                263,447
                
                
                
                2.5
                
                
                $
                10.2511.11
      – 12.49
                
                
                93,060
                
                
                
                4.5
                
                
                
                11.92
                
                
                
                67,210
                
                
                
                2.9
                
                
                
                11.9012.50
      – 14.74
                
                
                185,075
                
                
                
                5.3
                
                
                
                14.20
                
                
                
                92,345
                
                
                
                5.7
                
                
                
                14.2914.75
      – 16.00
                
                
                142,945
                
                
                
                6.3
                
                
                
                15.22
                
                
                
                134,585
                
                
                
                5.8
                
                
                
                15.23684,527
                
                
                
                4.5
                
                
                $
                12.58
                
                
                
                557,587
                
                
                
                3.9
                
                
                $
                12.32
 
 The
aggregate intrinsic value of all options outstanding at December 31, 2008 and
2007 was $0 and $188, respectively.  The aggregate intrinsic value of
all options that were exercisable at December 31, 2008 and 2007 was $0 and $0,
respectively.  The total intrinsic value of stock options exercised
was $29 and $282, respectively for 2008 and 2007.  Cash received from
the exercise of stock options during 2008 totaled $58.   Stock
based compensation recognized in 2008 and 2007 was $87 ($57 net of tax) and $97
($64 net of tax), respectively. Future compensation expense for unvested awards
outstanding as of December 31, 2008 is estimated to be $101 recognized over a
weighted average period of 1.7 years.
 
 Note
15 - Regulatory Matters
 
 The
Company and the Bank are subject to various regulatory capital requirements
administered by the federal banking agencies. Failure to meet minimum capital
requirements can initiate certain mandatory and possibly additional
discretionary actions by regulators that, if undertaken, could have a direct
material effect on the Company’s consolidated financial
statements.  Under capital adequacy guidelines on the regulatory
framework for prompt corrective action, the Bank must meet specific capital
adequacy guidelines that involve quantitative measures of the Bank’s assets,
liabilities and certain off-balance-sheet items as calculated under regulatory
accounting practices. The Bank’s capital classification is also subject to
qualitative judgments by the regulators about components, risk weightings and
other factors.
  F-25
  Pacific
Financial Corporation and Subsidiary
 December
31, 2008 and 2007 and for the three years ended December 31, 2008
 Notes
to Consolidated Financial Statements, Dollars in Thousands Except Per Share
Amounts
  Note 15 - Regulatory Matters(concluded)
 
 Quantitative
measures established by regulation to ensure capital adequacy require the
Company and the Bank to maintain minimum amounts and ratios (set forth in the
table below) of Tier 1 capital (as defined in the regulations) to total average
assets (as defined), and minimum ratios of Tier 1 and total capital (as defined)
to risk-weighted assets (as defined).
 
 As of
December 31, 2008, the most recent notification from the Bank’s regulator
categorized the Bank as well capitalized under the regulatory framework for
prompt corrective action.  To be categorized as well capitalized, the
Bank must maintain minimum total risk-based, Tier 1 risk-based, and Tier 1
leverage ratios as set forth in the table.  There are no conditions or
events since that notification that management believes have changed the
institution’s category.
 
 The
Company and the Bank’s actual capital amounts and ratios are presented in the
table below.  Management believes, as of December 31, 2008, the
Company and the Bank meet all capital requirements to which they are
subject.
  Actual
                        
                        
                        
                        
                        
                        CapitalAdequacyPurposes
                        
                        
                        To
      be WellCapitalized Under PromptCorrective Action
      ProvisionsAmount
                        
                        
                        Ratio
                        
                        
                        Amount
                        
                        
                        Ratio
                        
                        
                        Amount
                        
                        
                        RatioDecember
      31, 2008Tier
      1 capital (to average assets):Company
                        
                        $
                        53,011
                        
                        
                        
                        8.87
                        %
                        
                        $
                        23,905
                        
                        
                        
                        4.00
                        %
                        
                        NA
                        
                        
                        NABank
                        
                        
                        52,181
                        
                        
                        
                        8.75
                        
                        
                        
                        23,858
                        
                        
                        
                        4.00
                        
                        
                        $
                        29,823
                        
                        
                        
                        5.00
                        %Tier
      1 capital (to risk-weighted assets):Company
                        
                        
                        53,011
                        
                        
                        
                        10.54
                        
                        
                        
                        20,117
                        
                        
                        
                        4.00
                        
                        
                        NA
                        
                        
                        NABank
                        
                        
                        52,181
                        
                        
                        
                        10.40
                        
                        
                        
                        20,068
                        
                        
                        
                        4.00
                        
                        
                        
                        30,106
                        
                        
                        
                        6.00Total
      capital (to risk-weighted assets):Company
                        
                        
                        59,315
                        
                        
                        
                        11.79
                        
                        
                        
                        40,233
                        
                        
                        
                        8.00
                        
                        
                        NA
                        
                        
                        NABank
                        
                        
                        58,470
                        
                        
                        
                        11.65
                        
                        
                        
                        40,137
                        
                        
                        
                        8.00
                        
                        
                        
                        50,177
                        
                        
                        
                        10.00December
      31, 2007Tier
      1 capital (to average assets):Company
                        
                        $
                        50,825
                        
                        
                        
                        9.28
                        %
                        
                        $
                        21,906
                        
                        
                        
                        4.00
                        %
                        
                        NA
                        
                        
                        NABank
                        
                        
                        50,210
                        
                        
                        
                        9.19
                        
                        
                        
                        21,860
                        
                        
                        
                        4.00
                        
                        
                        $
                        27,325
                        
                        
                        
                        5.00
                        %Tier
      1 capital (to risk-weighted assets):Company
                        
                        
                        50,825
                        
                        
                        
                        11.37
                        
                        
                        
                        17,887
                        
                        
                        
                        4.00
                        
                        
                        NA
                        
                        
                        NABank
                        
                        
                        50,210
                        
                        
                        
                        11.26
                        
                        
                        
                        17,840
                        
                        
                        
                        4.00
                        
                        
                        
                        26,760
                        
                        
                        
                        6.00Total
      capital (to risk-weighted assets):Company
                        
                        
                        55,832
                        
                        
                        
                        12.49
                        
                        
                        
                        35,774
                        
                        
                        
                        8.00
                        
                        
                        NA
                        
                        
                        NABank
                        
                        
                        55,217
                        
                        
                        
                        12.38
                        
                        
                        
                        35,679
                        
                        
                        
                        8.00
                        
                        
                        
                        44,599
                        
                        
                        
                        10.00
 
 The
Company and the Bank are subject to certain restrictions on the amount of
dividends that it may declare without prior regulatory approval.
  F-26
  Pacific
Financial Corporation and Subsidiary
 December
31, 2008 and 2007 and for the three years ended December 31, 2008
 Notes
to Consolidated Financial Statements, Dollars in Thousands Except Per Share
Amounts
 Note
16 – Other Comprehensive Income (Loss)
 
 Net
unrealized gains and losses, net of tax, include $1,997 of unrealized losses and
$46 and $5 of unrealized gains arising during 2008, 2007 and 2006, respectively,
less reclassification adjustments of $165, $0 and $0 for losses included in net
income in 2008, 2007 and 2006, respectively, as follows:
 
 Before-
                
                
                TaxTax
                
                
                Benefit
                
                
                Net-of-TaxAmount
                
                
                (Expense)
                
                
                Amount2008Unrealized
      holding losses arising during the year
                
                $
                (3,190
                )
                
                $
                1,084
                
                
                $
                (2,106
                )Reclassification
      adjustments for losses realized in net income
                
                
                165
                
                
                
                (56
                )
                
                
                109Net
      unrealized losses
                
                $
                (3,025
                )
                
                $
                1,028
                
                
                $
                (1,997
                )2007Unrealized
      holding gains arising during the year
                
                $
                71
                
                
                $
                (25
                )
                
                $
                46Reclassification
      adjustments for gains realized in net income
                
                
                —
                
                
                
                —
                
                
                
                —Net
      unrealized gains
                
                $
                71
                
                
                $
                (25
                )
                
                $
                462006Unrealized
      holding gains arising during the year
                
                $
                8
                
                
                $
                (3
                )
                
                $
                5Reclassification
      adjustments for gains realized in net income
                
                
                —
                
                
                
                —
                
                
                
                —Net
      unrealized gains
                
                $
                8
                
                
                $
                (3
                )
                
                $
                5
 
 Note
17 - Fair Value of Financial Instruments
 
 SFAS No.
157 defines fair value, expands disclosures about fair value measurements and
establishes a hierarchy for measuring fair value that is intended to maximize
the use of observable inputs and minimize the use of unobservable
inputs.  This hierarchy uses three levels of inputs to measure the
fair value of assets and liabilities as follows:
 
 Level 1 –
Valuations based on quoted prices in active exchange markets for identical
assets or liabilities; includes certain U.S. Treasury securities, U.S.
Government and agency securities, and corporate debt securities actively traded
in over-the-counter markets.
 
 Level 2 –
Valuations of assets and liabilities traded in less active dealer or broker
markets.  Valuations include quoted prices for similar assets and
liabilities traded in the same market; 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 drivers are
observable.  Valuations may be obtained from, or corroborated by,
third-party pricing services.  This category generally includes
certain U.S. Government and agency securities and corporate debt securities that
are not actively traded, and residential mortgage loans held for
sale.
 
 Level 3 –
Valuation based on unobservable inputs supported by little or no market activity
for financial instruments whose value is determined using pricing models,
discounted cash flow methodologies, yield curves and similar techniques, as well
as instruments for which the determination of fair value requires significant
management judgment or estimation.  Level 3 valuations incorporate
certain assumptions and projections in determining the fair value assigned to
such assets or liabilities, but in all cases are corroborated by external data,
which may include third-party pricing services.
  F-27
  Pacific
Financial Corporation and Subsidiary
 December
31, 2008 and 2007 and for the three years ended December 31, 2008
 Notes
to Consolidated Financial Statements, Dollars in Thousands Except Per Share
Amounts
   Note 17 - Fair Value of Financial
Instruments(continued)
 
 The
following table presents the balances of assets and liabilities measured at fair
value on a recurring basis at December 31, 2008:
  Readily
      Available
                  Market
      Prices
                  Level
      1
                
                
                Observable
      Market Prices
                  Level
      2
                
                
                Significant
      Unobservable
                  Inputs
                  Level
      3
                
                
                TotalAvailable
      for sale securities
                
                $
                —
                
                
                $
                49,493
                
                
                $
                —
                
                
                $
                49,493
 
 The
Company did not have any Level 3 inputs in the investment portfolio during the
year.
 
 Certain
assets and liabilities are measured at fair value on a nonrecurring basis after
initial recognition such as loans measured for impairment and
OREO.  The following methods were used to estimate the fair value of
each such class of financial instrument:
 
 Impaired loans – a loan is
considered impaired when, based on current information and events, it is
probable that the Company will be unable to collect all amounts due (both
interest and principle) according to the contractual terms of the loan
agreement.  Impaired loans are measured based on the present value of
expected future cash flows or by the fair market value of the collateral if the
loan is collateral dependent.
 
 Other real estate owned – OREO
is initially recorded at the lower of the carrying amount of the loan or fair
value of the property less estimated costs to sell.  This amount
becomes the property’s new basis.  Management considers third party
appraisals in determining the fair value of particular
properties.  Any write-downs based on the property fair value less
estimated costs to sell at the date of acquisition are charged to the allowance
for loan and lease losses.  Management periodically reviews OREO in an
effort to ensure the property is carried at the lower of its new basis or fair
value, net of estimated costs to sell.
 
 The
following table presents the balances of assets measured at fair value on a
nonrecurring basis at December 31, 2008:
  Readily
      Available
                  Market
      Prices
                  Level
      1
                
                
                Observable
      Market Prices
                  Level
      2
                
                
                Significant
      Unobservable
                  Inputs
                  Level
      3
                
                
                TotalImpaired
      loans
                
                $
                —
                
                
                $
                —
                
                
                $
                9,532
                
                
                $
                9,532OREO
                
                $
                —
                
                
                $
                —
                
                
                $
                6,810
                
                
                $
                6,810
 
 Other
real estate owned with a carrying amount of $6,883 was acquired during the year
ended December 31, 2008.  These assets were written down $73 to their
fair value, less estimated costs to sell, which was charged to the allowance for
loan and lease losses during the period.
 
 F-28
 
 Pacific
Financial Corporation and Subsidiary
 December
31, 2008 and 2007 and for the three years ended December 31, 2008
 Notes
to Consolidated Financial Statements, Dollars in Thousands Except Per Share
Amounts
 
 
 Note 17 - Fair Value of Financial
Instruments(continued)
 
 The
following methods and assumptions were used by the Company in estimating the
fair values of financial instruments disclosed in these consolidated financial
statements:
 
 Cash,
Interest Bearing Deposits at Other Financial Institutions, and Federal Funds
Sold
 The
carrying amounts of cash, interest bearing deposits at other financial
institutions, and federal funds sold approximate their fair value.
 
 Securities
Available for Sale and Held to Maturity
 Fair
values for securities are based on quoted market prices.
 
 Loans
 For 2008,
the fair value of loans is estimated based on comparable market statistics for
loans with similar credit ratings.  An additional liquidity discount
is also incorporated to more closely align the fair value with observed market
prices.  For 2007, variable rate loans that reprice frequently and
have no significant change in credit risk, fair values are based on carrying
values.  Fair values for fixed rate loans in 2007 are estimated using
discounted cash flow analysis, using interest rates currently being offered for
loans with similar terms to borrowers of similar credit quality.  Fair
values of loans held for sale are based on their estimated market
prices.
 
 Deposit
Liabilities
 The fair
value of deposits with no stated maturity date is included at the amount payable
on demand.  Fair values for fixed rate certificates of deposit are
estimated using a discounted cash flow calculation based on interest rates
currently offered on similar certificates.
 
 Secured
borrowings
 For
variable rate secured borrowings that reprice frequently and have no significant
change in credit risk, fair values are based on carrying values.
 
 Short-Term
Borrowings
 The fair
values of the Company’s short-term borrowings are estimated using discounted
cash flow analysis based on the Company’s incremental borrowing rates for
similar types of borrowing arrangements.
 
 Long-Term
Borrowings
 The fair
values of the Company’s long-term borrowings is estimated using discounted cash
flow analysis based on the Company’s incremental borrowing rates for similar
types of borrowing arrangements.
 
 Junior
Subordinated Debentures
 The fair
value of the junior subordinated debentures and trust preferred securities
approximates the pricing of a preferred security at current market
prices.
 
 Off-Balance-Sheet
Instruments
 The fair
value of commitments to extend credit and standby letters of credit was
estimated using the rates currently charged to enter into similar agreements,
taking into account the remaining terms of the agreements and the present
creditworthiness of the customers.  Since the majority of the
Company’s off-balance-sheet instruments consist of non-fee producing,
variable-rate commitments, the Company has determined they do not have a
material fair value.
  F-29
  Pacific
Financial Corporation and Subsidiary
 December
31, 2008 and 2007 and for the three years ended December 31, 2008
 Notes
to Consolidated Financial Statements, Dollars in Thousands Except Per Share
Amounts
   Note 17 - Fair Value of Financial
Instruments(concluded)
 
 The
estimated fair value of the Company’s financial instruments at December 31 are
as follows:
 
 2008
                
                
                2007Carrying
                
                
                Fair
                
                
                Carrying
                
                
                FairAmount
                
                
                Value
                
                
                Amount
                
                
                ValueFinancial
      AssetsCash
      and due from banks, interest-bearing deposits in banks, and federal funds
      sold
                
                $
                17,539
                
                
                $
                17,539
                
                
                $
                15,297
                
                
                $
                15,297Securities
      available for sale
                
                
                49,493
                
                
                
                49,493
                
                
                
                42,912
                
                
                
                42,912Securities
      held to maturity
                
                
                6,386
                
                
                
                6,418
                
                
                
                4,329
                
                
                
                4,368Loans
      held for sale
                
                
                11,486
                
                
                
                11,752
                
                
                
                17,162
                
                
                
                17,407Loans,
      net
                
                
                478,695
                
                
                
                440,597
                
                
                
                433,904
                
                
                
                434,120Financial
      LiabilitiesDeposits
                
                $
                511,307
                
                
                $
                512,926
                
                
                $
                467,336
                
                
                $
                468,326Short-term
      borrowings
                
                
                23,500
                
                
                
                23,779
                
                
                
                10,125
                
                
                
                10,093Long-term
      borrowings
                
                
                22,500
                
                
                
                23,033
                
                
                
                12,500
                
                
                
                12,436Secured
      borrowings
                
                
                1,354
                
                
                
                1,354
                
                
                
                1,418
                
                
                
                1,418Junior
      subordinated debentures
                
                
                13,403
                
                
                
                7,113
                
                
                
                13,403
                
                
                
                13,275
 
 Note
18 - Earnings Per Share Disclosures
 
 Following
is information regarding the calculation of basic and diluted earnings per share
for the years indicated.
  Net
      Income
                
                
                Shares
                
                
                Per
      Share(Numerator)
                
                
                (Denominator)
                
                
                AmountYear
      Ended December 31, 2008Basic
      earnings per share:
                
                $
                951
                
                
                
                7,311,611
                
                
                $
                0.13Effect
      of dilutive securities:
                
                
                —
                
                
                
                16,557
                
                
                
                —Diluted
      earnings per share:
                
                $
                951
                
                
                
                7,328,168
                
                
                $
                0.13Year
      Ended December 31, 2007Basic
      earnings per share:
                
                $
                6,031
                
                
                
                7,239,323
                
                
                $
                0.83Effect
      of dilutive securities:
                
                
                —
                
                
                
                95,523
                
                
                
                (.01
                )Diluted
      earnings per share:
                
                $
                6,031
                
                
                
                7,334,846
                
                
                $
                0.82Year
      Ended December 31, 2006Basic
      earnings per share:
                
                $
                6,551
                
                
                
                7,131,707
                
                
                $
                0.92Effect
      of dilutive securities:
                
                
                —
                
                
                
                112,681
                
                
                
                (.02
                )Diluted
      earnings per share:
                
                $
                6,551
                
                
                
                7,244,388
                
                
                $
                0.90
 
 The
number of shares shown for “options” is the number of incremental shares that
would result from the exercise of options and use of the proceeds to repurchase
shares at the average market price during the year.
 
 F-30
  Pacific
Financial Corporation and Subsidiary
 December
31, 2008 and 2007 and for the three years ended December 31, 2008
 Notes
to Consolidated Financial Statements, Dollars in Thousands Except Per Share
Amounts
 
 Note
19 - Condensed Financial Information - Parent Company Only
 
 Condensed
Balance Sheets - December 31,
  2008
                
                
                2007AssetsCash
                
                $
                513
                
                
                $
                4,929Investment
      in the Bank
                
                
                62,244
                
                
                
                63,084Due
      from the Bank
                
                
                785
                
                
                
                783Other
      assets
                
                
                407
                
                
                
                403Total
      assets
                
                $
                63,949
                
                
                $
                69,199Liabilities
      and Shareholders’ EquityDividends
      payable
                
                $
                333
                
                
                $
                4,955Junior
      subordinated debentures
                
                
                13,403
                
                
                
                13,403Other
      liabilities
                
                
                139
                
                
                
                142Shareholders’
      equity
                
                
                50,074
                
                
                
                50,699Total
      liabilities and shareholders’ equity
                
                $
                63,949
                
                
                $
                69,199
 
 Condensed
Statements of Income - Years Ended December 31,
 
 2008
                
                
                2007
                
                
                2006Dividend
      Income from the Bank
                
                $
                900
                
                
                $
                4,700
                
                
                $
                5,150Other
      Income
                
                
                27
                
                
                
                27
                
                
                
                19Total
      Income
                
                
                927
                
                
                
                4,727
                
                
                
                5,169Expenses
                
                
                (1,066
                )
                
                
                (1,236
                )
                
                
                (934
                )Income
      (loss) before income tax benefit
                
                
                (139
                )
                
                
                3,491
                
                
                
                4,235Income
      Tax Benefit
                
                
                —
                
                
                
                —
                
                
                
                294Income
      (loss) before equity in undistributed income of the Bank
                
                
                (139
                )
                
                
                3,491
                
                
                
                4,529Equity
      in Undistributed Income of the Bank
                
                
                1,090
                
                
                
                2,540
                
                
                
                2,022Net
      income
                
                $
                951
                
                
                $
                6,031
                
                
                $
                6,551
 
 F-31
 Pacific
Financial Corporation and Subsidiary
 December
31, 2008 and 2007 and for the three years ended December 31, 2008
 Notes
to Consolidated Financial Statements, Dollars in Thousands Except Per Share
Amounts
  
 Note 19 - Condensed Financial
Information - Parent Company Only(concluded)
 
 Condensed
Statements of Cash Flows - Years Ended December 31
 
 2008
                
                
                2007
                
                
                2006Operating
      ActivitiesNet
      income
                
                $
                951
                
                
                $
                6,031
                
                
                $
                6,551Adjustments
      to reconcile net income tonet
      cash provided by operating activities:Equity
      in undistributed income of subsidiary
                
                
                (1,090
                )
                
                
                (2,540
                )
                
                
                (2,022
                )Net
      change in other assets
                
                
                (4
                )
                
                
                —
                
                
                
                (294
                )Net
      change in other liabilities
                
                
                (3
                )
                
                
                1
                
                
                
                141Other
      - net
                
                
                87
                
                
                
                97
                
                
                
                35Net
      cash provided by (used in) operating activities
                
                
                (59
                )
                
                
                3,589
                
                
                
                4,411Investing
      ActivitiesContribution
      to subsidiary
                
                
                —
                
                
                
                —
                
                
                
                (8,000
                )Purchase
      of trust common securities
                
                
                —
                
                
                
                —
                
                
                
                (248
                )Net
      cash used in investing activities
                
                
                —
                
                
                
                —
                
                
                
                (8,248
                )Financing
      ActivitiesProceeds
      from junior subordinated debentures
                
                
                —
                
                
                
                —
                
                
                
                8,248Common
      stock issued
                
                
                624
                
                
                
                1,269
                
                
                
                642Repurchase
      and retirement of common stock
                
                
                (26
                )
                
                
                (219
                )
                
                
                —Dividends
      paid
                
                
                (4,955
                )
                
                
                (4,893
                )
                
                
                (4,719
                )Net
      cash provided by (used in) financing activities
                
                
                (4,357
                )
                
                
                (3,843
                )
                
                
                4,171Net
      increase (decrease) in cash
                
                
                (4,416
                )
                
                
                (254
                )
                
                
                334CashBeginning
      of year
                
                
                4,929
                
                
                
                5,183
                
                
                
                4,849End
      of year
                
                $
                513
                
                
                $
                4,929
                
                
                $
                5,183
 
 F-32
 
 Pacific
Financial Corporation and Subsidiary
 December
31, 2008 and 2007 and for the three years ended December 31, 2008
 Notes
to Consolidated Financial Statements, Dollars in Thousands Except Per Share
Amounts
  
 Quarterly
Data (Unaudited)
 
 First
                
                
                Second
                
                
                Third
                
                
                FourthQuarter
                
                
                Quarter
                
                
                Quarter
                
                
                QuarterYear
      Ended December 31, 2008Interest
      income
                
                $
                8,937
                
                
                $
                8,279
                
                
                $
                8,460
                
                
                $
                8,037Interest
      expense
                
                
                3,492
                
                
                
                2,777
                
                
                
                2,784
                
                
                
                2,945Net
      interest income
                
                
                5,445
                
                
                
                5,502
                
                
                
                5,676
                
                
                
                5,092Provision
      for credit losses
                
                
                126
                
                
                
                2,228
                
                
                
                600
                
                
                
                1,837Non-interest
      income
                
                
                1,210
                
                
                
                1,292
                
                
                
                896
                
                
                
                1,659Non-interest
      expenses
                
                
                5,157
                
                
                
                5,505
                
                
                
                5,371
                
                
                
                5,558Income
      (loss) before income taxes
                
                
                1,372
                
                
                
                (939
                )
                
                
                601
                
                
                
                (644
                )Income
      taxes (benefit)
                
                
                324
                
                
                
                (266
                )
                
                
                14
                
                
                
                (633
                )Net
      income (loss)
                
                $
                1,048
                
                
                $
                (673
                )
                
                $
                587
                
                
                $
                (11
                )Earnings
      (loss) per common share:Basic
                
                $
                .15
                
                
                $
                (.09
                )
                
                $
                .08
                
                
                $
                (.01
                )Diluted
                
                
                .15
                
                
                
                (.09
                )
                
                
                .08
                
                
                
                (.01
                )Year
      Ended December 31, 2007Interest
      income
                
                $
                9,811
                
                
                $
                10,346
                
                
                $
                10,331
                
                
                $
                9,648Interest
      expense
                
                
                3,806
                
                
                
                4,033
                
                
                
                4,000
                
                
                
                3,794Net
      interest income
                
                
                6,005
                
                
                
                6,313
                
                
                
                6,331
                
                
                
                5,854Provision
      for credit losses
                
                
                257
                
                
                
                105
                
                
                
                60
                
                
                
                60Non-interest
      income
                
                
                946
                
                
                
                1,149
                
                
                
                1,063
                
                
                
                1,317Non-interest
      expenses
                
                
                4,820
                
                
                
                5,184
                
                
                
                5,017
                
                
                
                5,358Income
      before income taxes
                
                
                1,874
                
                
                
                2,173
                
                
                
                2,317
                
                
                
                1,753Income
      taxes
                
                
                340
                
                
                
                607
                
                
                
                686
                
                
                
                453Net
      income
                
                $
                1,534
                
                
                $
                1,566
                
                
                $
                1,631
                
                
                $
                1,300Earnings
      per common share:Basic
                
                $
                .21
                
                
                $
                .22
                
                
                $
                .22
                
                
                $
                .18Diluted
                
                
                .21
                
                
                
                .22
                
                
                
                .22
                
                
                
                .17
 
 F-33




SIGNATURES





Pursuant
to the requirements of Section 13 or 15(d) 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, on the 20th day of
March, 2009.




PACIFIC FINANCIAL
      CORPORATION
                (Registrant)/s/ Dennis A. Long
              
              /s/ Denise PortmannDennis
      A. Long, President and
      CEO
              
              Denise
      Portmann, CFO


Pursuant
to the requirements of the Securities Exchange Act of 1934, this report has been
signed below by the following persons on behalf of the registrant and in the
capacities indicated, on the 20th day of
March, 2009.




Principal
      Executive Officer and
      Director
              
              Principal
      Financial and Accounting Officer/s/ Dennis A. Long
              
              /s/
      Denise PortmannDennis
      A. Long, President and CEO and Director
              
              Denise
      Portmann, CFOPrincipal
      Executive Officer
              
              Principal
      Financial and Accounting OfficerRemaining
      Directors/s/ Gary C. Forcum
              
              /s/
      G. Dennis ArcherGary
      C. Forcum (Chairman of the Board)
              
              G.
      Dennis Archer/s/
      Joseph A. Malik
              
              /s/
      Edwin KetelJoseph
      A. Malik
              
              Edwin
      Ketel/s/
      Randy RustRandy
      Rust
              
              John
      Ferlin/s/
      Douglas M. Schermer
              
              /s/
      Robert J. WorrellDouglas
      M. Schermer
              
              Robert
      J. Worrell/s/
      Susan C. Freese
              
              /s/
      Randy W. RognlinSusan
      C. Freese
              
              Randy
      W. Rognlin


48




Exhibit
Index




EXHIBIT
      NO.
                  EXHIBIT3.1
                  RestatedArticles
      of Incorporation. Incorporated by reference to Exhibit 3.2 to the
      Company’s Quarterly Report on Form 10-Q for the quarter ended June 30,
      2000.
 3.2
                Bylaws.
      Incorporated by reference to Exhibit 2b to Form 8-A filed by the Company
      and declared effective on March 7, 2000 (Registration No.
      000-29329).
 10.1
                  Amendedand
      Restated Employment Agreement with Dennis A. Long dated December 29,
      2008.*
 10.2
                Amended
      and Restated Employment Agreement with John Van Dijk dated December 29,
      2008.*
 10.3
              Amended
      and Restated Employment Agreement with Bruce D. MacNaughton dated December
      29, 2008.*
 10.4
              Amended
      and Restated Employment Agreement with Denise Portmann dated December 29,
      2008.*
 10.5
              Bank
      of the Pacific Incentive Stock Option Plan.  Incorporated by
      reference to Exhibit 10.7 to the Company’s Annual Report on Form 10-K for
      the year ended December 31, 1999, (the “1999
  10-K”).*
 10.6
              The
      Bank of Grays Harbor Incentive Stock Option Plan.  Incorporated
      by reference to Exhibit 10.8 of the 1999
10-K.*
 10.7
              2000
      Stock Incentive Compensation Plan, as amended (the “2000
      Plan”).  Incorporated by reference to Exhibit 10.1 to the
      Company’s Quarterly Report on Form 10-Q for the quarter ended March 31,
      2007 (the “March 2007 10-Q”).
 10.8
              Forms
      of stock option agreements under the 2000 Plan.  Incorporated by
      reference to Exhibits 10.2 and 10.3 to the March 2007
    10-Q.*
 10.9
              2008
      SOX Officer Incentive Plan.  Incorporated by reference to
      Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the
      quarter ended June 30, 2008.*
 10.10
              The
      Bank of Grays Harbor Employee Deferred Compensation
      Plan.  Incorporated by reference to Exhibit 10.10 to the
      Company’s Annual Report on Form 10-K for the year ended December 31,
      2000.*
 10.11
              Supplemental
      Executive Retirement Plan effective January 1,
      2007.  Incorporated by reference to Exhibit 10.1 to the
      Company’s Current Report on Form 8-K dated March 13, 2008 (the “March 2008
      8-K”).*
 10.12
              Individual
      Participation Agreement (SERP) dated March 13, 2008, between the Company
      and Dennis A. Long.  Incorporated by reference to Exhibit 10.2
      to the March 2008 8-K.*
 10.13
              Individual
      Participation Agreement (SERP) dated March 13, 2008, between the Company
      and John Van Dijk.  Incorporated by reference to Exhibit 10.3 to
      the March 2008 8-K.*
 10.14
              Individual
      Participation Agreement (SERP) dated March 13, 2008, between the Company
      and Bruce MacNaughton.  Incorporated by reference to Exhibit
      10.4 to the March 2008 8-K.*
 10.15
              Individual
      Participation Agreement (SERP) dated March 13, 2008, between the Company
      and Denise Portmann.  Incorporated by reference to Exhibit 10.5
      to the March 2008 8-K.*
 21
              Subsidiaries
      of Registrant – Bank of the Pacific, organized under Washington
      law
 23.1
              Consent
      of Deloitte & Touche, LLP, Independent Registered Public Accounting
      Firm
 31.1
              Certification
      of Chief Executive Officer Pursuant to Rule
  13a-14(a)
 31.2
              Certification
      of Chief Financial Officer Pursuant to Rule
  13a-14(a)
 32
              Certification
      Pursuant to 18 U.S.C. 1350
 99
              Description
      of common stock of the Company.   Incorporated by reference
      to Exhibit 99 to the Company’s Quarterly Report on Form 10-Q for the
      quarter ended September 30,
2000.




* Listed
document is a management contract, compensation plan or
arrangement.