**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, 2007 ;
      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
o No x




Indicate
      by check mark if the registrant is not required to file reports pursuant to
      Section 13 or Section 14(d) of the Exchange Act.


Yes
o No
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 x No
      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 o
            
            Accelerated
                filer xNon-accelerated
                filer o
            
            Smaller
                reporting company o





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, 2007, was $94,791,092.





The
      number of shares outstanding of the registrant’s common stock, $1.00 par value
      as of February 29, 2008, was 6,645,908 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 23, 2008 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, 2007**





**TABLE
      OF CONTENTS**


PagePART
                  IForward
                  Looking Information
              
              3Item
                  1.
              Business
              
              4Item
                  1A.
              Risk
                  Factors
              
              10Item
                  1B.
              Unresolved
                  Staff Comments
              
              13Item
                  2.
              Properties
              
              13Item
                  3.
              Legal
                  Proceedings
              
              14Item
                  4.
              Submission
                  of Matters to a Vote of Security Holders
              
              14PART
                  IIItem
                  5.
              Market
                  for Registrant’s Common Equity, Related Stockholder Matters and Issuer
                  Purchases of Equity Securities
              
              15Item
                  6.
              Selected
                  Financial Data
              
              17Item
                  7.
              Management’s
                  Discussion and Analysis of Financial Condition and Results of
                  Operations
              
              18Item
                  7A.
              Quantitative
                  and Qualitative Disclosures About Market Risk
              
              36Item
                  8.
              Financial
                  Statements and Supplementary Data
              
              38Item
                  9.
              Changes
                  in and Disagreements with Accountants on Accounting and Financial
                  Disclosure
              
              38Item
                  9A.
              Controls
                  and Procedures
              
              38Item
                  9B.
              Other
                  Information
              
              40PART
                  IIIItem
                  10.
              Directors,
                  Executive Officers and Corporate Governance
              
              40Item
                  11.
              Executive
                  Compensation
              
              40Item
                  12.
              Security
                  Ownership of Certain Beneficial Owners and Management and Related
                  Stockholder Matters
              
              40Item
                  13.
              Certain
                  Relationships and Related Transactions and Director
                  Independence
              
              41Item
                  14.
              Principal
                  Accountant Fees and Services
              
              41PART
                  IVItem
                  15.
              Exhibits
                  and Financial Statement Schedules
              
              41SIGNATURES
              
              
              42




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 borrowers, depositors and other customers, retain
      our key employees, and/or maintain our interest margins and fee
      income;




2.  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;





3.  expenses
      and dedication of management resources in connection with our efforts to comply
      with changing laws, regulations, and standards, that may significantly increase
      our costs and ongoing compliance expenditures and place additional burdens
      on
      our limited management resources, or may lead to revisions to our strategic
      focus;





4.  general
      economic or business conditions, either nationally or in the state or regions
      in
      which we do business, that may be less favorable than expected, resulting in,
      among other things, a deterioration in credit quality and/or a reduced demand
      for credit;




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.  decreases
      in real estate prices, whether or not due to changes in economic conditions,
      that may reduce the value of our security for many of our loans;
      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 and share value
      are
      beyond our ability to control or predict. 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 18 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 2007. Two branches were opened during 2006 and one loan production office
      was converted to a full-service branch. 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, 2007, the Company had total
      consolidated assets of $565.6 million, total loans, including loans held for
      sale, of $456.1 million, total deposits of $467.3 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
      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 may
      also utilize 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 simple. 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 8 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. Non-bank and non-depository
      institutions can be expected to increase competition further as they offer
      bank-type products in the more permissive regulatory climate of today.





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, 2007, the
      Company held a deposit market share of 30.0% in Pacific County, 45.1% in
      Wahkiakum County, 21.3% in Grays Harbor County, 3.4% in Whatcom County, 0.4%
      in
      Skagit County and 0.1% in Clatsop County.





Employees





As
      of
      December 31, 2007, the Bank employed 212 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 following discussion is intended
      to provide a brief summary and, therefore, is not complete and is qualified
      by
      the statutes and regulations referenced.




The
      laws
      and regulations applicable to the Company and its subsidiary are primarily
      intended to protect depositors 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. The likelihood and timing of any such proposals or
      legislation and the impact they might have on the Company cannot be determined.
      Changes in applicable laws or regulations or in the policies of banking and
      other government regulators may have a material effect on our business and
      prospects. Violation of the laws and regulations applicable to the Company
      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.




**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 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**




In
      general, the BHCA limits a bank holding company to owning or controlling banks
      and engaging in other banking-related activities. Bank holding companies must
      obtain approval of the Federal Reserve before they: (1) acquire direct or
      indirect ownership or control of any voting shares of any bank that results
      in
      total ownership or control, directly or indirectly, of more than 5% of the
      voting shares of such bank; (2) merge or consolidate with another bank holding
      company; or (3) acquire 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 performance record under the Community Reinvestment Act.




6





Control
      of Nonbanks .
      With
      certain exceptions, the BHCA prohibits bank holding companies from acquiring
      direct or indirect ownership or control of more than 5% of the voting shares
      in
      any company that is not a bank or a bank holding company unless the Federal
      Reserve determines that the activities of such company are incidental or closely
      related to the business of banking. If a bank holding company is
      well-capitalized and meets certain criteria specified by the Federal Reserve,
      it
      may engage de novo in certain permissible nonbanking activities without prior
      Federal Reserve approval.





Control
      Transactions .
      The
      Change in Bank Control Act of 1978, as amended, requires a person (or group
      of
      persons acting in concert) acquiring control of a bank holding company to
      provide the Federal Reserve with 60 days’ prior written notice of the proposed
      acquisition. Following receipt of this notice, the Federal Reserve has 60 days
      within which to issue a notice disapproving the proposed acquisition, but the
      Federal Reserve may extend this time period for up to another 30 days. An
      acquisition may be completed before expiration of the disapproval period if
      the
      Federal Reserve issues written notice of its intent not to disapprove the
      transaction. In addition, any company must obtain approval of the Federal
      Reserve before acquiring 25% (5% if the company is a bank holding company)
      or
      more of the outstanding shares or otherwise obtaining control over the
      Company.





Source
      of Strength Requirements. Under
      Federal Reserve policy, the Company is expected to 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. Any capital loans made
      by
      the Company to the Bank would be subordinate in priority to deposits and to
      certain other indebtedness of the Bank.




**Financial
      Services Modernization Act**





On
      November 12, 1999, the Financial Services Modernization Act (the “FSMA”) was
      signed into law. The FSMA repeals the two affiliation provisions of the
      Glass-Steagall Act: Section 20, which restricted the affiliation of Federal
      Reserve member banks with firms “engaged principally” in specified securities
      activities; and Section 32, which restricts officer, director, or employee
      interlocks between a member bank and any company or person “primarily engaged”
in specified securities activities. In addition, the FSMA contains provisions
      that expressly preempt any state law restricting the establishment of financial
      affiliations, primarily related to insurance. The general effect of the law
      is
      to establish a comprehensive framework to permit affiliations among commercial
      banks, insurance companies, securities firms, and other financial service
      providers by revising and expanding the bank holding company framework to permit
      a holding company system to engage in a full range of financial activities
      through a new entity known as a financial holding company.





Financial
      holding companies may affiliate with securities firms and insurance companies
      and engage in other activities that are financial in nature or are incidental
      or
      complementary to activities that are financial in nature. “Financial in nature”
activities include securities underwriting, dealing, and market making,
      sponsoring mutual funds and investment companies, insurance underwriting and
      agency, merchant banking, and other activities approved by the Federal Reserve.





**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.




7





**USA
      Patriot Act of 2001**





On
      October 26, 2001, President Bush signed 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. The
      Department of the Treasury is empowered to administer and make rules to
      implement the act. We do not believe that compliance with the USA Patriot Act
      has had a material effect on our business and operations.





**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.





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.




8





**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. Currently,
      bank holding companies may purchase banks in any state, and states may not
      prohibit such purchases. Additionally, banks are permitted to merge with banks
      in other states as long as the home state of neither merging bank has opted
      out.
      The Interstate Act requires regulators to consult with community organizations
      before permitting an interstate institution to close a branch in a low-income
      area.





With
      regard to interstate bank mergers, Washington has
      opted in to the Interstate Act and allows in-state banks to merge with
      out-of-state banks subject to certain aging requirements. Washington law
      generally authorizes the acquisition of an in-state 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. With regard to
      interstate bank branching, out-of-state banks that do not already operate a
      branch in Washington may not establish de novo branches in Washington or
      establish and operate a branch by acquiring a branch in Washington. 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 $100,000 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.





FDICIA
      included provisions to reform the Federal deposit insurance system, including
      the implementation of risk-based deposit insurance premiums. FDICIA also permits
      the FDIC to 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. The Bank presently qualifies for the lowest premium level.





**Dividends**





The
      principal source of the Company’s cash revenues is dividends received from the
      Bank. The payment of dividends is subject to government regulation, in that
      regulatory authorities may prohibit banks and bank holding companies from paying
      dividends in a manner that would constitute an unsafe or unsound banking
      practice. In addition, a bank may not pay cash dividends if that payment could
      reduce the amount of its capital below that necessary to meet minimum applicable
      regulatory capital requirements. Other than the laws and regulations noted
      above, which apply to all banks and bank holding companies, neither the Company
      nor the Bank are currently subject to any regulatory restrictions on their
      dividends. Under applicable restrictions, as of December 31, 2007, the Bank
      could declare dividends totaling $6,031,000 without obtaining prior regulatory
      approval.





**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
      guideline levels, the holding company or bank may be denied approval to acquire
      or establish additional banks or non-bank businesses or to open new
      facilities.




9





The
      FDIC
      and Federal Reserve use risk-based capital guidelines for banks and bank holding
      companies. These are designed to make such 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 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 has noted
      that
      bank holding companies contemplating significant expansion programs should
      not
      allow expansion to diminish their capital ratios and should maintain ratios
      well
      in excess of the minimum. The 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 perpetual preferred stock and minority interests in equity accounts
      of consolidated subsidiaries, less intangibles except as described above and
      accumulated other comprehensive income (loss).





The
      Federal Reserve also employs a leverage ratio, which is Tier I capital as a
      percentage of total assets less intangibles, 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%.





FDICIA
      created a statutory framework of supervisory actions indexed to the capital
      level of the individual institution. Under regulations adopted by the FDIC,
      an
      institution is assigned to one of five capital categories depending on 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. The Company does
      not believe that these regulations had a material effect on its operations.





**Effects
      of Government Monetary Policy**





The
      earnings and growth of the Company are affected not only by general economic
      conditions, but also by the fiscal and monetary policies of the federal
      government, particularly the Federal Reserve. The Federal Reserve can and does
      implement national monetary policy for such purposes as curbing inflation and
      combating recession, but its open market operations in U.S. government
      securities, control of the discount rate applicable to borrowings from the
      Federal Reserve, and establishment of reserve requirements against certain
      deposits, influence the growth of bank loans, investments and deposits, and
      also
      affect interest rates charged on loans or paid on deposits. The nature and
      impact of future changes in monetary policies and their impact on the Company
      and the Bank cannot be predicted with certainty.




10
 
  **ITEM
          1A.**  **Risk
          Factors**
 
 The
          following are the 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.


**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 downturn in
      the economy or the real estate market in our market areas or a rapid change
      in
      interest rates could have a negative effect on collateral values and borrowers’
ability to repay. 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 charged to the provision for loan losses would reduce
      income.





**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
      growth 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.”





**Recent
      disruptions in the credit markets and expected weakness in real estate values
      in
      the markets in which we make loans may adversely affect our
      operations.**





Companies
      have recently experienced higher than anticipated levels of borrower defaults
      and lender foreclosures on many loan products, but particularly on sub-prime
      mortgage obligations. These defaults and other factors have led to disruptions
      in the credit markets and dramatic declines in the market for real estate in
      many areas. The areas in which we operate have been less affected by the credit
      crisis and declines in real estate values than others, but there is a
      possibility that our local real estate markets will experience increased
      declines in real estate values. In addition, there is a possibility that
      economic conditions will deteriorate. If the real estate market declines it
      could decrease the value and salability of the collateral for many of our loans.
      If the local economy deteriorates, we may see an increase in loan defaults.
      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. Also, we
      would then become directly affected by any decrease in sale prices on real
      estate we own, which could lead to write-downs. 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.





**Slower
      than anticipated growth in new branches and new product and service offerings
      could result in reduced net income.**





We
      have
      placed a strategic emphasis on expanding our branch network and product
      offerings. Executing this strategy carries risks of slower than anticipated
      growth both in new branches and new products. New branches and products require
      a significant investment of both financial and personnel resources. Lower than
      expected loan and deposit growth from new investments can result in revenues
      and
      net income generated by those investments that are less than anticipated. Also,
      opening new branches and introducing new products could result in more
      additional expenses than anticipated and divert resources from current
      operations.




11





**The
      financial services industry is very competitive.**





We
      face
      competition in attracting and retaining deposits, making loans, and providing
      other financial services throughout our market area. 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 us. 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 and face a reduction in our income from our lending
      activities.





**Decreased
      volumes and lower gains on sales of mortgage loans sold could reduce net
      income.**





We
      originate and sell mortgage loans. Changes in interest rates and other market
      conditions affect demand for our loan products and the revenue realized on
      the
      sale of loans. A decrease in the volume of loans sold can decrease our revenues
      and net income.





**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.





**Any
      regulatory response to the sub-prime mortgage crisis could have a negative
      effect on the way we conduct our business.**





Federal
      and state banking regulators have expressed concern with the high level of
      write-downs being taken by many financial institutions and the increase in
      defaults by many borrowers. In response, federal and state legislators and
      regulators may pursue increased regulation of lenders, including the methods
      by
      which loans are originated, purchased, or sold. Any legislative or regulatory
      response may impact how the Bank originates, buys and sells loans in the future
      or how the Bank underwrites loans that it originates, any of which could have
      a
      negative affect on our operations, including by reducing the liquidity provided
      to us by the secondary loan markets.




12





**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.





**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 thirteen 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
      $33,000.




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, 2007. The net book value of the Company’s premises and equipment
      was $15.4 million at that date.




13





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
      2007.




14


**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:





**2007**
            
            **2006****Shares
                Traded**
            
            **High**
            
            **Low**
            
            **Shares
                Traded**
            
            **High**
            
            **Low**First
                Quarter
            
            
            112,200
            
            $
            17.25
            
            $
            16.10
            
            
            233,500
            
            $
            16.00
            
            $
            14.55Second
                Quarter
            
            
            188,100
            
            $
            17.10
            
            $
            15.25
            
            
            117,400
            
            $
            15.30
            
            $
            14.55Third
                Quarter
            
            
            48,600
            
            $
            16.20
            
            $
            14.50
            
            
            138,000
            
            $
            18.25
            
            $
            14.60Fourth
                Quarter
            
            
            128,800
            
            $
            15.25
            
            $
            12.05
            
            
            58,900
            
            $
            18.25
            
            $
            16.40





As
      of
      December 31, 2007, there were approximately 1,153 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
      2007 and 2006 in the amount of $.75 per share. 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. Payment of dividends is subject to regulatory limitations.
      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. 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. Under applicable restrictions,
      as of December 31, 2007, the Bank could declare dividends totaling $6,031,000
      without obtaining prior regulatory approval.





**Issuer
      Purchases of Equity Securities**





The
      following table provides information about purchases of common stock by the
      Company during the quarter ended December 31, 2007:





**Period**
            
            **Total
                Number of Shares Purchased**
            
            **Average
                Price Paid Per Share**
            
            **Total
                Number of Shares Purchased as Part of Publicly Announced
                Plan**October
                1, 2007 - October 31, 2007
            
            
            —
            
            $
            —
            
            
            —November
                1, 2007 - November 30, 2007
            
            
            9,500
            
            
            12.70
            
            
            —December
                1, 2007 - December 31, 2007
            
            
            7,400
            
            
            13.50
            
            
            —**Total**
            
            
            **16,900**
            
            
            
            
            
            —




15


**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, 2002, and that
      all dividends were reinvested.





**COMPARISON
                OF FIVE YEAR CUMULATIVE TOTAL
                RETURN***















**Period
                Ending****Index**
            
            12/31/02
            
            12/31/03
            
            12/31/04
            
            12/31/05
            
            12/31/06
            
            12/31/07Pacific
                Financial Corporation
            
            $
            100.00
            
            $
            93.05
            
            $
            95.36
            
            $
            122.79
            
            $
            130.83
            
            $
            104.95S&P
                500
            
            
            100.00
            
            
            128.69
            
            
            140.27
            
            
            147.16
            
            
            170.40
            
            
            179.76NASDAQ
                Bank Index
            
            
            100.00
            
            
            133.04
            
            
            145.97
            
            
            143.15
            
            
            162.94
            
            
            130.50





16


**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,****2007**
            
            **2006**
            
            **2005**
            
            **2004**
            
            **2003**($
                in thousands, except per share data)**Operations
                Data**Net
                interest income
            
            $
            24,503
            
            $
            23,867
            
            $
            22,284
            
            $
            19,520
            
            $
            12,541Provision
                for credit losses
            
            
            482
            
            
            625
            
            
            1,100
            
            
            970
            
            
            —Non-interest
                income
            
            
            4,475
            
            
            4,176
            
            
            4,081
            
            
            3,162
            
            
            1,846Non-interest
                expense
            
            
            20,379
            
            
            18,118
            
            
            16,566
            
            
            13,555
            
            
            7,945Provision
                for income taxes
            
            
            2,086
            
            
            2,749
            
            
            2,653
            
            
            2,450
            
            
            1,863Net
                income
            
            
            6,031
            
            
            6,551
            
            
            6,046
            
            
            5,707
            
            
            4,579Net
                income per share:Basic
            
            
            .92
            
            
            1.01
            
            
            .94
            
            
            .93
            (1)
            
            .91
            (1)Diluted
            
            
            .90
            
            
            .99
            
            
            .92
            
            
            .91
            (1)
            
            .90
            (1)Dividends
                declared
            
            
            4,955
            
            
            4,893
            
            
            4,719
            
            
            4,624
            
            
            3,530Dividends
                declared per share
            
            
            .75
            
            
            .75
            
            
            .73
            
            
            .72
            (1)
            
            .
                70
            (1)Dividends
                paid ratio
            
            
            82
            %
            
            75
            %
            
            78
            %
            
            81
            %
            
            77
            %**Performance
                Ratios**Interest
                rate spread
            
            
            4.92
            %
            
            5.13
            %
            
            5.34
            %
            
            5.37
            %
            
            4.89
            %Net
                interest margin (2)
            
            
            4.82
            %
            
            5.04
            %
            
            5.25
            %
            
            5.25
            %
            
            4.75
            %Efficiency
                ratio (3)
            
            
            70.33
            %
            
            64.61
            %
            
            62.83
            %
            
            59.76
            %
            
            55.22
            %Return
                on average assets
            
            
            1.08
            %
            
            1.26
            %
            
            1.31
            %
            
            1.41
            %
            
            1.61
            %Return
                on average equity
            
            
            11.46
            %
            
            13.16
            %
            
            12.70
            %
            
            14.21
            %
            
            17.10
            %**Balance
                Sheet Data**Total
                assets
            
            $
            565,587
            
            $
            562,384
            
            $
            489,409
            
            $
            441,791
            
            $
            306,715Loans,
                net
            
            
            433,904
            
            
            420,768
            
            
            393,574
            
            
            341,671
            
            
            197,500Total
                deposits
            
            
            467,336
            
            
            466,841
            
            
            399,726
            
            
            363,501
            
            
            260,800Other
                borrowings
            
            
            37,446
            
            
            36,809
            
            
            35,790
            
            
            25,233
            
            
            14,500Shareholders’
                equity
            
            
            50,699
            
            
            48,984
            
            
            46,600
            
            
            45,303
            
            
            25,650Book
                value per share (4)
            
            
            7.67
            
            
            7.51
            
            
            7.21
            
            
            7.06
            (1)
            
            5.09
            (1)Equity
                to assets ratio
            
            
            8.96
            %
            
            8.71
            %
            
            9.52
            %
            
            10.25
            %
            
            8.36
            %**Asset
                Quality Ratios**Nonperforming
                loans to total loans
            
            
            1.41
            %
            
            1.76
            %
            
            1.67
            %
            
            .15
            %
            
            .27
            %Allowance
                for loan losses to total loans
            
            
            1.14
            %
            
            .95
            %
            
            1.33
            %
            
            1.23
            %
            
            1.12
            %Allowance
                for loan losses to nonperforming loans
            
            
            143.92
            %
            
            54.98
            %
            
            79.64
            %
            
            832.22
            %
            
            411.40
            %Nonperforming
                assets to total assets
            
            
            .62
            %
            
            1.30
            %
            
            1.36
            %
            
            .12
            %
            
            .18
            %





(1)
            Retroactively
                adjusted for a two-for-one 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.




17




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





The
      following discussion 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.





**EXECUTIVE
      OVERVIEW**





Net
      income in 2007 was $6,031,000, or $0.90 per diluted share compared to
      $6,551,000, or $0.99 per diluted share in 2006. The following are major factors
      impacting the Company’s results of operations for 2007 as compared to
      2006.





·
            Net
                interest income increased by 2.7% or $636,000 to $24,503,000 as compared
                to 2006. The increase was primarily due to growth in earning assets
                which
                was partially offset by margin compression. Growth in earning assets
                was
                mainly driven by loan production and was funded from federal funds
                sold
                and interest bearing deposits.





·
            The
                net interest margin for 2007 declined to 4.82% compared to 5.04%
                in 2006.
                The decrease in the net interest margin was mainly attributable to
                rate
                reductions in the Federal Funds rate by the Federal Open Market Committee
                (FOMC) in the third and fourth quarters of 2007 of a combined 100
                basis
                points which caused an immediate reduction in the variable rate loan
                portfolio and a delayed reduction of the Bank’s costs of its portfolio of
                time deposits. To a lesser extent, a change in the loan portfolio
                mix
                contributed to the margin compression, as the majority of the loan
                growth
                in 2007 came from government guaranteed loans which generally have
                a lower
                yield than real estate or commercial loans. In addition, the slight
                decrease in demand deposits and increase in savings and interest-bearing
                demand deposits contributed to the decrease in net interest
                margin.





·
            The
                loan loss provision decreased $143,000, or 22.9%, to $482,000 for
                2007 due
                primarily to flat growth in the non-government guaranteed loan portfolio
                and a large single recovery of a credit during 2007 in the amount
                of
                $619,000. Management’s assessment of the credit risk inherent in the
                portfolio is based on a migration, quantitative and qualitative analysis,
                other historical factors and
                trends.





·
            In
                2007, return on average assets and return on average equity decreased
                to
                1.08% and 11.46%, respectively, compared to 1.26% and 13.16% in 2006
                as a
                result of the aforementioned net interest margin
                compression.





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





·
            Total
                assets at December 31, 2007 increased by $3,203,000, or 0.6%, to
                $565,587,000 compared to $562,384,000 at the end of 2006. Net loans
                (including loans held for sale) grew $15,930,000, or 3.7%, to $451,066,000
                compared to $435,136,000 at December 31, 2006. The growth in loans
                was
                comprised primarily of net increases in government guaranteed
                loans.





·
            The
                Company purchased an additional $5,000,000 in bank owned life insurance
                during the fourth quarter of 2007.





·
            Non-accrual
                loans decreased $3,856,000, or 52.5%, to $3,479,000 at December 31,
                2007.
                This improvement is mainly attributable to the resolution of a single
                large problem loan at December 31, 2006 to a borrower in the forest
                products industry. We believe the ratio of nonperforming assets to
                total
                assets of 0.62% at December 31, 2007 reflects the Company’s conservative
                underwriting policies and continued efforts to monitor and address
                potential credit issues early and
                effectively.




18




**RESULTS
      OF OPERATIONS**





Years
      ended December 31, 2007, 2006, and 2005





*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, 2007.





**(dollars
                in thousands)**
            
            **2007**
            
            **Increase
                (Decrease) Amount**
            
            **%**
            
            **2006**
            
            **Increase
                (Decrease) Amount**
            
            **%**
            
            **2005**Interest
                income
            
            $
            40,136
            
            $
            3,692
            
            
            10.1
            
            $
            36,444
            
            $
            6,813
            
            
            23.0
            
            $
            29,631Interest
                expense
            
            
            15,633
            
            
            3,056
            
            
            24.3
            
            
            12,577
            
            
            5,230
            
            
            71.2
            
            
            7,347Net
                interest income
            
            
            24,503
            
            
            636
            
            
            2.7
            
            
            23,867
            
            
            1,583
            
            
            7.1
            
            
            22,284Provision
                for credit losses
            
            
            482
            
            
            (143
            )
            
            (22.9
            )
            
            625
            
            
            (475
            )
            
            (43.2
            )
            
            1,100Net
                  interest income after provision for credit losses
            
            
            24,021
            
            
            779
            
            
            3.4
            
            
            23,242
            
            
            2,058
            
            
            9.7
            
            
            21,184Other
                operating income
            
            
            4,475
            
            
            299
            
            
            7.2
            
            
            4,176
            
            
            95
            
            
            2.3
            
            
            4,081Other
                operating expense
            
            
            20,379
            
            
            2,261
            
            
            12.5
            
            
            18,118
            
            
            1,552
            
            
            9.4
            
            
            16,566Income
                before income taxes
            
            
            8,117
            
            
            (1,183
            )
            
            (12.7
            )
            
            9,300
            
            
            601
            
            
            6.9
            
            
            8,699Income
                taxes
            
            
            2,086
            
            
            (663
            )
            
            (24.1
            )
            
            2,749
            
            
            96
            
            
            3.6
            
            
            2,653**Net
                income**
            ****
            **$**
            **6,031**
            ****
            **$**
            **(520**
            **)**
            ****
            **(7.9**
            **)**
            **$**
            **6,551**
            ****
            **$**
            **505**
            ****
            ****
            **8.4**
            ****
            **$**
            **6,046**




*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.




19




**Year
                Ended December 31,****2007**
            
            **2006**
            
            **2005**(**dollars
                in thousands)**
            
            **Average
                Balance**
            
            **Interest
                Income (Expense)**
            
            **Avg
                Rate**
            
            **Average
                Balance**
            
            **Interest
                Income (Expense)**
            
            **Avg
                Rate**
            
            **Average
                Balance**
            
            **Interest
                Income (Expense)**
            
            **Avg
                Rate****Assets**Earning
                assets:Loans
                (1)
            
            $
            453,940
            
            $
            37,823
            
            
            8.33
            %
            $
            415,695
            
            $
            34,002
            
            
            8.18
            %
            $
            371,609
            
            $
            27,652
            
            
            7.44
            %Investment
                securities:Taxable
            
            
            26,522
            
            
            1,336
            
            
            5.04
            %
            
            22,395
            
            
            1,021
            
            
            4.56
            %
            
            23,231
            
            
            1,004
            
            
            4.32
            %Tax-Exempt
                (1)
            
            
            17,514
            
            
            1,074
            
            
            6.13
            %
            
            16,120
            
            
            983
            
            
            6.10
            %
            
            16,313
            
            
            1,018
            
            
            6.24
            %Total
                  investment securities
            
            
            44,036
            
            
            2,410
            
            
            5.47
            %
            
            38,515
            
            
            2,004
            
            
            5.20
            %
            
            39,544
            
            
            2,022
            
            
            5.11
            %Federal
                Home Loan Bank Stock
            
            
            1,858
            
            
            7
            
            
            0.38
            %
            
            1,858
            
            
            —
            
            
            —
            %
            
            1,855
            
            
            —
            
            
            —
            %Federal
                  funds sold anddeposits
                  in banks
            
            
            8,499
            
            
            426
            
            
            5.01
            %
            
            17,631
            
            
            909
            
            
            5.16
            %
            
            11,282
            
            
            344
            
            
            3.05
            %**Total
                  earning assets/interest income**
            
            **$**
            **508,333**
            ****
            **$**
            **40,666**
            ****
            ****
            **8.00**
            **%**
            **$**
            **473,699**
            ****
            **$**
            **36,915**
            ****
            ****
            **7.79**
            **%**
            **$**
            **424,290**
            ****
            **$**
            **30,018**
            ****
            ****
            **7.07**
            **%**Cash
                and due from banks
            
            
            12,236
            
            
            
            
            
            
            
            
            12,150
            
            
            
            
            
            
            
            
            10,009Bank
                premises and equipment (net)
            
            
            13,249
            
            
            
            
            
            
            
            
            11,103
            
            
            
            
            
            
            
            
            8,180Other
                assets
            
            
            30,013
            
            
            
            
            
            
            
            
            26,904
            
            
            
            
            
            
            
            
            24,876Allowance
                for credit losses
            
            
            (4,618
            )
            
            
            
            
            
            
            
            (5,114
            )
            
            
            
            
            
            
            
            (4,818
            )**Total
                assets**
            ****
            **$**
            **559,213**
            ****
            ****
            ****
            ****
            ****
            ****
            ****
            **$**
            **518,742**
            ****
            ****
            ****
            ****
            ****
            ****
            ****
            **$**
            **462,537**
            ****
            ******Liabilities
                and Shareholders’ Equity**Interest
                bearing liabilities:Deposits:Savings
                and interest-bearing demand
            
            $
            194,356
            
            $
            (4,947
            )
            
            2.55
            %
            $
            195,921
            
            $
            (4,650
            )
            
            2.37
            %
            $
            195,040
            
            $
            (3,089
            )
            
            1.58
            %Time
            
            
            177,362
            
            
            (8,513
            )
            
            4.80
            %
            
            148,055
            
            
            (6,196
            )
            
            4.18
            %
            
            112,345
            
            
            (3,323
            )
            
            2.96
            %**Total
                deposits**
            ****
            ****
            **371,718**
            ****
            ****
            **(13,460**
            **)**
            ****
            **3.62**
            **%**
            ****
            **343,976**
            ****
            ****
            **(10,846**
            **)**
            ****
            **3.15**
            **%**
            ****
            **307,385**
            ****
            ****
            **(6,412**
            **)**
            ****
            **2.09**
            **%**Short-term
                borrowings
            
            
            5,961
            
            
            (329
            )
            
            5.52
            %
            
            1,388
            
            
            (75
            )
            
            5.40
            %
            
            69
            
            
            (4
            )
            
            5.80
            %Long-term
                borrowings
            
            
            21,286
            
            
            (820
            )
            
            3.85
            %
            
            23,092
            
            
            (868
            )
            
            3.76
            %
            
            22,982
            
            
            (768
            )
            
            3.34
            %Secured
                borrowings
            
            
            1,517
            
            
            (110
            )
            
            7.25
            %
            
            1,981
            
            
            (141
            )
            
            7.12
            %
            
            2,942
            
            
            (163
            )
            
            5.54
            %Junior
                subordinated debentures
            
            
            13,403
            
            
            (914
            )
            
            6.82
            %
            
            9,539
            
            
            (647
            )
            
            6.78
            %
            
            152
            
            
            —
            
            
            —**Total
                borrowings**
            ****
            ****
            **42,167**
            ****
            ****
            **(2,173**
            **)**
            ****
            **5.15**
            **%**
            ****
            **36,000**
            ****
            ****
            **(1,731**
            **)**
            ****
            **4.81**
            **%**
            ****
            **26,145**
            ****
            ****
            **(935**
            **)**
            ****
            **3.58**
            **%****Total
                  interest-bearing liabilities/Interest
                  expense**
            
            **$**
            **413,885**
            ****
            **$**
            **(15,633**
            **)**
            ****
            **3.78**
            **%**
            **$**
            **379,976**
            ****
            **$**
            **(12,577**
            **)**
            ****
            **3.31**
            **%**
            **$**
            **333,530**
            ****
            **$**
            **(7,347**
            **)**
            ****
            **2.20**
            **%**Demand
                deposits
            
            
            87,467
            
            
            
            
            
            
            
            
            84,846
            
            
            
            
            
            
            
            
            78,787Other
                liabilities
            
            
            5,227
            
            
            
            
            
            
            
            
            4,133
            
            
            
            
            
            
            
            
            2,600Shareholders’
                equity
            
            
            52,634
            
            
            
            
            
            
            
            
            49,787
            
            
            
            
            
            
            
            
            47,620**Total
                liabilities and shareholders’equity**
            ****
            **$**
            **559,213**
            ****
            ****
            ****
            ****
            ****
            ****
            ****
            **$**
            **518,742**
            ****
            ****
            ****
            ****
            ****
            ****
            ****
            **$**
            **462,537**
            ****
            ****
            ****
            ****
            ****
            ****
            ******Net
                interest income (1)**
            ****
            ****
            ****
            ****
            **$**
            **25,033**
            ****
            ****
            ****
            ****
            ****
            ****
            ****
            **$**
            **24,338**
            ****
            ****
            ****
            ****
            ****
            ****
            ****
            **$**
            **22,671****Net
                interest income as a percentage of average earning
                assets**Interest
                income
            
            
            
            
            
            
            
            
            8.00
            %
            
            
            
            
            
            
            
            7.79
            %
            
            
            
            
            
            
            
            7.07
            **%**Interest
                expense
            
            
            
            
            
            
            
            
            3.08
            %
            
            
            
            
            
            
            
            2.66
            %
            
            
            
            
            
            
            
            1.73
            %**Net
                interest income**
            ****
            ****
            ****
            ****
            ****
            ****
            ****
            ****
            **4.92**
            **%**
            ****
            ****
            ****
            ****
            ****
            ****
            ****
            **5.13**
            **%**
            ****
            ****
            ****
            ****
            ****
            ****
            ****
            **5.34**
            **%****Net
                interest margin (2)**
            ****
            ****
            ****
            ****
            ****
            ****
            ****
            ****
            **4.82**
            **%**
            ****
            ****
            ****
            ****
            ****
            ****
            ****
            **5.04**
            **%**
            ****
            ****
            ****
            ****
            ****
            ****
            ****
            **5.25**
            **%****Tax
                equivalent adjustment (1)**
            ****
            ****
            ****
            ****
            **$**
            **530**
            ****
            ****
            ****
            ****
            ****
            ****
            ****
            **$**
            **471**
            ****
            ****
            ****
            ****
            ****
            ****
            ****
            **$**
            **387**
            ****
            ****




(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
      $1,828,000, $1,508,000, and $2,439,000 in 2007, 2006, and 2005,
      respectively .





20


Net
        interest income on a tax equivalent basis totaled $25,033,000 for the year
        ended
        December 31, 2007, an increase of $695,000, or 2.9%, compared to 2006. Net
        interest income increased 7.1% to $23,867,000 in 2006 compared to 2005. The
        Company’s tax equivalent interest income increased 10.2% to $40,666,000 from
        year end 2006 to year end 2007, and 23.0% to $36,915,000 in 2006 from
        $30,018,000 in 2005. 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
        $34,634,000, or 7.3%, in 2007 and was offset by compression of its net interest
        margin. The decrease in net interest margin was due to a 100 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.
        Additionally, the FOMC cut the Federal Funds rate another 125 basis points
        in
        January 2008. Approximately 75% 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 $38,245,000, or 9.2%, from year end
        2006 to year end 2007, and increased $44,086,000, or 11.9%, from 2005 to
        2006.
        The increase in the average portfolio in 2007 was a result of the purchase
        of
        $22 million in variable rate loans that are fully guaranteed by U.S. government
        agencies. Of this amount, approximately $16 million are real estate loans,
        with
        the remaining $6 million being commercial loans. Excluding the purchase of
        loans
        previously mentioned, loan balances are down in 2007 due to softer loan demand.
        Additionally, the Company experienced higher than expected prepayments on
        the
        government guaranteed loan portfolio in 2007 which contributed to a reduction
        in
        net interest income of $529,000 during the course of the year. The increase
        in
        loans in 2006 was a result of the Company’s expanded presence in Whatcom County,
        which enjoyed a very strong residential real estate construction market in
        2006
        and to some degree in 2007. Whatcom County is showing some signs of a slow
        down
        in the real estate market, however, we do not expect that geographic area
        to
        exhibit the price depreciation and market issues of the same magnitude realized
        in other parts of the country due in part to the strong Canadian dollar.
 
 The
        Company’s average investment portfolio increased $5,521,000, or 14.3%, from
        2006, and decreased $1,029,000, or 2.6%, from 2005 to 2006. The increase
        in 2007
        was due to management’s decision to redistribute federal funds sold into
        investment securities to capture a higher return. The change in 2006 was
        due to
        maturing investments being utilized to fund loan production.
 
 The
        Company’s average deposits increased $30,363,000, or 7.1%, from 2006, and
        increased $42,650,000 or 11.0% in 2006 from 2005. The Company attributes
        its
        growth to its experienced branch staff, a commitment to improving customer
        service throughout its branch delivery system, and continued success from
        branches opened in 2006. During 2007, average deposits from branches opened
        in
        recent years contributed $12,389,000 or 40.8%, to the overall increase. Actual
        deposit balances outstanding remained flat year over year 2007 to 2006 at
        $467,336,000 compared to $466,841,000. 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 2007 by $6,167,000 or 17.1%,
        and
        by $9,855,000, or 37.7%, during 2006. The increase in both years 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 and secured borrowings. The
        Company’s overall cost of interest-bearing liabilities increased to 3.78% in
        2007 from 3.31% and 2.20% in 2006 and 2005, respectively. 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.
        The increase from 2005 to 2006 was due to the funding of the Company’s loan
        growth with time deposits, which are more sensitive to market rate increases
        versus funding such growth with lower cost demand, money market, NOW or savings
        deposits.
  21
 
 Net
        interest margins were 4.82%, 5.04%, and 5.25%, for the years ended December
        31,
        2007, 2006, and 2005, 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.
  **2007****compared to 2006**
              
              **2006
                  compared to 2005****Increase
                  (decrease) due to**
              
              **Increase
                  (decrease) due to****(dollars
                  in thousands)**
              
              **Volume**
              
              **Rate**
              
              **Net**
              
              **Volume**
              
              **Rate**
              
              **Net**Interest
                  earned on:Loans
              
              $
              3,177
              
              $
              644
              
              $
              3,821
              
              $
              3,458
              
              $
              2,892
              
              $
              6,350Securities:Taxable
              
              
              201
              
              
              114
              
              
              315
              
              
              (37
              )
              
              54
              
              
              17Tax-exempt
              
              
              85
              
              
              6
              
              
              91
              
              
              (12
              )
              
              (23
              )
              
              (35
              )Total
                  securities
              
              
              286
              
              
              120
              
              
              406
              
              
              (49
              )
              
              31
              
              
              (18
              )Federal
                  Home Loan Bank Stock
              
              
              —
              
              
              7
              
              
              7
              
              
              —
              
              
              —
              
              
              —Fed
                  funds sold and interestbearing
                  deposits in other banks
              
              
              (458
              )
              
              (25
              )
              
              (483
              )
              
              254
              
              
              311
              
              
              565**Total
                  interest earning assets**
              ****
              ****
              **3,005**
              ****
              ****
              **746**
              ****
              ****
              **3,751**
              ****
              ****
              **3,663**
              ****
              ****
              **3,234**
              ****
              ****
              **6,897**Interest
                  paid on:Savings
                  and interest bearingdemand
                  deposits
              
              
              37
              
              
              (334
              )
              
              (297
              )
              
              (14
              )
              
              (1,547
              )
              
              (1,561
              )Time
                  deposits
              
              
              (1,330
              )
              
              (987
              )
              
              (2,317
              )
              
              (1,246
              )
              
              (1,627
              )
              
              (2,873
              )Total
                  borrowings
              
              
              (312
              )
              
              (130
              )
              
              (442
              )
              
              (416
              )
              
              (380
              )
              
              (7,96
              )**Total
                  interest bearing liabilities**
              
              
              **(1,605**
              **)**
              ****
              **(1,451**
              **)**
              ****
              **(3,056**
              **)**
              ****
              **(1,676**
              **)**
              ****
              **(3,554**
              **)**
              ****
              **(5,230**
              **)****Change
                  in net interest income**
              
              **$**
              **1,400**
              ****
              **$**
              **(705**
              **)**
              **$**
              **695**
              ****
              **$**
              **1,987**
              ****
              **$**
              **(320**
              **)**
              **$**
              **1,667**
 
 *Non-Interest
        Income.* Non-interest income was $4,475,000 for 2007, an increase of $299,000 or 7.2%
        from 2006 when it totaled $4,176,000. The 2006 amount increased $95,000 or
        2.3%
        compared to the 2005 total of $4,081,000.
 
 The
        following table represents the principal categories of non-interest income
        for
        each of the years in the three-year period ended December 31, 2007.
  **Increase**
              
              
              
              
              
              **Increase****(Decrease)**
              
              
              
              
              
              **(Decrease)****(dollars
                  in thousands)**
              
              **2007**
              
              **Amount**
              
              **%**
              
              **2006**
              
              **Amount**
              
              **%**
              
              **2008**Service
                  charges ondeposit
                  accounts
              
              $
              1,494
              
              $
              42
              
              
              2.9
              %
              $
              1,452
              
              $
              (18
              )
              
              (1.2
              %)
              $
              1,470Income
                  from and gains on sale offoreclosed
                  real estate
              
              
              —
              
              
              (5
              )
              
              (100.0
              %)
              
              5
              
              
              5
              
              
              —
              
              
              —Net
                  gains from sales of loans
              
              
              1,984
              
              
              89
              
              
              4.7
              %
              
              1,895
              
              
              86
              
              
              4.8
              %
              
              1,809Net
                  gain on sale of securities
              
              
              (20
              )
              
              (20
              )
              
              (100.0
              %)
              
              —
              
              
              (2
              )
              
              (100.0
              %)
              
              2Earnings
                  on bank owned life insurance
              
              
              397
              
              
              43
              
              
              12.1
              %
              
              354
              
              
              (39
              )
              
              (9.9
              %)
              
              393Other
                  operating income
              
              
              620
              
              
              150
              
              
              31.9
              %
              
              470
              
              
              63
              
              
              15.5
              %
              
              407**Total
                  non-interest income**
              ****
              **$**
              **4,475**
              ****
              **$**
              **299**
              ****
              ****
              **7.2**
              **%**
              **$**
              **4,176**
              ****
              **$**
              **95**
              ****
              ****
              **2.3**
              **%**
              **$**
              **4,081**
  22
  Service
        charges on deposits increased 2.9% during 2007 and decreased 1.2% during
        2006.
        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 2007. Flattening overdraft revenue in 2006 contributed to the
        decrease in service charges in 2006 as the Bank discontinued advertising
        of its
        overdraft protection product in mid-year.
 
 Income
        from sources other than service charges on deposit accounts totaled $2,981,000
        in 2007, an increase of $257,000 from 2006, or 9.4%. The largest component
        is
        gain on sales of loans. The market interest rate environment heavily influences
        revenue from mortgage banking activities. Refinance activity continued to
        be
        strong for most of 2007, as long-term interest rates remained stable, with
        a
        softening of demand in the fourth quarter which was partially due to issues
        surrounding the subprime mortgage crisis. The Company does not engage in
        or have
        any exposure to subprime loans or subprime mortgage backed securities.
        Management expects gains on sale of loans to remain flat in 2008 due to new
        home
        construction slowing and downward pressure on home values in our markets,
        which
        may be partially offset by increased refinancing activity from lower interest
        rates partially attributable to recent rate reductions by the FOMC. 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 increases for both 2007 and
        2006
        were attributable primarily to increased merchant card and loan document
        preparation fees.
  *Non-Interest
        Expense* . Total
        non-interest expense in 2007 was $20,379,000, an increase of $2,261,000 or
        12.5%
        compared to $18,118,000 in 2006. In 2006, non-interest expense increased
        $1,552,000 or 9.4% compared to $16,566,000 in 2005. Changes in non-interest
        expense are discussed in greater detail below. The Company expects that
        non-interest expense will increase approximately 5% during 2008 as it continues
        to make infrastructure improvements to support the future growth of the Company.
 
 The
        following table represents the principal categories of non-interest expense
        for
        each of the years in the three-year period ended December 31, 2007.
  **Increase**
              
              
              
              
              
              **Increase****(Decrease)**
              
              
              
              
              
              **(Decrease)****(dollars
                  in thousands)**
              
              **2007**
              
              **Amount**
              
              **%**
              
              **2006**
              
              **Amount**
              
              **%**
              
              **2005**Salaries
                  and employee benefits
              
              $
              12,280
              
              $
              1,671
              
              
              15.8
              %
              $
              10,609
              
              $
              536
              
              
              5.3
              %
              $
              10,073Occupancy
                  and equipment
              
              
              2,528
              
              
              110
              
              
              4.5
              %
              
              2,418
              
              
              381
              
              
              18.7
              %
              
              2,037Marketing
                  and advertising
              
              
              560
              
              
              75
              
              
              15.5
              %
              
              485
              
              
              (10
              )
              
              (2.0
              %)
              
              495State
                  taxes
              
              
              436
              
              
              61
              
              
              16.3
              %
              
              375
              
              
              27
              
              
              7.8
              %
              
              348Data
                  processing
              
              
              393
              
              
              (29
              )
              
              (6.9
              %)
              
              422
              
              
              (57
              )
              
              (11.9
              %)
              
              479Other
                  expense
              
              
              4,182
              
              
              373
              
              
              9.8
              %
              
              3,809
              
              
              675
              
              
              21.5
              %
              
              3,134**Total
                  non-interest expense**
              ****
              **$**
              **20,379**
              ****
              **$**
              **2,261**
              ****
              ****
              **12.5**
              **%**
              **$**
              **18,118**
              ****
              **$**
              **1,552**
              ****
              ****
              **9.4**
              **%**
              **$**
              **16,566**
 
 Salary
        and employee benefits, the largest component of non-interest expense, increased
        by $1,671,000, or 15.8%, in 2007 to $12,280,000 and increased by $536,000,
        or
        5.3%, in 2006 compared to 2005. 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 203 to 212 during 2007. In 2006, higher
        salaries, additional employees primarily from new branches and increased
        performance-based compensation were the key drivers of increased personnel
        expense. Also included in salaries and benefits for 2007 and 2006 was stock
        option expense of $97,000 and $36,000, respectively, in accordance with SFAS
        No.
        123R.
 
 Occupancy
        and equipment expenses increased $110,000 to $2,528,000 in 2007 compared
        with
        $2,418,000 for 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. Occupancy and equipment expenses increased
        $381,000, or 18.7%, for 2006 compared to 2005 due to increased operational
        costs
        resulting from a full year of expenses associated with the Raymond and
        Anacortes, Washington branches opened in early 2006.
  23
 
 Marketing
        and advertising expense increased 15.5% to $560,000 in 2007 compared with
        $485,000 for 2006. The increase in 2007 is due to the Company’s efforts to
        increase awareness of its brand in the markets we serve, which included a
        strategic brand initiative, an evaluation of marketing materials, and ongoing
        customer surveys. The 2006 decline was the result of increased promotional
        activity incurred in 2005 to expand the Company’s presence in the Whatcom County
        market following the acquisition of BNW and a name change for all BNW
        branches.
 
 Data
        processing expense decreased 6.9% to $393,000 in 2007 compared with $422,000
        for
        2006. The decrease 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. Data processing expense decreased $57,000
        or
        11.9% in 2006 compared to 2005 due to costs savings associated with
        consolidating the BNW processing operations into the Company’s existing system.
 
 Other
        operating expense increased 9.8% to $4,182,000 in 2007 compared with $3,809,000
        for 2006 primarily due to increased software amortization, business travel,
        and
        training expenses, which were up $149,000, $65,000, and $42,000, respectively.
        Additionally, the Company recorded an expense of $115,000 in 2007 relating
        to
        the settlement of an employment contract dispute. Other operating expenses
        increased 21.5% to $3,809,000 in 2006 compared to 2005 primarily due to
        increases in accounting and consulting fees, legal fees, FDIC assessments,
        and
        loan collection expense, each of which were up $354,000, $67,000, $63,000
        and
        $41,000, respectively.
 
 *Income
        Tax Expense* .
        For the
        years ended December 31, 2007, 2006, and 2005, the provision for income taxes
        was $2,086,000, $2,749,000 and $2,653,000, respectively, representing effective
        tax rates of 25.7%, 29.6% and 30.5%, respectively. 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, 2007, the Company had a net deferred tax liability
        of $441,000.
 
 **FINANCIAL
        CONDITION**
 
 **INVESTMENT
        PORTFOLIO**
 
 The
        Company’s investment securities portfolio increased $4,529,000, or 10.6%, during
        2007 to $47,241,000, which was offset by a reduction in interest bearing
        deposits in banks and federal funds sold. The Company’s investment securities
        portfolio increased $6,460,000, or 17.8%, during 2006 to $42,712,000 at year
        end
        from $36,252,000 in 2005 funded by strong deposit growth 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 securities that have been in a continuous unrealized loss position for
        twelve months or longer at December 31, 2007 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,
        2007. 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,
        2007. Additionally, the Company does not hold any securities backed by subprime
        mortgages, collateralized debt obligations, or special investment vehicles
        at
        December 31, 2007.
  24
 
 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)**
              
              **2007**
              
              **2006**
              
              **2005**Obligations
                  of states and political subdivisions
              
              $
              3,562
              
              $
              5,155
              
              $
              5,315Mortgage-backed
                  securities
              
              
              767
              
              
              949
              
              
              1,189**Total**
              
              **$**
              **4,329**
              
              **$**
              **6,104**
              
              **$**
              **6,504**
  **AVAILABLE
        FOR SALE**
 
 **(dollars
                  in thousands)**
              
              **2007**
              
              **2006**
              
              **2005**U.S.
                  Agency securities
              
              $
              3,818
              
              $
              8,311
              
              $
              4,370Obligations
                  of states and political subdivisions
              
              
              16,136
              
              
              13,619
              
              
              12,172Mortgage-backed
                  securities
              
              
              18,540
              
              
              10,232
              
              
              8,257Corporate
                  bonds
              
              
              1,512
              
              
              1,512
              
              
              2,024Mutual
                  funds
              
              
              2,906
              
              
              2,934
              
              
              2,925**Total**
              
              **$**
              **42,912**
              
              **$**
              **36,608**
              
              **$**
              **29,748**
 
 
 The
        following table presents the maturities of investment securities at December
        31,
        2007. 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**
              
              **Total**Mortgage-backed
                  securities
              
              $
              —
              
              $
              —
              
              $
              —
              
              $
              767
              
              $
              767Weighted
                  average yield
              
              
              —
              
              
              —
              
              
              —
              
              
              5.42
              %Obligations
                  of states and political subdivisions
              
              
              646
              
              
              784
              
              
              1,128
              
              
              1,004
              
              
              3,562Weighted
                  average yield
              
              
              3.87
              %
              
              7.03
              %
              
              6.11
              %
              
              6.93
              %**Total**
              
              **$**
              **646**
              
              **$**
              **784**
              
              **$**
              **1,128**
              
              **$**
              **1,771**
              
              **$**
              **4,329**
 
 25
  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**
              
              **Total**U.S.
                  Agency securities
              
              $
              999
              
              $
              2,084
              
              $
              —
              
              $
              735
              
              $
              3,818Weighted
                  average yield
              
              
              5.23
              %
              
              4.53
              %
              
              —
              
              
              5.81
              %Mortgage-backed
                  securities
              
              
              —
              
              
              239
              
              
              1,598
              
              
              16,703
              
              
              18,540Weighted
                  average yield
              
              
              —
              
              
              4.37
              %
              
              4.75
              %
              
              5.10
              %Obligations
                  of states and political subdivisions
              
              
              501
              
              
              5,577
              
              
              3,564
              
              
              6,494
              
              
              16,136Weighted
                  average yield
              
              
              6.64
              %
              
              5.48
              %
              
              5.35
              %
              
              5.74
              %Other
                  securities
              
              
              3,399
              
              
              1,019
              
              
              —
              
              
              —
              
              
              4,418Weighted
                  average yield
              
              
              4.50
              %
              
              4.21
              %
              
              —
              
              
              —**Total**
              
              **$**
              **4,899**
              
              **$**
              **8,919**
              
              **$**
              **5,162**
              
              **$**
              **23,932**
              
              **$**
              **42,912**
 
 **LOAN
        PORTFOLIO**
 
 *General* . The
        Company’s policy is to originate loans primarily in its local markets. Depending
        on the purpose of the loan, the loans may be secured by a variety of collateral,
        including business assets, real estate, and personal assets. Loans, including
        loans held for sale, represented 81% of total assets as of December 31, 2007,
        compared to 78% at December 31, 2006. The majority of the Company’s loan
        portfolio is comprised of commercial and industrial 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
        Company emphasizes commercial real estate and construction and land development
        loans. Our commercial real estate portfolio generally consists of a wide
        cross-section of retail, small office, warehouse, and industrial type
        properties. A substantial number of these properties are owner-occupied.
        Loan to
        value ratios for the Company’s commercial real estate loans generally do not
        exceed 80% at origination and debt service ratios are 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 if there were to be a downturn in the commercial real estate market.
        Additionally, this is a sector in which we have significant and long-term
        management experience. During the third quarter of 2007, the Company tightened
        its underwriting criteria for advance rates on raw land loans, land development
        loans, residential lots, speculative construction for condominiums and all
        construction loans.
 
 It
        is our
        strategic plan to continue to emphasize growth in commercial and small business
        loans. We believe this will be a key contributor to growing more low cost
        deposits. Additionally, we are currently in the process of automating our
        consumer loan approval procedures. We anticipate this system will expedite
        the
        loan approval process and reduce overhead, while increasing consumer loan
        balances, including installment and credit card categories.
  26
 
 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)**
              
              **2007**
              
              **2006**
              
              **2005**
              
              **2004**
              
              **2003**Commercial
              
              $
              128,145
              
              $
              132,843
              
              $
              124,536
              
              $
              111,050
              
              $
              64,344Real
                  estate construction
              
              
              93,249
              
              
              87,063
              
              
              87,621
              
              
              49,347
              
              
              11,894Real
                  estate mortgage
              
              
              224,714
              
              
              209,206
              
              
              185,503
              
              
              176,011
              
              
              117,940Installment
              
              
              7,283
              
              
              8,668
              
              
              9,945
              
              
              9,653
              
              
              4,625Credit
                  cards and overdrafts
              
              
              3,363
              
              
              1,990
              
              
              1,863
              
              
              1,979
              
              
              935Less
                  unearned income
              
              
              (681
              )
              
              (601
              )
              
              (487
              )
              
              (281
              )
              
              —**Total**
              
              **$**
              **456,073**
              
              **$**
              **439,169**
              
              **$**
              **408,981**
              
              **$**
              **347,759**
              
              **$**
              **199,738**
 
 *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, 2007.
 
 ****
              ****
              **Due
                  after**
              ****
              ****
              ****
              ****
              ********
              ****
              **Due
                  in one**
              ****
              **one
                  through**
              ****
              **Due
                  after****(dollars
                  in thousands)**
              
              **year
                  or less**
              ****
              **five
                  years**
              ****
              **five
                  years**
              ****
              **Total**Commercial
              
              $
              58,773
              
              $
              35,185
              
              $
              34,187
              
              $
              128,145Real
                  estate construction
              
              
              75,823
              
              
              13,050
              
              
              4,376
              
              
              93,249**Total**
              ****
              **$**
              **134,596**
              ****
              **$**
              **48,235**
              ****
              **$**
              **38,563**
              ****
              **$**
              **221,394****Total
                  loans maturing after one year with**Predetermined
                  interest rates (fixed)
              
              
              
              
              $
              26,969
              
              $
              45,620
              
              $
              72,589Floating
                  or adjustable rates (variable)
              
              
              
              
              
              86,159
              
              
              4,183
              
              
              90,342**Total**
              ****
              ****
              ****
              ****
              **$**
              **113,128**
              ****
              **$**
              **49,803**
              ****
              **$**
              **162,931**
 
 At
        December 31, 2007, 33.9% 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)**
              
              **2007**
              
              **2006**
              
              **2005**
              
              **2004**
              
              **2003**Non-accrual
                  loans
              
              $
              3,479
              
              $
              7,335
              
              $
              6,650
              
              $
              470
              
              $
              465Accruing
                  loans past due 90days
                  or more
              
              
              2,932
              
              
              376
              
              
              82
              
              
              —
              
              
              —Restructured
                  loans
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              —Foreclosed
                  real estate
              
              
              —
              
              
              —
              
              
              37
              
              
              40
              
              
              98
  27
  Non-accrual
        loans totaled $3,479,000 at December 31, 2007, a decrease of $3,856,000 as
        compared to $7,335,000 at December 31, 2006. The balance of non-accrual loans
        at
        year end is equal to 0.76% of total loans including loans held for sale,
        compared to 1.67% at December 31, 2006. The totals are net of charge-offs
        based
        on management’s estimate of fair market value or the result of appraisals. 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, of which
        $3,510,000 was guaranteed by the United States Department of Agriculture
        (USDA).
        The improvement in non-accrual loans in 2007 resulted from the resolution
        of
        this loan. Loans ninety days or more and still accruing interest of $2,932,000
        at December 31, 2007 are made up entirely of two loans which are 100% guaranteed
        by the USDA. Subsequent to December 31, 2007, these loans were paid off in
        full.
        Sales of foreclosed real estate owned totaled $0, $42,000, and $0 during
        2007,
        2006 and 2005, respectively. We consider the current level of nonperforming
        assets to be manageable.
 
 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
        $270,000 for 2007, $306,000 for 2006, $76,000 for 2005, $8,000 for 2004,
        and
        $37,000 for 2003. Interest income recognized on impaired loans for 2007 was
        $457,000, for 2006 was $272,000, for 2005 was $569,000, for 2004 was $16,000,
        and for 2003 was $19,000.
 
 *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, 2007, loans secured by real estate totaled $317,963,000,
        which represents 69.7% of the total loan portfolio. Real estate construction
        loans comprised $93,249,000 of that amount, while real estate loans secured
        by
        residential properties totaled $60,616,000. As a result of these concentrations
        of loans, the loan portfolio is susceptible to changes in economic and market
        conditions in the Company’s market areas. The Company generally requires
        collateral on all real estate exposures and typically maintains 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.
 
 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.
  28
 
 Transactions
        in the allowance for credit losses for the five years ended December 31,
        2007
        are as follows:
  **(dollars
                  in thousands)**
              
              **2007**
              
              **2006**
              
              **2005**
              
              **2004**
              
              **2003**Balance
                  at beginning of year
              
              $
              4,033
              
              $
              5,296
              
              $
              4,236
              
              $
              2,238
              
              $
              2,473Charge-offs:Commercial
              
              
              —
              
              
              1,925
              
              
              41
              
              
              235
              
              
              17Real
                  estate loans
              
              
              40
              
              
              —
              
              
              —
              
              
              18
              
              
              239Credit
                  card
              
              
              18
              
              
              16
              
              
              7
              
              
              11
              
              
              6Installment
              
              
              93
              
              
              4
              
              
              17
              
              
              11
              
              
              3**Total
                  charge-offs**
              
              
              **151**
              
              
              **1,945**
              
              
              **65**
              
              
              **275**
              
              
              **265**Recoveries:Commercial
              
              
              619
              
              
              —
              
              
              3
              
              
              7
              
              
              5Real
                  estate loans
              
              
              21
              
              
              51
              
              
              19
              
              
              123
              
              
              23Credit
                  card
              
              
              2
              
              
              5
              
              
              1
              
              
              1
              
              
              1Installment
              
              
              1
              
              
              1
              
              
              2
              
              
              —
              
              
              1**Total
                  recoveries**
              
              
              **643**
              
              
              **57**
              
              
              **25**
              
              
              **131**
              
              
              **30**Net
                  charge-offs (recoveries)
              
              
              (492
              )
              
              1,888
              
              
              40
              
              
              144
              
              
              235Provision
                  for credit losses
              
              
              482
              
              
              625
              
              
              1,100
              
              
              970
              
              
              —BNW
                  Bancorp, Inc. acquisition
              
              
              —
              
              
              —
              
              
              —
              
              
              1,172
              
              
              —**Balance
                  at end of year**
              
              **$**
              **5,007**
              
              **$**
              **4,033**
              
              **$**
              **5,296**
              
              **$**
              **4,236**
              
              **$**
              **2,238**Ratio
                  of net charge-offs (recoveries)to
                  average loans outstanding
              
              
              (.11
              %)
              
              .45
              %
              
              .01
              %
              
              .05
              %
              
              .12
              %
  The
        allowance for credit losses was $5,007,000 at year-end 2007, compared with
        $4,033,000 at year-end 2006, an increase of $974,000 or 24.2%. The increase
        in
        2007 was due to increased recoveries and provision expense of $482,000 during
        2007. Total recoveries in 2007 include a $619,000 recovery on the $1,925,000
        charge-off in 2006 that was attributable to one commercial borrower. The
        Company
        continued to record loss provisions in 2007 to compensate for both growth
        in the
        Company’s loan portfolio and weakening economic trends in our markets. The
        increased level of allowance for credit losses in 2005 and 2006 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, 2007, 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.
        Management is committed to maintaining the allowance for credit losses at
        a
        level that is considered commensurate with estimated and known risks in the
        portfolio. 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, 2007, management deems the allowance for credit
        losses of $5,007,000 (1.14% of total loans outstanding and 143.92% of
        non-performing loans) adequate to provide for probable losses based on an
        evaluation of known and inherent risks in the loan portfolio at that date. 
See “Risk Factors” under Item 1A above for a discussion of certain risks faced
        by the Company that could affect the adequacy of the allowance.
  29
 
 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)**
              
              **2007**
              
              **2006**
              
              **2005**
              
              **2004**
              
              **2003**Total
                  impaired loans
              
              $
              6,431
              
              $
              7,379
              
              $
              6,650
              
              $
              7,934
              
              $
              588Total
                  impaired loans withvaluation
                  allowance
              
              
              3,052
              
              
              51
              
              
              4,917
              
              
              7,464
              
              
              123Valuation
                  allowance related toimpaired
                  loans
              
              
              72
              
              
              17
              
              
              924
              
              
              200
              
              
              23
 
 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 their historical net charge-off
        experience and other business considerations at December 31 in each of the
        last
        five years.
 
 **%
                  of**
              
              
              
              **%
                  of**
              
              
              
              **%
                  of**
              
              
              
              **%
                  of**
              
              
              
              **%
                  of****2007**
              
              **Total**
              
              **2006**
              
              **Total**
              
              **2005**
              
              **Total**
              
              **2004**
              
              **Total**
              
              **2003**
              
              **Total****(dollars
                  in thousands)**
              
              **Reserve**
              
              **Loans**
              
              **Reserve**
              
              **Loans**
              
              **Reserve**
              
              **Loans**
              
              **Reserve**
              
              **Loans**
              
              **Reserve**
              
              **Loans**Commercial
                  loans
              
              $
              1,780
              
              
              36
              %
              $
              1,705
              
              
              42
              %
              $
              1,589
              
              
              32
              %
              $
              1,680
              
              
              32
              %
              $
              764
              
              
              32
              %Real
                  estate loans
              
              
              3,016
              
              
              60
              %
              
              2,167
              
              
              54
              %
              
              3,548
              
              
              65
              %
              
              2,432
              
              
              65
              %
              
              1,399
              
              
              65
              %Consumer
                  loans
              
              
              211
              
              
              4
              %
              
              161
              
              
              4
              %
              
              159
              
              
              3
              %
              
              124
              
              
              3
              %
              
              75
              
              
              3
              %**Total
                  allowance**
              ****
              **$**
              **5,007**
              ****
              ****
              **100**
              **%**
              **$**
              **4,033**
              ****
              ****
              **100**
              **%**
              **$**
              **5,296**
              ****
              ****
              **100**
              **%**
              **$**
              **4,236**
              ****
              ****
              **100**
              **%**
              **$**
              **2,238**
              ****
              ****
              **100**
              **%**Ratio
                  of allowance for credit losses to loans outstanding at end of
                  year
              
              
              1.14
              %
              
              
              
              
              .95
              %
              
              
              
              
              
              
              
              1.33
              %
              
              
              
              
              1.23
              %
              
              
              
              
              1.12
              %
 
 The
        table
        indicates an increase of $849,000 in the allowance related to real estate
        loans
        from December 31, 2006 to December 31, 2007. The primary reason for the
        increases and changes in percentage allocations are due to changes in portfolio
        mix and the growth trend in real estate and real estate construction loans.
        The
        Company had a specific reserve of $857,000 at December 31, 2005 relative
        to one
        borrower. This specific reserve was used to offset losses on that credit
        in
        2006. The overall net reduction in the allowance for credit losses attributable
        to that borrower was $1,263,000 during 2006.
  30
 
 **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
        for the foreseeable future.
 
 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)**
              
              **2007**
              
              **Rate**
              
              **2006**
              
              **Rate**
              
              **2005**
              
              **Rate**Non-interest
                  bearing demanddeposits
              
              $
              87,467
              
              
              0.00
              %
              $
              84,846
              
              
              0.00
              %
              $
              79,866
              
              
              0.00
              %Interest
                  bearing demand deposits
              
              
              42,803
              
              
              0.48
              %
              
              48,140
              
              
              0.57
              %
              
              56,615
              
              
              0.58
              %Savings
                  deposits
              
              
              151,553
              
              
              3.13
              %
              
              147,781
              
              
              2.96
              %
              
              138,425
              
              
              1.99
              %Time
                  deposits
              
              
              177,362
              
              
              4.80
              %
              
              148,055
              
              
              4.18
              %
              
              112,345
              
              
              2.96
              %**Total**
              
              **$**
              **459,185**
              
              
              **2.93**
              **%**
              **$**
              **428,822**
              
              
              **2.53**
              **%**
              **$**
              **387,251**
              
              
              **1.66**
              **%**
 
 Maturities
        of time certificates of deposit as of December 31, 2007 are summarized as
        follows:
 
 **(dollars
                  in thousands)**
              
              **Under**
                **$100,000**
              
              **Over**
                **$100,000**
              
              **Total**3
                  months or less
              
              $
              24,322
              
              $
              40,247
              
              $
              64,569Over
                  3 through 6 months
              
              
              27,275
              
              
              33,100
              
              
              60,375Over
                  6 through 12 months
              
              
              13,500
              
              
              10,449
              
              
              23,949Over
                  12 months
              
              
              11,041
              
              
              15,744
              
              
              26,785**Total**
              
              **$**
              **76,138**
              
              **$**
              **99,540**
              
              **$**
              **175,678**
 
 Total
        deposits slightly increased 0.1% to $467.3 million at December 31, 2007 compared
        to $466.8 million at December 31, 2006, primarily in money market accounts
        from
        a business investment sweep product launched in 2007, which were partially
        offset by decreases in non-interest bearing demand deposits. The ratio of
        non-interest bearing deposits to total deposits was 18.6% and 19.6% at December
        31, 2007 and 2006, respectively. Total deposits increased 16.8% to $466.8
        million at December 31, 2006 compared to $399.7 million at December 31, 2005
        primarily as a result of growth in money market accounts and time certificates.
        Management attributes the growth in 2006 to aggressive rate specials offered
        to
        attract new customers at three new locations in 2006 as well as a shift of
        consumers towards higher rate products.
  31
 
 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 are generally
        less desirable because of higher interest rates. Brokered deposits totaled
        $5,000,000 and $8,000,000 at December 31, 2007 and 2006,
        respectively.
 
 **SHORT-TERM
        BORROWINGS**
 
 The
        following is information regarding the Company’s short-term borrowings for the
        years ended December 31, 2007, 2006 and 2005.
 
 (**dollars
                  in thousands)**
              
              **2007**
              
              **2006**
              
              **2005**Amount
                  outstanding at end of period
              
              $
              10,125
              
              $
              —
              
              $
              3,985Weighted
                  average interest rate thereon
              
              
              4.26
              %
              
              —
              %
              
              5.13
              %Maximum
                  month-end balance during the year
              
              
              18,695
              
              $
              6,500
              
              
              3,985Average
                  balance during the year
              
              
              5,961
              
              
              1,388
              
              
              69Average
                  interest rate during the year
              
              
              5.52
              %
              
              5.40
              %
              
              5.80
              %
 
 **CONTRACTUAL
        OBLIGATIONS**
 
 The
        following is information regarding the Company’s long-term obligations, which
        consist of borrowings from the Federal Home Loan Bank of Seattle, Junior
        Subordinated Debentures and premises under operating leases for the year
        ended
        December 31, 2007.
 
 **Payments
                  due by Period****Contractual
                  obligations**
              
              **Less
                  than**
                **1
                  year**
              
              **1
                  - 3 years**
              
              **3
                  - 5 years**
              
              **More
                  than**
                **5
                  years**
              
              **Total**Federal
                  Home Loan Bank borrowings
              
              $
              —
              
              $
              12,500
              
              $
              —
              
              $
              —
              
              $
              12,500Operating
                  leases
              
              
              268
              
              
              309
              
              
              103
              
              
              —
              
              
              680Secured
                  borrowings
              
              
              —
              
              
              350
              
              
              1,068
              
              
              —
              
              
              1,418Junior
                  subordinated debentures
              
              
              —
              
              
              —
              
              
              —
              
              
              13,403
              
              
              13,403**Total
                  long-term obligations**
              
              **$**
              **268**
              
              **$**
              **13,159**
              
              **$**
              **1,171**
              
              **$**
              **13,403**
              
              **$**
              **28,001**
 
 **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:
  **2007**
              
              **2006**Commitments
                  to extend credit
              
              $
              108,095
              
              $
              100,792Standby
                  letters of credit
              
              
              3,489
              
              
              2,650
  32
  **KEY
        FINANCIAL RATIOS**
 
 **Year
                  ended December 31,**
              
              **2007**
              
              **2006**
              
              **2005**
              
              **2004**
              
              **2003**Return
                  on average assets
              
              
              1.08
              %
              
              1.26
              %
              
              1.31
              %
              
              1.41
              %
              
              1.61
              %Return
                  on average equity
              
              
              11.46
              %
              
              13.16
              %
              
              12.70
              %
              
              14.21
              %
              
              17.10
              %Average
                  equity to average assets ratio
              
              
              9.41
              %
              
              9.60
              %
              
              10.30
              %
              
              9.91
              %
              
              9.44
              %Dividend
                  payout ratio
              
              
              82
              %
              
              75
              %
              
              78
              %
              
              81
              %
              
              77
              %
 
 **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 ensure adequate funds are available at all times, the Company
        monitors and projects the amount of funds required on a daily basis. Through
        the
        Bank, the Company obtains funds from its customer base, which provides a
        stable
        source of “core” demand and consumer deposits.
 
 Other
        sources are available with borrowings from the Federal Home Loan Bank of
        Seattle
        and 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, consisting of cash and due from banks,
        interest bearing deposits with banks, and federal funds sold to support the
        daily cash flow requirements.
 
 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,
        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.
        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
        results of operations.
 
 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.
        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 Footnote 8 - “Junior Subordinated Debentures”.
 
 *Capital.* The
        Company endeavors to maintain equity capital at an adequate level to support
        and
        promote investor confidence. 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
        $52,634,000 in 2007, which includes $11,282,000 of goodwill associated with
        the
        BNW acquisition. Shareholders’ equity averaged $49,787,000 in 2006, compared to
        $47,620,000 in 2005.
  33
 
 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.
 
 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” for each of the past
        three year-end reporting dates.
 
 The
        following table sets forth the minimum required capital ratios and actual
        ratios
        for December 31, 2007 and 2006.
  **Actual**
              
              **Capital
                  Adequacy****(dollars
                  in thousands)**
              
              **Amount**
              
              **Ratio**
              
              **Amount**
              
              **Ratio****December
                  31, 2007***Tier
                  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
              %**December
                  31, 2006***Tier
                  1 capital (to average assets)*Consolidated
              
              $
              49,042
              
              
              9.27
              %
              $
              21,173
              
              
              4.00
              %Bank
              
              
              48,162
              
              
              9.11
              %
              
              21,147
              
              
              4.00
              %*Tier
                  1 capital (to risk-weighted assets)*Consolidated
              
              
              49,042
              
              
              11.03
              %
              
              17,784
              
              
              4.00
              %Bank
              
              
              48,162
              
              
              10.91
              %
              
              17,662
              
              
              4.00
              %*Total
                  capital (to risk-weighted assets)*Consolidated
              
              
              53,075
              
              
              11.94
              %
              
              35,567
              
              
              8.00
              %Bank
              
              
              52,195
              
              
              11.82
              %
              
              35,324
              
              
              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 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.
  34
 
 **Allowance
        for Credit Losses**
 
 The
        Company’s allowance for credit loss 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. As of December 31, 2007,
        there
        have been no events or changes in circumstances that would indicate a potential
        impairment.
 
 **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.
  35




The
      following table shows the dollar amount of interest sensitive assets and
      interest sensitive liabilities at December 31, 2007 and differences between
      them
      for the maturity or repricing periods indicated.


**Due
                  after****Due
                  in one**
              
              **one
                  through**
              
              **Due
                  after**(**dollars
                  in thousands)**
              
              **year
                  or less**
              
              **five
                  years**
              
              **five
                  years**
              
              **Total****Interest
                  earning assets**Loans,
                  including loans held for sale
              
              $
              293,816
              
              $
              113,137
              
              $
              49,120
              
              $
              456,073Investment
                  securities
              
              
              5,545
              
              
              9,703
              
              
              31,993
              
              
              47,241Fed
                  Funds sold and interest bearingbalances
                  with banks
              
              
              253
              
              
              —
              
              
              —
              
              
              253Federal
                  Home Loan Bank stock
              
              
              —
              
              
              —
              
              
              1,858
              
              
              1,858**Total
                  interest earning assets**
              
              **$**
              **299,614**
              
              **$**
              **122,840**
              
              **$**
              **82,971**
              
              **$**
              **505,425****Interest
                  bearing liabilities**Interest
                  bearing demand deposits
              
              $
              44,305
              
              $
              —
              
              $
              —
              
              $
              44,305Savings
                  deposits
              
              
              160,470
              
              
              —
              
              
              —
              
              
              160,470Time
                  deposits
              
              
              148,893
              
              
              26,785
              
              
              —
              
              
              175,678Short
                  term borrowings
              
              
              10,125
              
              
              —
              
              
              —
              
              
              10,125Long
                  term borrowings
              
              
              —
              
              
              12,500
              
              
              —
              
              
              12,500Secured
                  borrowings
              
              
              —
              
              
              1,418
              
              
              —
              
              
              1,418Junior
                  subordinated debentures
              
              
              8,248
              
              
              5,155
              
              
              —
              
              
              13,403**Total
                  interest bearing liabilities**
              
              **$**
              **372,041**
              
              **$**
              **45,858**
              
              **$**
              **—**
              
              **$**
              **417,899**Net
                  interest rate sensitivity GAP
              
              $
              (72,427
              )
              $
              76,982
              
              $
              82,971
              
              $
              87,526Cumulative
                  interest rate sensitivity GAP
              
              
              
              
              
              4,555
              
              
              87,526
              
              
              87,526Cumulative
                  interest rate sensitivity GAPas
                  a % of earning assets
              
              
              
              
              
              .9
              %
              
              17.3
              %
              
              17.3
              %





*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.





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 75% 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, 2007.




36





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, 2007.
      Fair values are estimated in accordance with generally accepted accounting
      principles as disclosed in the financial statements.


**Expected
                    Maturity****Year
                    ended December 31, 2007**
                
                
                
                
                
                
                
                
                
                
                
                **There-**
                
                
                
                **Fair**(dollars
                    in thousands)
                
                **2008**
                
                **2009**
                
                **2010**
                
                **2011**
                
                **2012**
                
                **after**
                
                **Total**
                
                **Value****Financial
                    Assets**Cash
                    and cash equivalentsNon-interest
                    bearing
                
                $
                15,044
                
                $
                —
                
                $
                —
                
                $
                —
                
                $
                —
                
                $
                —
                
                $
                15,044
                
                $
                15,044Interest
                    bearing deposits in banks
                
                
                253
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                253
                
                
                253Weighted
                    average interest rate
                
                
                3.65
                %
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                —Securities
                    available for saleFixed
                    rate
                
                
                4,899
                
                
                3,912
                
                
                1,227
                
                
                2,296
                
                
                1,484
                
                
                21,328
                
                
                35,146
                
                
                35,146Weighted
                    average interest rate
                
                
                4.87
                %
                
                4.99
                %
                
                5.47
                %
                
                4.93
                %
                
                5.24
                %
                
                5.26
                %Variable
                    rate
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                7,766
                
                
                7,766
                
                
                7,766Weighted
                    average interest rate
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                5.31
                %Securities
                    held to maturityFixed
                    rate
                
                
                646
                
                
                34
                
                
                750
                
                
                —
                
                
                —
                
                
                2,899
                
                
                4,329
                
                
                4,368Weighted
                    average interest rate
                
                
                3.87
                %
                
                9.29
                %
                
                6.93
                %
                
                —
                
                
                —
                
                
                6.22
                %Loans
                    receivableFixed
                    rate
                
                
                41,388
                
                
                6,936
                
                
                5,973
                
                
                6,356
                
                
                7,704
                
                
                45,620
                
                
                113,977
                
                
                109,431Weighted
                    average interest rate
                
                
                7.52
                %
                
                7.38
                %
                
                7.48
                %
                
                7.50
                %
                
                7.77
                %
                
                7.09
                %Adjustable
                    rate
                
                
                251,754
                
                
                28,773
                
                
                38,225
                
                
                5,955
                
                
                13,206
                
                
                4,183
                
                
                342,096
                
                
                342,096Weighted
                    average interest rate
                
                
                7.95
                %
                
                8.12
                %
                
                8.38
                %
                
                8.47
                %
                
                8.21
                %
                
                7.53
                %Federal
                    Home Loan Bank stock
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                1,858
                
                
                1,858
                
                
                1,858Weighted
                    average interest rate
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                .40
                %**Financial
                    Liabilities**Non-interest
                    bearing deposits
                
                $
                13,032
                
                $
                11,078
                
                $
                9,416
                
                $
                8,004
                
                $
                6,803
                
                $
                38,550
                
                $
                86,883
                
                $
                86,883Interest
                    bearing checking accounts
                
                
                11,076
                
                
                8,307
                
                
                6,230
                
                
                4,673
                
                
                3,505
                
                
                10,514
                
                
                44,305
                
                
                44,305Weighted
                    average interest rate
                
                
                .40
                %
                
                .40
                %
                
                .40
                %
                
                .40
                %
                
                .40
                %
                
                .40
                %Money
                    Market accounts
                
                
                26,315
                
                
                19,736
                
                
                14,802
                
                
                11,102
                
                
                8,326
                
                
                24,979
                
                
                105,260
                
                
                105,260Weighted
                    average interest rate
                
                
                3.18
                %
                
                3.18
                %
                
                3.18
                %
                
                3.18
                %
                
                3.18
                %
                
                3.18
                %Savings
                    accounts
                
                
                11,042
                
                
                8,834
                
                
                7,067
                
                
                5,653
                
                
                4,523
                
                
                18,091
                
                
                55,210
                
                
                55,210Weighted
                    average interest rate
                
                
                2.32
                %
                
                2.32
                %
                
                2.32
                %
                
                2.32
                %
                
                2.32
                %
                
                2.32
                %Certificates
                    of depositFixed
                    rate
                
                
                146,985
                
                
                6,974
                
                
                4,045
                
                
                6,778
                
                
                8,583
                
                
                —
                
                
                173,365
                
                
                174,355Weighted
                    average interest rate
                
                
                4.78
                %
                
                4.15
                %
                
                4.43
                %
                
                5.11
                %
                
                4.93
                %
                
                —Variable
                    rate
                
                
                1,909
                
                
                404
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                2,313
                
                
                2,313Weighted
                    average interest rate
                
                
                3.81
                %
                
                3.88
                %
                
                —
                
                
                —
                
                
                —
                
                
                —Short
                    Term borrowings
                
                
                10,125
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                10,125
                
                
                10,093Weighted
                    average interest rate
                
                
                4.26
                %
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                —Long
                    Term BorrowingsFixed
                    rate
                
                
                —
                
                
                11,000
                
                
                1,500
                
                
                —
                
                
                —
                
                
                —
                
                
                12,500
                
                
                12,436Weighted
                    average interest rate
                
                
                —
                
                
                3.84
                %
                
                4.12
                %
                
                —
                
                
                —
                
                
                —Secured
                    borrowings
                
                
                —
                
                
                351
                
                
                —
                
                
                175
                
                
                892
                
                
                —
                
                
                1,418
                
                
                1,418Weighted
                    average interest rate
                
                
                —
                
                
                6.81
                %
                
                —
                
                
                6.66
                %
                
                7.56
                %
                
                —Junior
                    subordinated debentures
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                13,403
                
                
                13,403
                
                
                13,275Weighted
                    average interest rate
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                6.67
                %




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 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.




37





**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.





**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, 2007. 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, 2007, the Company’s
      internal control over financial reporting is effective based on those criteria.




38




Report
        of
        Independent Registered Public Accounting Firm
  To
        the
        Board of Directors and Stockholders 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, 2007, 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.




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, 2007, 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, 2007 of the Company and our report dated March
      14, 2008 expressed an unqualified opinion on those financial
      statements.




/s/
      Deloitte & Touche LLP




Portland,
      Oregon


March
      14,
      2008




39




**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, 2007 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 2008 Proxy Statement for its annual meeting of shareholders to
      be held on April 23, 2008 ("2008 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.





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 Duane E. Hagstrom, 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 Duane E. Hagstrom, Gary C.
      Forcum and G. Dennis Archer are audit committee financial experts as defined
      in
      Item 401(h) of the SEC’s Regulation S-K. Directors Hagstrom, 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 2008 Proxy Statement in the sections entitled
“DIRECTOR COMPENSATION FOR 2007” and “EXECUTIVE COMPENSATION,” and is
      incorporated into this report by reference.





**ITEM
      12. Security Ownership of Certain Beneficial Owners and Management and Related** **Stockholder
      Matters**





Information
      concerning security ownership of certain beneficial owners and management
      requested by this item is contained in the registrant’s 2008 Proxy Statement in
      the section entitled “SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
      MANAGEMENT,” and is incorporated into this report by reference.




40





**Equity
      Compensation Plan Information.** The
      following table summarizes share and exercise price information about the
      Company’s equity compensation plans as of December 31, 2007.


Plan
                  Category
              
              (a)
                Number
                  of securities
                to
                  be issued upon
                exercise
                  of
                outstanding
                  options,
                warrants
                  and rights
              
              (b)
                Weighted-average
                exercise
                  price
                of
                  outstanding
                options,
                  warrants
                and
                  rights
              
              (c)
                Number
                  remaining
                available
                  for future
                issuance
                  under equity
                compensation
                  plans
                (excluding
                  securities
                reflected
                  in column (a)Equity
                  compensation plans approvedby
                  security holders:
              
              
              621,797
              (1)
              $
              13.87
              
              
              279,250Equity
                  compensation plans not approvedby
                  security holders:
              
              
              —
              
              
              —
              
              
              —Total
              
              
              621,797
              (1)
              
              
              
              
              279,250


(1)
      Excludes 5,356 shares under outstanding options, with an aggregate exercise
      price of $6.18, granted by the Company pursuant to a merger agreement in
      substitution of BNW Bancorp, Inc. options.





**ITEM
      13. Certain Relationships and Related Transactions**





Information
      concerning certain relationships and related transactions requested by this
      item
      is contained in the registrant’s 2008 Proxy Statement in the sections entitled
“COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION” and "RELATED
      PERSON TRANSACTIONS" 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 2008 Proxy Statement and is incorporated into this report by
      reference.





**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


Report
      of
      Independent Registered Public Accounting Firm - McGladrey & Pullen
      LLP


Consolidated
      Balance Sheets


Consolidated
      Statements of Income


Consolidated
      Statements of Shareholders’ Equity


Consolidated
      Statements of Cash Flows


Notes
      to
      Consolidated Financial Statements





(a)
            (2)
                Schedules: None





(a)
            (3)
                Exhibits: See Exhibit Index immediately following the signature
                page.




41




**REPORT
        OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**
  To
        the
        Board of Directors and Stockholders 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, 2007 and 2006,
        and
        the related consolidated statements of income, shareholders' equity, and
        cash
        flows for each of the two years in the period ended December 31, 2007. 
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 Corporation and subsidiary
        as of December 31, 2007 and 2006, and the results of their operations and
        their
        cash flows for each of the two years in the period ended December 31, 2007,
        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, 2007, 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 14, 2008 expressed an unqualified opinion on the Company's
        internal control over financial reporting.
  /s/
          Deloitte & Touche LLP
  Portland,
        Oregon
 March
        14,
        2008
  F-1
 
  **Report
          of Independent Registered Public Accounting Firm**
 
 
 To
          the
          Board of Directors
 **Pacific
          Financial Corporation**
 Aberdeen,
          Washington
 
 
 We
          have
          audited the accompanying consolidated statement of income, shareholders’ equity
          and cash flows of **Pacific
          Financial Corporation and Subsidiary** for the
          year ended December 31, 2005. 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 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 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 audit provides a
          reasonable basis for our opinion.
  In
          our
          opinion, the consolidated financial statements referred to above present
          fairly,
          in all material respects, the results of operations and cash flows of **Pacific
          Financial Corporation and Subsidiary** for the
          year ended December 31, 2005, in conformity with United States generally
          accepted accounting principles.
 
 
 /s/
          McGladrey & Pullen, LLP
  Tacoma,
          Washington
 March
          13,
          2006
  F-2
 **Pacific
        Financial Corporation and Subsidiary**
 **December
        31, 2007 and 2006**
 **Consolidated
        Balance Sheets**
 (Dollars
        in Thousands)
  **2007**
                
                **2006****Assets**Cash
                    and due from banks
                
                $
                15,044
                
                $
                14,964Interest
                    bearing deposits in banks
                
                
                253
                
                
                5,479Federal
                    funds sold
                
                
                —
                
                
                20,345Securities
                    available for sale, at fair value (amortized cost of $43,323
                    and
                    $37,090)
                
                
                42,912
                
                
                36,608Securities
                    held to maturity (fair value of $4,368 and $6,101)
                
                
                4,329
                
                
                6,104Federal
                    Home Loan Bank stock, at cost
                
                
                1,858
                
                
                1,858Loans
                    held for sale
                
                
                17,162
                
                
                14,368Loans
                
                
                438,911
                
                
                424,801Allowance
                    for credit losses
                
                
                5,007
                
                
                4,033**Loans
                    - net**
                
                
                **433,904**
                
                
                **420,768**Premises
                    and equipment
                
                
                15,427
                
                
                11,537Accrued
                    interest receivable
                
                
                3,165
                
                
                3,006Cash
                    surrender value of life insurance
                
                
                15,111
                
                
                9,714Goodwill
                
                
                11,282
                
                
                11,282Other
                    intangible assets
                
                
                1,728
                
                
                1,871Other
                    assets
                
                
                3,412
                
                
                4,480**Total
                    assets**
                
                **$**
                **565,587**
                
                **$**
                **562,384****Liabilities
                    and Shareholders’ Equity****Liabilities**Deposits:Demand,
                    non-interest bearing
                
                $
                86,883
                
                $
                91,657Savings
                    and interest-bearing demand
                
                
                204,775
                
                
                199,505Time,
                    interest-bearing
                
                
                175,678
                
                
                175,679**Total
                    deposits**
                
                
                **467,336**
                
                
                **466,841**Accrued
                    interest payable
                
                
                1,399
                
                
                1,415Secured
                    borrowings
                
                
                1,418
                
                
                1,906Short-term
                    borrowings
                
                
                10,125
                
                
                —Long-term
                    borrowings
                
                
                12,500
                
                
                21,500Junior
                    subordinated debentures
                
                
                13,403
                
                
                13,403Other
                    liabilities
                
                
                8,707
                
                
                8,335**Total
                    liabilities**
                
                
                **514,888**
                
                
                **513,400****Commitments
                    and Contingencies (See note 12)**
                
                
                **—**
                
                
                —**Shareholders’
                    Equity**Common
                    stock (par value $1); authorized: 25,000,000 shares; issued and
                    outstanding: 2007 - 6,606,545 shares; 2006 - 6,524,407
                    shares
                
                
                6,607
                
                
                6,524Additional
                    paid-in capital
                
                
                27,163
                
                
                26,047Retained
                    earnings
                
                
                17,807
                
                
                16,731Accumulated
                    other comprehensive loss
                
                
                (878
                )
                
                (318
                )**Total
                    shareholders’ equity**
                
                
                **50,699**
                
                
                **48,984****Total
                    liabilities and shareholders’ equity**
                
                **$**
                **565,587**
                
                **$**
                **562,384**
 *See
        notes to consolidated financial statements.*
  F-3
  **Pacific
        Financial Corporation and Subsidiary**
 **Years
        Ended December 31, 2007, 2006 and 2005**
 **Consolidated
        Statements of Income**
 (Dollars
        in Thousands, Except Per Share Amounts)
  **2007**
                
                **2006**
                
                **2005****Interest
                    and Dividend Income**Loans
                
                $
                37,658
                
                $
                33,883
                
                $
                27,611Federal
                    funds sold and deposits in banks
                
                
                426
                
                
                909
                
                
                344Securities
                    available for sale:Taxable
                
                
                1,290
                
                
                946
                
                
                933Tax-exempt
                
                
                528
                
                
                434
                
                
                446Securities
                    held to maturity:Taxable
                
                
                46
                
                
                57
                
                
                71Tax-exempt
                
                
                181
                
                
                215
                
                
                226Federal
                    Home Loan Bank stock dividends
                
                
                7
                
                
                —
                
                
                —**Total
                    interest and dividend income**
                
                
                **40,136**
                
                
                **36,444**
                
                
                **29,631****Interest
                    Expense**Deposits
                
                
                13,460
                
                
                10,846
                
                
                6,412Short-term
                    borrowings
                
                
                329
                
                
                75
                
                
                4Long-term
                    borrowings
                
                
                820
                
                
                868
                
                
                768Secured
                    borrowings
                
                
                110
                
                
                141
                
                
                163Junior
                    subordinated debentures
                
                
                914
                
                
                647
                
                
                —**Total
                    interest expense**
                
                
                **15,633**
                
                
                **12,577**
                
                
                **7,347****Net
                    interest income**
                
                
                **24,503**
                
                
                **23,867**
                
                
                **22,284****Provision
                    for Credit Losses**
                
                
                482
                
                
                625
                
                
                1,100**Net
                    interest income after provision for credit losses**
                
                
                **24,021**
                
                
                **23,242**
                
                
                **21,184****Non-Interest
                    Income**Service
                    charges on deposit accounts
                
                
                1,494
                
                
                1,452
                
                
                1,470Income
                    from and gains on sale of foreclosed real estate
                
                
                —
                
                
                5
                
                
                —Net
                    gains from sales of loans
                
                
                1,984
                
                
                1,895
                
                
                1,809Net
                    gain (loss) on sales of securities available for sale
                
                
                (20
                )
                
                —
                
                
                2Earnings
                    on bank owned life insurance
                
                
                397
                
                
                354
                
                
                393Other
                    operating income
                
                
                620
                
                
                470
                
                
                407**Total
                    non-interest income**
                
                
                **4,475**
                
                
                **4,176**
                
                
                **4,081****Non-Interest
                    Expense**Salaries
                    and employee benefits
                
                
                12,280
                
                
                10,609
                
                
                10,073Occupancy
                
                
                1,336
                
                
                1,266
                
                
                1,035Equipment
                
                
                1,192
                
                
                1,152
                
                
                1,002State
                    taxes
                
                
                436
                
                
                375
                
                
                348Data
                    processing
                
                
                393
                
                
                422
                
                
                479Professional
                    services
                
                
                541
                
                
                647
                
                
                302Other
                
                
                4,201
                
                
                3,647
                
                
                3,327**Total
                    non-interest expense**
                
                
                **20,379**
                
                
                **18,118**
                
                
                **16,566****Income
                    before income taxes**
                
                
                **8,117**
                
                
                **9,300**
                
                
                **8,699****Income
                    Taxes**
                
                
                2,086
                
                
                2,749
                
                
                2,653**Net
                    income**
                
                **$**
                **6,031**
                
                **$**
                **6,551**
                
                **$**
                **6,046****Earnings
                    Per Share**Basic
                
                $
                0.92
                
                $
                1.01
                
                $
                0.94Diluted
                
                $
                0.90
                
                $
                0.99
                
                $
                0.92**Weighted
                    Average Shares Outstanding:**Basic
                
                
                6,581,203
                
                
                6,483,370
                
                
                6,425,615Diluted
                
                
                6,668,042
                
                
                6,585,807
                
                
                6,538,250
  *See
        notes to consolidated financial statements.*
  F-4
  **Pacific
        Financial Corporation and Subsidiary**
 **Years
        Ended December 31, 2007, 2006 and 2005**
 **Consolidated
        Statements of Shareholders’ Equity**
 (Dollars
        in Thousands, Except Per Share Amounts)
  **Accumulated****Shares
                      of**
                  
                  
                  
                  **Additional**
                  
                  
                  
                  **Other****Common**
                  
                  **Common**
                  
                  **Paid-in**
                  
                  **Retained**
                  
                  **Comprehensive****Stock**
                  
                  **Stock**
                  
                  **Capital**
                  
                  **Earnings**
                  
                  **Income
                      (Loss)**
                  
                  **Total**Balance
                      at January 1, 2005
                  
                  
                  6,421,396
                  
                  $
                  6,421
                  
                  $
                  25,003
                  
                  $
                  13,746
                  
                  $
                  133
                  
                  $
                  45,303Comprehensive
                      income:Net
                      income
                  
                  
                  —
                  
                  
                  —
                  
                  
                  —
                  
                  
                  6,046
                  
                  
                  —
                  
                  
                  6,046Other
                      comprehensive income, net of tax:Change
                      in fair value of securities available for sale
                  
                  
                  —
                  
                  
                  —
                  
                  
                  —
                  
                  
                  —
                  
                  
                  (456
                  )
                  
                  (456
                  )**Comprehensive
                      income**
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  **5,590**Stock
                      options exercised
                  
                  
                  42,620
                  
                  
                  43
                  
                  
                  362
                  
                  
                  —
                  
                  
                  —
                  
                  
                  405Issuance
                      of common stock
                  
                  
                  520
                  
                  
                  —
                  
                  
                  —
                  
                  
                  —
                  
                  
                  —
                  
                  
                  —Stock
                      compensation expense
                  
                  
                  —
                  
                  
                  —
                  
                  
                  12
                  
                  
                  —
                  
                  
                  —
                  
                  
                  12Cash
                      dividends declared ($0.73 per share)
                  
                  
                  —
                  
                  
                  —
                  
                  
                  —
                  
                  
                  (4,719
                  )
                  
                  —
                  
                  
                  (4,719
                  )Tax
                      benefit from exercise of stock options
                  
                  
                  —
                  
                  
                  —
                  
                  
                  9
                  
                  
                  —
                  
                  
                  —
                  
                  
                  9**Balance
                      at December 31, 2005**
                  
                  
                  **6,464,536**
                  
                  **$**
                  **6,464**
                  
                  **$**
                  **25,386**
                  
                  **$**
                  **15,073**
                  
                  **$**
                  **(323**
                  **)**
                  **$**
                  **46,600**Comprehensive
                      income:Net
                      income
                  
                  
                  —
                  
                  
                  —
                  
                  
                  —
                  
                  
                  6,551
                  
                  
                  —
                  
                  
                  6,551Other
                      comprehensive income, net of tax:Change
                      in fair value of securities available for sale
                  
                  
                  —
                  
                  
                  —
                  
                  
                  —
                  
                  
                  —
                  
                  
                  5
                  
                  
                  5**Comprehensive
                      income**
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  **6,556**Stock
                      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 exercise of stock options
                  
                  
                  —
                  
                  
                  —
                  
                  
                  43
                  
                  
                  —
                  
                  
                  —
                  
                  
                  43**Balance
                      at December 31, 2006**
                  
                  
                  **6,524,407**
                  
                  **$**
                  **6,524**
                  
                  **$**
                  **26,047**
                  
                  **$**
                  **16,731**
                  
                  **$**
                  **(318**
                  **)**
                  **$**
                  **48,984**Comprehensive
                      income:Net
                      income
                  
                  
                  —
                  
                  
                  —
                  
                  
                  —
                  
                  
                  6,031
                  
                  
                  —
                  
                  
                  6,031Other
                      comprehensive income, net of tax:Change
                      in fair value of securities available for sale
                  
                  
                  —
                  
                  
                  —
                  
                  
                  —
                  
                  
                  —
                  
                  
                  46
                  
                  
                  46Prior
                      service cost at initiation of defined benefit plan
                  
                  
                  —
                  
                  
                  —
                  
                  
                  —
                  
                  
                  —
                  
                  
                  (704
                  )
                  
                  (704
                  )Amortization
                      of unrecognized prior service costs and net gains/losses
                  
                  
                  —
                  
                  
                  —
                  
                  
                  —
                  
                  
                  —
                  
                  
                  98
                  
                  
                  98**Comprehensive
                      income**
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  **5,471**Stock
                      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 ofstock
                      options
                  
                  
                  —
                  
                  
                  —
                  
                  
                  52
                  
                  
                  —
                  
                  
                  —
                  
                  
                  52**Balance
                      at December 31, 2007**
                  
                  
                  **6,606,545**
                  
                  **$**
                  **6,607**
                  
                  **$**
                  **27,163**
                  
                  **$**
                  **17,807**
                  
                  **$**
                  **(878**
                  **)**
                  **$**
                  **50,699**
  *See
        notes to consolidated financial statements* .
  F-5
  **Pacific
        Financial Corporation and Subsidiary**
 **Years
        Ended December 31, 2007, 2006 and 2005**
 **Consolidated
        Statements of Cash Flows**
 (Dollars
        in Thousands)
  **2007**
                
                **2006**
                
                **2005****Cash
                    Flows from Operating Activities**Net
                    income
                
                $
                6,031
                
                $
                6,551
                
                $
                6,046Adjustments
                    to reconcile net income to net cash provided by (used in) operating
                    activities:Depreciation
                    and amortization
                
                
                1,476
                
                
                1,257
                
                
                1,127Provision
                    for credit losses
                
                
                482
                
                
                625
                
                
                1,100Deferred
                    income tax (benefit)
                
                
                (305
                )
                
                759
                
                
                (24
                )Originations
                    of loans held for sale
                
                
                (123,406
                )
                
                (109,444
                )
                
                (117,364
                )Proceeds
                    from sales of loans held for sale
                
                
                122,549
                
                
                107,082
                
                
                110,914Net
                    gains on sales of loans
                
                
                (1,984
                )
                
                (1,895
                )
                
                (1,809
                )(Gain)
                    loss on sale of securities available for sale
                
                
                20
                
                
                —
                
                
                (2
                )Gains
                    on sales of foreclosed real estate
                
                
                —
                
                
                (5
                )
                
                —Loss
                    on sale of premises and equipment
                
                
                18
                
                
                3
                
                
                8Earnings
                    on bank owned life insurance
                
                
                (397
                )
                
                (354
                )
                
                (393
                )Increase
                    in accrued interest receivable
                
                
                (159
                )
                
                (642
                )
                
                (491
                )Increase
                    (decrease) in accrued interest payable
                
                
                (16
                )
                
                868
                
                
                162Write-down
                    of foreclosed real estate
                
                
                —
                
                
                —
                
                
                3Other
                    - net
                
                
                1,129
                
                
                (864
                )
                
                (291
                )**Net
                    cash provided by (used in) operating activities**
                
                
                **5,438**
                
                
                **3,941**
                
                
                **(1,014**
                **)****Cash
                    Flows from Investing Activities**Net
                    (increase) decrease in interest bearing deposits in banks
                
                
                5,226
                
                
                (5,196
                )
                
                5,177Net
                    (increase) decrease in federal funds sold
                
                
                20,345
                
                
                (20,345
                )
                
                6,034Activity
                    in securities available for sale:Sales
                
                
                805
                
                
                —
                
                
                3,645Maturities,
                    prepayments and calls
                
                
                8,807
                
                
                4,822
                
                
                7,944Purchases
                
                
                (15,090
                )
                
                (11,783
                )
                
                (6,394
                )Activity
                    in securities held to maturity:Maturities
                
                
                943
                
                
                392
                
                
                691Investment
                    in PFC Statutory Trust I and II
                
                
                —
                
                
                (248
                )
                
                (155
                )Proceeds
                    from sales of SBA loan pools
                
                
                1,139
                
                
                —
                
                
                3,405Increase
                    in loans made to customers, net of principal collections
                
                
                (14,821
                )
                
                (27,959
                )
                
                (56,633
                )Purchases
                    of premises and equipment
                
                
                (5,191
                )
                
                (2,718
                )
                
                (4,377
                )Proceeds
                    from sales of premises and equipment
                
                
                190
                
                
                4
                
                
                124Proceeds
                    from sales of foreclosed real estate
                
                
                —
                
                
                42
                
                
                —Purchase
                    of bank owned life insurance
                
                
                (5,000
                )
                
                —
                
                
                —Deposit
                    assumption and transfer
                
                
                —
                
                
                (1,268
                )
                
                —**Net
                    cash used in investing activities**
                
                
                **(2,647**
                **)**
                
                **(64,257**
                **)**
                
                **(40,539**
                **)**
 
 *(continued)*
  *See
        notes to consolidated financial statements.*
  F-6
  **Pacific
        Financial Corporation and Subsidiary**
 **Years
        Ended December 31, 2007, 2006 and 2005**
 **Consolidated
        Statements of Cash Flows**
 *(concluded)* (Dollars
        in Thousands)
  **2007**
                
                **2006**
                
                **2005****Cash
                    Flows from Financing Activities**Net
                    increase in deposits
                
                $
                495
                
                $
                67,115
                
                $
                36,225Net
                    increase (decrease) in short-term borrowings
                
                
                3,125
                
                
                (3,985
                )
                
                3,985Decrease
                    in secured borrowings
                
                
                (488
                )
                
                (244
                )
                
                (1,583
                )Proceeds
                    from issuance of long-term borrowings
                
                
                —
                
                
                2,000
                
                
                8,000Repayments
                    of long-term borrowings
                
                
                (2,000
                )
                
                (5,000
                )
                
                (5,000
                )Proceeds
                    from junior subordinated debentures
                
                
                —
                
                
                8,248
                
                
                5,155Common
                    stock issued
                
                
                1,269
                
                
                642
                
                
                405Repurchase
                    and retirement of common stock
                
                
                (219
                )
                
                —
                
                
                —Cash
                    dividends paid
                
                
                (4,893
                )
                
                (4,719
                )
                
                (4,624
                )**Net
                    cash provided by (used in) financing activities**
                
                
                **(2,711**
                **)**
                
                **64,057**
                
                
                **42,563****Net
                    change in cash and due from banks**
                
                
                **80**
                
                
                **3,741**
                
                
                **1,010****Cash
                    and Due from Banks**Beginning
                    of year
                
                
                14,964
                
                
                11,223
                
                
                10,213**End
                    of year**
                
                **$**
                **15,044**
                
                **$**
                **14,964**
                
                **$**
                **11,223****Supplemental
                    Disclosures of Cash Flow Information**Interest
                    paid
                
                $
                15,649
                
                $
                11,709
                
                $
                7,185Income
                    taxes paid
                
                
                2,297
                
                
                1,667
                
                
                3,020**Supplemental
                    Disclosures of Non-Cash Investing Activities**Fair
                    value adjustment of securities available for sale, net of
                    tax
                
                $
                46
                
                $
                5
                
                $
                (456
                )Transfer
                    of securities held to maturity to available for sale
                
                
                825
                
                
                —
                
                
                —
  *See
        notes to consolidated financial statements.*
  F-7
  **Pacific
          Financial Corporation and Subsidiary**
 **December
          31, 2007 and 2006 and for the three years ended December 31,
          2007**
 **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 eighteen 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 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 and the valuation of deferred tax
        assets.
 
 **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. Such securities may be sold to implement the Company’s
        asset/liability management strategies and in response to changes in interest
        rates and similar factors. 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-8
  **Pacific
          Financial Corporation and Subsidiary**
 **December
          31, 2007 and 2006 and for the three years ended December 31,
          2007**
 **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, as a member of the Federal Home Loan Bank (FHLB) system, is required
        to
        maintain an investment in capital stock of the FHLB in an amount equal to
        the
        greater of 1% of its outstanding home loans or 5% of advances from the FHLB.
        The
        recorded amount of FHLB stock equals its fair value because the shares can
        only
        be redeemed by the FHLB at the $100 per share par value.
 
 **Loans
        Held for Sale**
 
 Mortgage
        loans originated for sale in the foreseeable future in the secondary market
        are
        carried at the lower of aggregate ** cost
        or
        estimated market 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. All sales are made without
        recourse. ** 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.
 
 **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.
  F-9
  **Pacific
          Financial Corporation and Subsidiary**
 **December
          31, 2007 and 2006 and for the three years ended December 31,
          2007**
 **Notes
          to Consolidated Financial Statements, Dollars in Thousands Except Per Share
          Amounts**
  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 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.
 
 **Goodwill
        and other intangible assets**
 
 At
        December 31, 2007, the Company had $13,010 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. As of December 31, 2007, there have been
        no
        events or changes in circumstances that would indicate a potential impairment.
        Core deposit intangibles are amortized to non-interest expense using a straight
        line method over seven years. Net unamortized core deposit intangible totaled
        $461 at December
        31, 2007. Amortization expense related to core deposit intangible totaled
        $142
        during each of the years ended December 31, 2007, 2006, and 2005. Amortization
        expense for the core deposit intangible is estimated to be $142 for each
        of the
        next three years.
  F-10
  **Pacific
          Financial Corporation and Subsidiary**
 **December
          31, 2007 and 2006 and for the three years ended December 31,
          2007**
 **Notes
          to Consolidated Financial Statements, Dollars in Thousands Except Per Share
          Amounts**
 **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 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.
 
 **Stock-Based
        Compensation**
 
 Prior
        to
        January 1, 2006, the Company accounted for stock option plans under recognition
        and measurement principles of Accounting Principles Bulletin (APB) Opinion
        No.
        25, Accounting for Stock Issued to Employees, and related interpretations.
        No
        stock-based employee compensation cost was reflected in net income for previous
        awards, as all options granted under the plans had an exercise price equal
        to
        the market value of the underlying common stock on the date of
        grant.
 
 Effective
        January 1, 2006, the Company adopted 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 Company has adopted SFAS No. 123R using the modified prospective method,
        which provides for no restatement of prior periods and no cumulative adjustment
        to equity awards. It also provides for expense recognition for both new and
        existing unvested stock-based awards.
  F-11
 **Pacific
          Financial Corporation and Subsidiary**
 **December
          31, 2007 and 2006 and for the three years ended December 31,
          2007**
 **Notes
          to Consolidated Financial Statements, Dollars in Thousands Except Per Share
          Amounts**
  The
        following illustrates the effect on net income and earnings per share if
        the
        Company had applied the fair value recognition provisions of SFAS No. 123,
        Accounting for Stock-Based Compensation, to stock-based compensation awards
        for
        all options granted for the year ended December 31, 2005:
  Net
                    income, as reported
                
                $
                6,046Add
                    stock compensation expensed
                
                
                12Less
                    total stock-based compensation expense determined under fair
                    value method
                    for all qualifying awards, net of tax
                
                
                586**Pro
                    forma net income**
                
                **$**
                **5,472****Earnings
                    Per Share**Basic
                    - as reported
                
                $
                0.94Basic
                    - Pro forma
                
                
                0.85Diluted
                    - as reported
                
                
                0.92Diluted
                    - pro forma
                
                
                0.84
  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 213,700, 252,550 and 272,600 in 2007,
        2006
        and 2005, 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.
 
 **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,
        2007,
        2006 and 2005.
  F-12
  **Pacific
          Financial Corporation and Subsidiary**
 **December
          31, 2007 and 2006 and for the three years ended December 31,
          2007**
 **Notes
          to Consolidated Financial Statements, Dollars in Thousands Except Per Share
          Amounts**
  **Recent
        Accounting Pronouncements**
 
 In
        July
        2006, the Financial Accounting Standards Board (“FASB”) issued FASB
        Interpretation No. 48 (“FIN 48”), “Accounting for Uncertainty in Income Taxes -
        an Interpretation of FASB Statement No. 109.” FIN 48 prescribes a comprehensive
        model for how a company should recognize, measure, present and disclose in
        its
        financial statements uncertain tax positions that it has taken or expects
        to
        take on a tax return. FIN 48 was effective as of the beginning of the Company’s
        2007 fiscal year. The cumulative effect, if any, of applying FIN 48 is to
        be
        reported as an adjustment to the opening balance of retained earnings in
        the
        year of adoption. The Company adopted FIN 48 on January 1, 2007. As of January
        1, 2007 and December 31, 2007, 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, 2007. The tax years that remain subject to
        examination by federal and state taxing authorities are the years ended December
        31, 2006, 2005 and 2004.
 
 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 becomes effective for the Company on
        January 1, 2008. The Company is currently evaluating the impact of this standard
        on its consolidated financial statements.
 
 In
        September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined
        Benefit Pension and Other Post-retirement Plans,” an amendment of FASB
        Statements No. 87, 88, 106 and 132(R). SFAS No. 158 requires recognition
        of the
        funded status of the Company’s defined benefit and post retirement plans as an
        asset or liability in the consolidated financial statements for fiscal years
        ending after December 15, 2006. SFAS No. 158 also requires that assets and
        obligations that determine funded status be measured as of the end of the
        fiscal
        year. The requirement to use the fiscal year-end date as the measurement
        date is
        effective for fiscal years ending after December 15, 2008. The Company is
        currently assessing the measurement date requirement of SFAS No. 158 and
        its
        impact, if any, on the Company’s consolidated financial statements.
 
 In
        February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for
        Financial Assets and Financial Liabilities,” which is effective for fiscal years
        beginning after November 15, 2007. 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 in carrying
        value and fair value at election is recorded as a transition adjustment to
        opening retained earnings. Subsequent changes in fair value are recognized
        in
        earnings. The Company did not early adopt SFAS No. 159, and is currently
        assessing the impact the adoption of this standard will have on its 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.
  F-13
  **Pacific
          Financial Corporation and Subsidiary**
 **December
          31, 2007 and 2006 and for the three years ended December 31,
          2007**
 **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, 2007 and 2006 was approximately $653 and $665,
        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**
                
                **Gross****Amortized**
                
                **Unrealized**
                
                **Unrealized**
                
                **Fair****Securities
                    Available for Sale**
                
                **Cost**
                
                **Gains**
                
                **Losses**
                
                **Value****December
                    31, 2007**U.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
                
                
                2,906**$**
                **43,323**
                
                **$**
                **128**
                
                **$**
                **539**
                
                **$**
                **42,912****December
                    31, 2006**U.S.
                    Government agency securities
                
                $
                8,346
                
                $
                22
                
                $
                57
                
                $
                8,311Obligations
                    of states and political subdivisions
                
                
                13,719
                
                
                69
                
                
                169
                
                
                13,619Mortgage-backed
                    securities
                
                
                10,434
                
                
                27
                
                
                229
                
                
                10,232Corporate
                    bonds
                
                
                1,550
                
                
                —
                
                
                38
                
                
                1,512Mutual
                    funds
                
                
                3,041
                
                
                —
                
                
                107
                
                
                2,934**$**
                **37,090**
                
                **$**
                **118**
                
                **$**
                **600**
                
                **$**
                **36,608****Securities
                    Held to Maturity****December
                    31, 2007**State
                    and municipal securities
                
                $
                3,562
                
                $
                48
                
                $
                5
                
                $
                3,605Mortgage-backed
                    securities
                
                
                767
                
                
                —
                
                
                4
                
                
                763**$**
                **4,329**
                
                **$**
                **48**
                
                **$**
                **9**
                
                **$**
                **4,368****December
                    31, 2006**State
                    and municipal securities
                
                $
                5,155
                
                $
                38
                
                $
                35
                
                $
                5,158Mortgage-backed
                    securities
                
                
                949
                
                
                —
                
                
                6
                
                
                943**$**
                **6,104**
                
                **$**
                **38**
                
                **$**
                **41**
                
                **$**
                **6,101**
  For
        all
        the above investment securities, the unrealized losses are primarily due
        to
        changes in interest rates and, as such, are considered to be temporary by
        the
        Company. 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.
        Additionally, the contractual cash flows of mortgage-backed securities are
        guaranteed by an agency of the U.S. Government. 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.
  F-14
 **Pacific
          Financial Corporation and Subsidiary**
 **December
          31, 2007 and 2006 and for the three years ended December 31,
          2007**
 **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, 2007 and 2006 are summarized as follows:
  **Less
                    than 12 Months**
                
                **More
                    than 12 Months**
                
                **Total****Fair**
                
                **Unrealized**
                
                **Fair**
                
                **Unrealized**
                
                **Fair**
                
                **Unrealized****Value**
                
                **Loss**
                
                **Value**
                
                **Loss**
                
                **Value**
                
                **Loss****December
                    31, 2007****Available
                    for Sale**Obligations
                    of states and political 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
                
                
                135**Total**
                
                **$**
                **13,566**
                
                **$**
                **126**
                
                **$**
                **15,313**
                
                **$**
                **413**
                
                **$**
                **28,879**
                
                **$**
                **539****Held
                    to Maturity**State
                    and municipal securities
                
                $
                83
                
                $
                —
                
                $
                980
                
                $
                5
                
                $
                1,063
                
                $
                5Mortgage-backed
                    securities
                
                
                —
                
                
                —
                
                
                763
                
                
                4
                
                
                763
                
                
                4**Total**
                
                **$**
                **83**
                
                **$**
                **—**
                
                **$**
                **1,743**
                
                **$**
                **9**
                
                **$**
                **1,826**
                
                **$**
                **9****December
                    31, 2006****Available
                    for Sale**U.S.
                    Government agency securities
                
                $
                2,988
                
                $
                1
                
                $
                4,050
                
                $
                56
                
                $
                7,038
                
                $
                57Obligations
                    of states and political subdivisions
                
                
                4,927
                
                
                114
                
                
                3,471
                
                
                55
                
                
                8,398
                
                
                169Mortgage-backed
                    securities
                
                
                948
                
                
                21
                
                
                6,503
                
                
                208
                
                
                7,451
                
                
                229Corporate
                    bonds
                
                
                —
                
                
                —
                
                
                1,513
                
                
                38
                
                
                1,513
                
                
                38Mutual
                    funds
                
                
                —
                
                
                —
                
                
                2,934
                
                
                107
                
                
                2,934
                
                
                107**Total**
                
                **$**
                **8,863**
                
                **$**
                **136**
                
                **$**
                **18,471**
                
                **$**
                **464**
                
                **$**
                **27,334**
                
                **$**
                **600****Held
                    to Maturity**State
                    and municipal securities
                
                $
                —
                
                $
                —
                
                $
                2,392
                
                $
                35
                
                $
                2,392
                
                $
                35Mortgage-backed
                    securities
                
                
                943
                
                
                6
                
                
                —
                
                
                —
                
                
                943
                
                
                6**Total**
                
                **$**
                **943**
                
                **$**
                **6**
                
                **$**
                **2,392**
                
                **$**
                **35**
                
                **$**
                **3,335**
                
                **$**
                **41**
 The
        contractual maturities of investment securities held to maturity and available
        for sale at December 31, 2007 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.
  F-15
  **Pacific
        Financial Corporation and Subsidiary**
 **December
        31, 2007 and 2006 and for the three years ended December 31,
        2007**
 **Notes
        to Consolidated Financial Statements, Dollars in Thousands Except Per Share
        Amounts**
 
 **Note
        3 - Securities** *(concluded)*
 **Held
                    to Maturity**
                
                **Available
                    for Sale****Amortized**
                
                **Fair**
                
                **Amortized**
                
                **Fair****Cost**
                
                **Value**
                
                **Cost**
                
                **Value**Due
                    in one year or less
                
                $
                646
                
                $
                642
                
                $
                1,998
                
                $
                1,994Due
                    from one year to five years
                
                
                784
                
                
                792
                
                
                8,667
                
                
                8,680Due
                    from five to ten years
                
                
                1,128
                
                
                1,144
                
                
                3,530
                
                
                3,564Due
                    after ten years
                
                
                1,004
                
                
                1,027
                
                
                7,381
                
                
                7,228Mortgage-backed
                    securities
                
                
                767
                
                
                763
                
                
                18,706
                
                
                18,540Mutual
                    funds
                
                
                —
                
                
                —
                
                
                3,041
                
                
                2,906**Total**
                
                **$**
                **4,329**
                
                **$**
                **4,368**
                
                **$**
                **43,323**
                
                **$**
                **42,912**
  Gross
        gains realized on sales of securities were $0, $0 and $65 and gross losses
        realized were $20, $0 and $63 in 2007, 2006, and 2005 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 $17,708 at December 31, 2007 and $15,830 at December
        31, 2006 were pledged to secure public 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:
 **2007**
                
                **2006**Commercial
                    and agricultural
                
                $
                128,145
                
                $
                132,843Real
                    estate:Construction
                
                
                93,249
                
                
                87,063Residential
                    1-4 family
                
                
                60,616
                
                
                64,545Multi-family
                
                
                6,353
                
                
                6,927Commercial
                
                
                137,620
                
                
                117,608Farmland
                
                
                20,125
                
                
                20,126Consumer
                
                
                10,646
                
                
                10,658**456,754**
                
                
                **439,770**Less
                    unearned income
                
                
                (681
                )
                
                (601
                )**$**
                **456,073**
                
                **$**
                **439,169**
  Changes
        in the allowance for credit losses for the years ended December 31 are as
        follows:
 **2007**
                
                **2006**
                
                **2005**Balance
                    at beginning of year
                
                $
                4,033
                
                $
                5,296
                
                $
                4,236Provision
                    for credit losses
                
                
                482
                
                
                625
                
                
                1,100Charge-offs
                
                
                (151
                )
                
                (1,945
                )
                
                (65
                )Recoveries
                
                
                643
                
                
                57
                
                
                25**Net
                    (charge-offs) recoveries**
                
                
                **492**
                
                
                **(1,888**
                **)**
                ****
                **(40**
                **)****Balance
                    at end of year**
                
                **$**
                **5,007**
                
                **$**
                **4,033**
                
                **$**
                **5,296**
  F-16
 **Pacific
          Financial Corporation and Subsidiary**
 **December
          31, 2007 and 2006 and for the three years ended December 31,
          2007**
 **Notes
          to Consolidated Financial Statements, Dollars in Thousands Except Per Share
          Amounts**
  **Note
        4 - Loans** *(concluded)*
 
 Following
        is a summary of information pertaining to impaired loans:
 **2007**
                
                **2006**
                
                **2005****December
                    31**Impaired
                    loans without a valuation allowance
                
                $
                3,379
                
                $
                7,328
                
                $
                1,733Impaired
                    loans with a valuation allowance
                
                
                3,052
                
                
                51
                
                
                4,917**Total
                    impaired loans**
                
                **$**
                **6,431**
                
                **$**
                **7,379**
                
                **$**
                **6,650****Valuation
                    allowance related to impaired loans**
                
                **$**
                **72**
                
                **$**
                **17**
                
                **$**
                **924****Years
                    Ended December 31**Average
                    investment in impaired loans
                
                $
                2,938
                
                $
                6,475
                
                $
                6,925Interest
                    income recognized on a cash basis on impaired loans
                
                
                457
                
                
                272
                
                
                569
  At
        December 31, 2007, 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, 2007 and 2006 were $2,932 and $376,
        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 2007
        and
        2006. Total related party loans outstanding at December 31, 2007 and 2006
        to key
        officers and directors were $1,223 and $2,072, respectively. During 2007
        and
        2006, new loans of $43 and $2,027, respectively, were made, and repayments
        totaled $892 and $4,722, 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, 2007.
  **Note
        5 - Premises and Equipment**
 
 The
        components of premises and equipment at December 31 are as follows:
 **2007**
                
                **2006**Land
                    and premises
                
                $
                12,261
                
                $
                11,962Equipment,
                    furniture and fixtures
                
                
                7,569
                
                
                7,246Construction
                    in progress
                
                
                4,462
                
                
                664**24,292**
                
                
                **19,872**Less
                    accumulated depreciation and amortization
                
                
                8,865
                
                
                8,335**Total
                    premises and equipment**
                
                **$**
                **15,427**
                
                **$**
                **11,537**
  Depreciation
        expense was $975, $844, and $705 for 2007, 2006 and 2005, respectively. The
        Bank
        leases premises under operating leases. Rental expense of leased premises
        was
        $426, $378 and $327 for 2007, 2006 and 2005, respectively, which is included
        in
        occupancy expense.
  F-17
 **Pacific
          Financial Corporation and Subsidiary**
 **December
          31, 2007 and 2006 and for the three years ended December 31,
          2007**
 **Notes
          to Consolidated Financial Statements, Dollars in Thousands Except Per Share
          Amounts**
  **Note
        5 - Premises and Equipment** *(concluded)*
 
 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:
 2008
                
                $
                2682009
                
                
                2182010
                
                
                912011
                
                
                582012
                
                
                45**Total
                    minimum payments required**
                
                **$**
                **680**
  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:
 **2007**
                
                **2006**Demand
                    deposits, non-interest bearing
                
                $
                86,883
                
                $
                91,657NOW
                    and money market accounts
                
                
                149,565
                
                
                147,277Savings
                    deposits
                
                
                55,210
                
                
                52,228Time
                    certificates, $100,000 or more
                
                
                99,540
                
                
                99,863Other
                    time certificates
                
                
                76,138
                
                
                75,816**Total**
                
                **$**
                **467,336**
                
                **$**
                **466,841**
  Scheduled
        maturities of time certificates of deposit are as follows for future years
        ending December 31:
 2008
                
                $
                148,8932009
                
                
                7,3782010
                
                
                4,0462011
                
                
                6,7782012
                
                
                8,583**$**
                **175,678**
  **Note
        7 - Borrowings**
 
 Long-term
        borrowings at December 31, 2007 and 2006 represent advances from the Federal
        Home Loan Bank of Seattle. Advances at December 31, 2007 bear interest at
        3.49%
        to 4.27% and mature in various years as follows: 2009 - $11,000; and 2010
        -
        $1,500. The Bank has pledged $77,984 of securities and loans as collateral
        for
        these borrowings at December 31, 2007.
 
 Secured
        borrowings at December 31, 2007 and 2006 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 6.66% to 7.75%. Original maturities range from May
        2009 to
        May 2012.
  F-18
 **Pacific
          Financial Corporation and Subsidiary**
 **December
          31, 2007 and 2006 and for the three years ended December 31,
          2007**
 **Notes
          to Consolidated Financial Statements, Dollars in Thousands Except Per Share
          Amounts**
  **Note
        7 - Borrowings** *(concluded)*
 
 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:
 **2007**
                
                **2006**
                
                **2005**Amount
                    outstanding at end of year
                
                $
                10,125
                
                $
                —
                
                $
                3,985Weighted
                    average interest rate at December 31
                
                
                4.26
                %
                
                —
                
                
                5.13
                %Maximum
                    month-end balance during the year
                
                
                18,695
                
                
                6,500
                
                
                3,985Average
                    balance during the year
                
                
                5,961
                
                
                1,388
                
                
                69Average
                    interest rate during the year
                
                
                5.52
                %
                
                5.40
                %
                
                5.80
                %
  **Note
        8 - Junior Subordinated Debentures**
 
 At
        December 31, 2007, 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 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, 2007:
 *(dollars
                    in thousands)*
                
                **Issuance**
                
                **Preferred**
                
                **Rate**
                
                **Initial**
                
                **Rate
                    at**
                
                **Maturity****Issuance
                    Trust**
                
                **Date**
                
                **Security**
                
                **Type**
                
                **Rate**
                
                **12/31/07**
                
                **Date**PFC
                    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
                %
                
                6.84
                %
                
                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, 2007
        and
        2006, 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. The Company recorded $403 in the consolidated balance
        sheet at December 31, 2007 and 2006, respectively, for the common capital
        securities issued by the issuer trusts.
 
 F-19
 **Pacific
          Financial Corporation and Subsidiary**
 **December
          31, 2007 and 2006 and for the three years ended December 31,
          2007**
 **Notes
          to Consolidated Financial Statements, Dollars in Thousands Except Per Share
          Amounts**
 **Note
        8 - Junior Subordinated Debentures** *(concluded)*
 
 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:
 **2007**
                
                **2006**
                
                **2005**Current
                
                $
                2,391
                
                $
                1,990
                
                $
                2,677Deferred
                    provision (benefit)
                
                
                (305
                )
                
                759
                
                
                (24
                )**Total
                    income taxes**
                
                **$**
                **2,086**
                
                **$**
                **2,749**
                
                **$**
                **2,653**
  The
        tax
        effects of temporary differences that give rise to significant portions of
        deferred tax assets and liabilities at December 31 are:
 **2007**
                
                **2006****Deferred
                    Tax Assets**Allowance
                    for credit losses
                
                $
                1,579
                
                $
                1,213Deferred
                    compensation
                
                
                160
                
                
                166Supplemental
                    executive retirement plan
                
                
                275
                
                
                —Unrealized
                    loss on securities available for sale
                
                
                140
                
                
                164Loan
                    fees/costs
                
                
                242
                
                
                204Other
                
                
                132
                
                
                135**Total
                    deferred tax assets**
                
                
                **2,528**
                
                
                **1,882****Deferred
                    Tax Liabilities**Depreciation
                
                $
                88
                
                $
                103Loan
                    fees/costs
                
                
                2,346
                
                
                1,937Core
                    deposit intangible
                
                
                157
                
                
                205Other
                
                
                378
                
                
                359**Total
                    deferred tax liabilities**
                
                
                **2,969**
                
                
                **2,604****Net
                    deferred tax liabilities**
                
                **$**
                **(441**
                **)**
                **$**
                **(722**
                **)**
  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-20
 **Pacific
          Financial Corporation and Subsidiary**
 **December
          31, 2007 and 2006 and for the three years ended December 31,
          2007**
 **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:
 **Percent**
                
                
                
                **Percent**
                
                
                
                **Percent****2007**
                
                **of
                    Pre-tax**
                
                **2006**
                
                **of
                    Pre-tax**
                
                **2005**
                
                **Pre-tax****Amount**
                
                **Income**
                
                **Amount**
                
                **Income**
                
                **Amount**
                
                **Income**Income
                    tax at statutory rate
                
                $
                2,841
                
                
                35.0
                %
                $
                3,255
                
                
                35.0
                %
                $
                3,031
                
                
                35.0
                %Adjustments
                    resulting from:Tax-exempt
                    income
                
                
                (316
                )
                
                (3.9
                )
                
                (275
                )
                
                (2.9
                )
                
                (244
                )
                
                (2.8
                )Net
                      earnings on life insurance policies
                
                
                (139
                )
                
                (1.7
                )
                
                (112
                )
                
                (1.2
                )
                
                (125
                )
                
                (1.4
                )Other
                
                
                (300
                )
                
                (3.7
                )
                
                (119
                )
                
                (1.3
                )
                
                (9
                )
                
                (.1
                )**Total
                    income tax expense**
                
                **$**
                **2,086**
                
                
                **25.7**
                **%**
                **$**
                **2,749**
                
                
                **29.6**
                **%**
                **$**
                **2,653**
                
                
                **30.7**
                **%**
 **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 $943, $1,016, and $1,023 in 2007, 2006 and 2005,
        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 $398,
        $334 and $290 for 2007, 2006 and 2005, 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 $145, $149 and $134 at December
        31, 2007, 2006 and 2005, 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 $3,232 and $3,124
        at
        December 31, 2007 and 2006, respectively. In 2007, 2006 and 2005, the net
        benefit recorded from these plans, including the cost of the related life
        insurance, was $371, $306 and $334, 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 $326 and $339 at December
        31,
        2007 and 2006, respectively.
  F-21
 **Pacific
          Financial Corporation and Subsidiary**
 **December
          31, 2007 and 2006 and for the three years ended December 31,
          2007**
 **Notes
          to Consolidated Financial Statements, Dollars in Thousands Except Per Share
          Amounts**
 **Note
        10 - Employee Benefits** *(continued)*
  **Non-Qualified
        Deferred Compensation Plan**
 
 The
        Company has a non-qualified deferred compensation plan to cover selected
        employees. Its annual contributions to the plan totaled $0, $5 and $5 in
        2007,
        2006 and 2005, respectively. Covered employees may also contribute to the
        plan.
        The liability associated with this plan totaled $0 and $6 at December 31,
        2007
        and 2006.
 
 **Supplemental
        Executive Retirement Plan**
 
 Effective
        January 1, 2007, the Company adopted a non-qualifed 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 $5,058 at December
        31, 2007.
 
 The
        following table sets forth the net periodic pension cost and obligation
        assumptions used in the measurement of the benefit obligation for the year
        ended
        December 31, 2007:
  **Net
                    periodic pension cost:**Service
                    Cost
                
                $
                91Interest
                    Cost
                
                
                41Amortization
                    of prior service cost
                
                
                70**Net
                    periodic pension cost**
                
                **$**
                **202****Weighted
                    average assumptions:**Discount
                    rate
                
                
                5.94
                %Rate
                    of compensation increases
                
                
                5.00
  The
                    following table sets forth the change in benefit obligation at
                    December
                    31, 2007:
  **Change
                    in Benefit Obligation:**Benefit
                    obligation at inception of plan during the year
                
                $
                704Service
                    cost
                
                
                91Interest
                    cost
                
                
                41Actuarial
                    gain
                
                
                (28
                )**Benefit
                    obligation at end of year**
                
                
                **808**
  F-22
 **Pacific
          Financial Corporation and Subsidiary**
 **December
          31, 2007 and 2006 and for the three years ended December 31,
          2007**
 **Notes
          to Consolidated Financial Statements, Dollars in Thousands Except Per Share
          Amounts**
  **Note
        10 - Employee Benefits** *(concluded)*
 
 The
        following table sets forth the amounts recognized in accumulated other
        comprehensive loss at December 31, 2007:
 Net
                    gain
                
                $
                (28
                )Prior
                    service cost
                
                
                634**Total
                    recognized in accumulative other comprehensive
                    loss**
                
                **$**
                **606**
  The
        following table summarizes the projected and accumulated benefit obligations
        at
        December 31, 2007:
 Projected
                    benefit obligation
                
                $
                808Accumulated
                    benefit obligation
                
                
                633
  Estimated
          future benefit payments as of December 31, 2007 are as
          follows:
 2008
                    - 2012
                
                $
                02013
                    - 2017
                
                
                33
  **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 shareholder election. Under the plan, 1,000,000 shares are
        authorized for dividend reinvestment, of which 39,938 shares have been issued
        through December 31, 2007.
  **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:
  **2007**
                
                **2006**Commitments
                    to extend credit
                
                $
                108,095
                
                $
                100,792Standby
                    letters of credit
                
                
                3,489
                
                
                2,650
 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.
  F-23
 **Pacific
          Financial Corporation and Subsidiary**
 **December
          31, 2007 and 2006 and for the three years ended December 31,
          2007**
 **Notes
          to Consolidated Financial Statements, Dollars in Thousands Except Per Share
          Amounts**
  **Note
        12 - Commitments and Contingencies** *(concluded)*
 
 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 $41,000,
        of
        which $3,125 was used at December 31, 2007. In addition, the Bank has a credit
        line with the Federal Home Loan Bank of Seattle totaling 20% of assets, $19,500
        of which was used at December 31, 2007. 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 1,000,000 shares (279,250 shares are available for grant at December
        31, 2007). 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.
 
 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.
  F-24
 **Pacific
          Financial Corporation and Subsidiary**
 **December
          31, 2007 and 2006 and for the three years ended December 31,
          2007**
 **Notes
          to Consolidated Financial Statements, Dollars in Thousands Except Per Share
          Amounts**
  **Note
        14 - Stock Options** *(continued)*
 
 **Grant
                  period ended**
              
              **Expected
                  Life**
              
              **Risk
                  Free**
                **Interest
                  Rate**
              
              **Expected**
                **Volatility**
              
              **Dividend**
                **Yield**
              
              **Average**
                **Fair
                  Value**December
                  31, 2007
              
              
              6.5
                  years
              
              
              4.59
              %
              
              15.66
              %
              
              4.92
              %
              $
              1.69December
                  31, 2006
              
              
              6.5
                  years
              
              
              4.97
              %
              
              16.53
              %
              
              4.83
              %
              $
              1.88December
                  31, 2005
              
              
              10
                  years
              
              
              4.47
              %
              
              17.23
              %
              
              4.44
              %
              $
              4.37
 
 A
        summary
        of the status of the Company’s stock option plans as of December 31, 2007, 2006
        and 2005, and changes during the years ending on those dates, is presented
        below:
 **2007**
                
                **2006**
                
                **2005****Weighted**
                
                
                
                **Weighted**
                
                
                
                **Weighted****Average**
                
                
                
                **Average**
                
                
                
                **Average****Exercise**
                
                
                
                **Exercise**
                
                
                
                **Exercise****Shares**
                
                **Price**
                
                **Shares**
                
                **Price**
                
                **Shares**
                
                **Price**Outstanding
                    at beginning of year
                
                
                699,729
                
                $
                13.70
                
                
                687,674
                
                $
                13.28
                
                
                619,794
                
                $
                12.51Granted
                
                
                97,250
                
                
                15.32
                
                
                57,000
                
                
                15.13
                
                
                122,500
                
                
                16.22Exercised
                
                
                (74,026
                )
                
                11.47
                
                
                (44,945
                )
                
                9.13
                
                
                (42,620
                )
                
                9.50Expired
                
                
                (1,700
                )
                
                5.88
                
                
                —
                
                
                —
                
                
                —
                
                
                —Forfeited
                
                
                (94,100
                )
                
                16.60
                
                
                —
                
                
                —
                
                
                (12,000
                )
                
                16.77**Outstanding
                    at end of year**
                
                
                **627,153**
                
                **$**
                **13.80**
                
                
                **699,729**
                
                **$**
                **13.70**
                
                
                **687,674**
                
                **$**
                **13.28****Exercisable
                    at end of year**
                
                
                **450,895**
                
                **$**
                **13.46**
                
                
                **570,523**
                
                **$**
                **13.66**
                
                
                **543,668**
                
                **$**
                **14.15**
  A
        summary
        of the status of the Company’s nonvested options as of December 31, 2007 and
        2006 and changes during the period then ended are presented below:
 **Weighted
                      average****Shares**
                  
                  **Fair
                      value****Non-vested
                      January 1, 2006**
                  
                  
                  **144,006**
                  
                  **$**
                  **2.01**Granted
                  
                  
                  57,000
                  
                  
                  1.82Vested
                  
                  
                  (71,800
                  )
                  
                  1.26Forfeited
                  
                  
                  —
                  
                  
                  —**Non-vested
                      December 31, 2006**
                  
                  
                  **129,206**
                  
                  **$**
                  **2.37**Granted
                  
                  
                  97,250
                  
                  
                  1.69Vested
                  
                  
                  (32,898
                  )
                  
                  2.61Forfeited
                  
                  
                  (17,300
                  )
                  
                  2.02**Non-vested
                      December 31, 2007**
                  
                  
                  **176,258**
                  
                  **$**
                  **1.98**
  F-25
 **Pacific
          Financial Corporation and Subsidiary**
 **December
          31, 2007 and 2006 and for the three years ended December 31,
          2007**
 **Notes
          to Consolidated Financial Statements, Dollars in Thousands Except Per Share
          Amounts**
  **Note
        14 - Stock Options** *(concluded)*
 
 The
        following information summarizes information about stock options outstanding
        and
        exercisable at December 31, 2007:
  **Options
                  Outstanding**
              
              **Options
                  Exercisable****Range
                  of exercise prices**
              
              **Number**
              
              **Weighted
                  average remaining contractual life (years)**
              
              **Weighted
                  average exercise price**
              
              **Number**
              
              **Weighted
                  average remaining contractual life (years)**
              
              **Weighted
                  average exercise price**$5.88
                  - $6.18
              
              
              5,356
              
              
              2.0
              
              $
              6.18
              
              
              5,356
              
              
              2.0
              
              $
              6.1811.11
                  - 12.49
              
              
              242,797
              
              
              3.6
              
              
              11.32
              
              
              224,189
              
              
              3.4
              
              
              11.2712.50
                  - 14.74
              
              
              86,800
              
              
              5.4
              
              
              13.30
              
              
              41,300
              
              
              2.5
              
              
              13.3314.75
                  - 15.99
              
              
              78,500
              
              
              8.4
              
              
              15.28
              
              
              19,100
              
              
              7.0
              
              
              15.3116.00
                  - 17.50
              
              
              213,700
              
              
              7.3
              
              
              16.47
              
              
              160,950
              
              
              7.7
              
              
              16.57**627,153**
              
              
              **5.7**
              
              **$**
              **13.80**
              
              
              **450,895**
              
              
              **4.7**
              
              **$**
              **13.46**
 
 The
        aggregate intrinsic value of all options outstanding at December 31, 2007
        and
        2006 was $188 and $2,275, respectively. The aggregate intrinsic value of
        all
        options that were exercisable at December 31, 2007 and 2006 was $0 and $1,878,
        respectively. The total intrinsic value of stock options exercised was $282
        and
        $314, respectively for the 2007 and 2006. Cash received from the exercise
        of
        stock options during 2007 totaled $861. Stock based compensation recognized
        in
        2007 and 2006 was $97 ($64 net of tax and $36 ($24 net of tax), respectively.
        Future compensation expense for unvested awards outstanding as of December
        31,
        2007 is estimated to be $181 recognized over a weighted average period of
        1.9
        years.
 
 In
        July
        2005, the Board of Directors approved the acceleration of vesting of 257,600
        out
        of the money options previously awarded under the 2000 Stock Option Plan.
        As a
        result, the accelerated stock options became exercisable
        immediately.
  **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.
 
 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).
 
 F-26
 **Pacific
          Financial Corporation and Subsidiary**
 **December
          31, 2007 and 2006 and for the three years ended December 31,
          2007**
 **Notes
          to Consolidated Financial Statements, Dollars in Thousands Except Per Share
          Amounts**
  **Note
        15 - Regulatory Matters** *(concluded)*
 
 As
        of
        December 31, 2007, 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 also presented in
        the table. Management believes, as of December 31, 2007, the Company and
        the
        Bank meet all capital requirements to which they are subject.
 **To
                    be Well****Capitalized****Under
                    Prompt****Capital
                    Adequacy**
                
                **Corrective
                    Action****Actual**
                
                
                
                **Purposes**
                
                **Provisions****Amount**
                
                **Ratio**
                
                **Amount**
                
                **Ratio**
                
                **Amount**
                
                **Ratio****December
                    31, 2007***Tier
                    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
                
                
                6.00*Total
                    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**December
                    31, 2006***Tier
                    1 capital (to average assets):*Company
                
                $
                49,042
                
                
                9.27
                %
                $
                21,173
                
                
                4.00
                %
                
                NA
                
                
                NABank
                
                
                48,162
                
                
                9.11
                
                
                21,147
                
                
                4.00
                
                $
                26,432
                
                
                5.00
                %*Tier
                    1 capital (to risk-weighted assets):*Company
                
                
                49,042
                
                
                11.03
                
                
                17,784
                
                
                4.00
                
                
                NA
                
                
                NABank
                
                
                48,162
                
                
                10.91
                
                
                17,662
                
                
                4.00
                
                
                26,493
                
                
                6.00*Total
                    capital (to risk-weighted assets):*Company
                
                
                53,075
                
                
                11.94
                
                
                35,567
                
                
                8.00
                
                
                NA
                
                
                NABank
                
                
                52,195
                
                
                11.82
                
                
                35,324
                
                
                8.00
                
                
                44,155
                
                
                10.00
  At
        December 31, 2007 and 2006, approximately $6,031 and $6,551, respectively,
        of
        undistributed earnings of the Bank, included in consolidated retained earnings,
        was available for distribution as dividends without prior regulatory
        approval.
  F-27
 **Pacific
          Financial Corporation and Subsidiary**
 **December
          31, 2007 and 2006 and for the three years ended December 31,
          2007**
 **Notes
          to Consolidated Financial Statements, Dollars in Thousands Except Per Share
          Amounts**
  **Note
          16 - Other Comprehensive Income**
 
 Net
          unrealized gains and losses, net of tax, include $46 and $5 of unrealized
          gains
          and $455 of unrealized losses arising during 2007, 2006 and 2005, respectively,
          less reclassification adjustments of $0, $0 and $1 for gains included in
          net
          income in 2007, 2006 and 2005, respectively, as follows:
 **Before-**
                
                **Tax****Tax**
                
                **Benefit**
                
                **Net-of-Tax****Amount**
                
                **(Expense)**
                
                **Amount****2007**Unrealized
                    holding gains arising during the year
                
                $
                71
                
                
                ($25
                )
                $
                46Reclassification
                    adjustments for gains realized in net income
                
                
                —
                
                
                —
                
                
                —**Net
                    unrealized gains**
                
                **$**
                **71**
                
                
                **($25**
                **)**
                **$**
                **46****2006**Unrealized
                    holding gains arising during the year
                
                $
                8
                
                
                ($3
                )
                $
                5Reclassification
                    adjustments for gains realized in net income
                
                
                —
                
                
                —
                
                
                —**Net
                    unrealized gains**
                
                **$**
                **8**
                
                
                **($3**
                **)**
                **$**
                **5****2005**Unrealized
                    holding losses arising during the year
                
                $
                (689
                )
                $
                234
                
                $
                (455
                )Reclassification
                    adjustments for gains realized in net income
                
                
                (2
                )
                
                1
                
                
                (1
                )**Net
                    unrealized losses**
                
                **$**
                **(691**
                **)**
                **$**
                **235**
                
                **$**
                **(456**
                **)**
 
 **Note
        17 - Fair Value of Financial Instruments**
 
 The
        estimated fair value of the Company’s financial instruments at December 31 are
        as follows:
 **2007**
                
                
                
                **2006****Carrying**
                
                **Fair**
                
                **Carrying**
                
                **Fair****Amount**
                
                **Value**
                
                **Amount**
                
                **Value****Financial
                    Assets**Cash
                    and due from banks, interest-bearingdeposits
                    in banks, and federal funds sold
                
                $
                15,297
                
                $
                15,297
                
                $
                40,788
                
                $
                40,788Securities
                    available for sale
                
                
                42,912
                
                
                42,912
                
                
                36,608
                
                
                36,608Securities
                    held to maturity
                
                
                4,329
                
                
                4,368
                
                
                6,104
                
                
                6,101Investment
                    in PFC Statutory Trusts
                
                
                403
                
                
                403
                
                
                403
                
                
                403Federal
                    Home Loan Bank stock
                
                
                1,858
                
                
                1,858
                
                
                1,858
                
                
                1,858Loans
                    receivable, net
                
                
                433,904
                
                
                434,120
                
                
                420,768
                
                
                420,215Loans
                    held for sale
                
                
                17,162
                
                
                17,407
                
                
                14,368
                
                
                14,684Accrued
                    interest receivable
                
                
                3,165
                
                
                3,165
                
                
                3,006
                
                
                3,006**Financial
                    Liabilities**Deposits
                
                $
                467,336
                
                $
                468,326
                
                $
                466,841
                
                $
                466,719Short-term
                    borrowings
                
                
                10,125
                
                
                10,093
                
                
                —
                
                
                —Long-term
                    borrowings
                
                
                12,500
                
                
                12,436
                
                
                21,500
                
                
                20,880Secured
                    borrowings
                
                
                1,418
                
                
                1,418
                
                
                1,906
                
                
                1,906Junior
                    subordinated debentures
                
                
                13,403
                
                
                13,275
                
                
                13,403
                
                
                13,403Accrued
                    interest payable
                
                
                1,399
                
                
                1,399
                
                
                1,415
                
                
                1,415
  **Note
        17 - Fair Value of Financial Instruments** *(continued)*
 
 The
        Bank
        assumes interest rate risk (the risk that general interest rate levels will
        change) as a result of its normal operations. As a result, the fair values
        of
        the Bank’s financial instruments will change when interest rate levels change
        and that change may either be favorable or unfavorable to the Bank. Management
        attempts to match maturities of assets and liabilities to the extent believed
        appropriate to maintain interest rate risk at acceptable levels. However,
        borrowers with fixed rate obligations are less likely to prepay in a rising
        rate
        environment and more likely to prepay in a falling rate environment. Conversely,
        depositors who are receiving fixed rates are more likely to withdraw funds
        before maturity in a rising rate environment and less likely to do so in
        a
        falling rate environment. Management monitors rates and maturities of assets
        and
        liabilities, and attempts to minimize interest rate risk by adjusting terms
        of
        new loans and deposits and by investing in securities with terms that mitigate
        the Bank’s overall interest rate risk.
  F-28
 **Pacific
          Financial Corporation and Subsidiary**
 **December
          31, 2007 and 2006 and for the three years ended December 31,
          2007**
 **Notes
          to Consolidated Financial Statements, Dollars in Thousands Except Per Share
          Amounts**
 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.
 
 **Federal
        Home Loan Bank Stock**
  The
        carrying value of Federal Home Loan Bank stock approximates its fair
        value.
 
 **Investment
        in PFC Statutory Trust I and II**
  The
        carrying value of the Investment in PFC Statutory Trust I and II approximates
        their fair value and is recorded in other assets.
 
 **Loans**
  For
        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 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. Fair values
 for
        impaired loans are estimated using discounted cash flow analysis or underlying
        collateral values, where applicable.
 
 **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.
  **Note
        17 - Fair Value of Financial Instruments** *(concluded)*
 
 **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.
  F-29
  **Pacific
          Financial Corporation and Subsidiary**
 **December
          31, 2007 and 2006 and for the three years ended December 31,
          2007**
 **Notes
          to Consolidated Financial Statements, Dollars in Thousands Except Per Share
          Amounts**
  **Long-Term
        Borrowings and Junior Subordinated Debentures**
  The
        fair
        values of the Company’s long-term borrowings and junior subordinated debentures
        are estimated using discounted cash flow analysis based on the Company’s
        incremental borrowing rates for similar types of borrowing
        arrangements.
 
 **Accrued
        Interest Receivable and Payable**
  The
        carrying amounts of accrued interest receivable and payable approximate their
        fair values.
 
 **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.
  **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)**
                
                **Amount****Year
                    Ended December 31, 2007**Basic
                    earnings per share:
                
                $
                6,031
                
                
                6,581,203
                
                $
                0.92Effect
                    of dilutive securities:
                
                
                —
                
                
                86,839
                
                
                (.02
                )**Diluted
                    earnings per share:**
                
                **$**
                **6,031**
                
                
                **6,668,042**
                
                **$**
                **0.90****Year
                    Ended December 31, 2006**Basic
                    earnings per share:
                
                $
                6,551
                
                
                6,483,370
                
                $
                1.01Effect
                    of dilutive securities:
                
                
                —
                
                
                102,437
                
                
                (.02
                )**Diluted
                    earnings per share:**
                
                **$**
                **6,551**
                
                
                **6,585,807**
                
                **$**
                **0.99****Year
                    Ended December 31, 2005**Basic
                    earnings per share:
                
                $
                6,046
                
                
                6,425,615
                
                $
                0.94Effect
                    of dilutive securities:
                
                
                —
                
                
                112,635
                
                
                (.02
                )**Diluted
                    earnings per share:**
                
                **$**
                **6,046**
                
                
                **6,538,250**
                
                **$**
                **0.92**
  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, 2007 and 2006 and for the three years ended December 31,
            2007**
 **Notes
            to Consolidated Financial Statements, Dollars in Thousands Except Per
            Share
            Amounts**
  **Condensed
          Statements of Income - Years Ended December 31**
  **Note
        19 - Condensed Financial Information - Parent Company Only**
 
 **Condensed
        Balance Sheets - December 31**
 **2007**
                
                **2006****Assets**Cash
                
                $
                4,929
                
                $
                5,183Investment
                    in the Bank
                
                
                63,084
                
                
                61,104Due
                    from the Bank
                
                
                783
                
                
                731Other
                    assets
                
                
                403
                
                
                403**Total
                    assets**
                
                **$**
                **69,199**
                
                **$**
                **67,421****Liabilities
                    and Shareholders’ Equity**Dividends
                    payable
                
                $
                4,955
                
                $
                4,893Junior
                    subordinated debentures
                
                
                13,403
                
                
                13,403Other
                    liabilities
                
                
                142
                
                
                141Shareholders’
                    equity
                
                
                50,699
                
                
                48,984**Total
                    liabilities and shareholders’ equity**
                
                **$**
                **69,199**
                
                **$**
                **67,421**
  **Condensed Statements
          of Income - Years Ended December 31**
 
 **2007**
              
              **2006**
              
              **2005**Dividend
                  Income from the Bank
              
              $
              4,700
              
              $
              5,150
              
              $
              4,250Other
                  Income
              
              
              27
              
              
              19
              
              
              —**Total
                  Income**
              
              
              **4,727**
              
              
              **5,169**
              
              
              **4,250****Expenses**
              
              
              (1,236
              )
              
              (934
              )
              
              (205
              )**Income
                  before income tax benefit**
              
              
              **3,491**
              
              
              **4,235**
              
              
              **4,045****Income
                  Tax Benefit**
              
              
              —
              
              
              294
              
              
              69**Income
                  before equity in undistributed income of the Bank**
              
              
              **3,491**
              
              
              **4,529**
              
              
              **4,114****Equity
                  in Undistributed Income of the Bank**
              
              
              2,540
              
              
              2,022
              
              
              1,932**Net
                  income**
              
              **$**
              **6,031**
              
              **$**
              **6,551**
              
              **$**
              **6,046**
  F-31
 **Pacific
          Financial Corporation and Subsidiary**
 **December
          31, 2007 and 2006 and for the three years ended December 31,
          2007**
 **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**
 **2007**
                
                **2006**
                
                **2005****Operating
                    Activities**Net
                    income
                
                $
                6,031
                
                $
                6,551
                
                $
                6,046Adjustments
                      to reconcile net income to net cash provided by operating
                      activities:Equity
                    in undistributed income of subsidiary
                
                
                (2,540
                )
                
                (2,022
                )
                
                (1,932
                )Net
                    change in other assets
                
                
                —
                
                
                (294
                )
                
                (69
                )Net
                    change in other liabilities
                
                
                1
                
                
                141
                
                
                —Other
                    - net
                
                
                97
                
                
                35
                
                
                12**Net
                    cash provided by operating activities**
                
                
                **3,589**
                
                
                **4,411**
                
                
                **4,057****Investing
                    Activities**Contribution
                    to subsidiary
                
                
                —
                
                
                (8,000
                )
                
                (5,000
                )Purchase
                    of trust common securities
                
                
                —
                
                
                (248
                )
                
                (155
                )**Net
                    cash used in investing activities**
                
                
                —
                
                
                **(8,248**
                **)**
                
                **(5,155**
                **)****Financing
                    Activities**Proceeds
                    from junior subordinated debentures
                
                
                —
                
                
                8,248
                
                
                5,155Common
                    stock issued
                
                
                1,269
                
                
                642
                
                
                405Repurchase
                    and retirement of common stock
                
                
                (219
                )
                
                —
                
                
                —Dividends
                    paid
                
                
                (4,893
                )
                
                (4,719
                )
                
                (4,624
                )**Net
                    cash provided by (used in) financing activities**
                
                
                **(3,843**
                **)**
                
                **4,171**
                
                
                **936****Net
                    increase (decrease) in cash**
                
                
                **(254**
                **)**
                
                **334**
                
                
                **(162**
                **)****Cash**Beginning
                    of year
                
                
                5,183
                
                
                4,849
                
                
                5,011**End
                    of year**
                
                **$**
                **4,929**
                
                **$**
                **5,183**
                
                **$**
                **4,849**
  F-32
  **Quarterly
        Data (Unaudited)**
 **First**
                
                **Second**
                
                **Third**
                
                **Fourth****Quarter**
                
                **Quarter**
                
                **Quarter**
                
                **Quarter****Year
                    Ended December 31, 2007**Interest
                    income
                
                $
                9,811
                
                $
                10,346
                
                $
                10,331
                
                $
                9,648Interest
                    expense
                
                
                3,806
                
                
                4,033
                
                
                4,000
                
                
                3,794**Net
                    interest income**
                
                
                **6,005**
                
                
                **6,313**
                
                
                **6,331**
                
                
                **5,854**Provision
                    for credit losses
                
                
                257
                
                
                105
                
                
                60
                
                
                60Non-interest
                    income
                
                
                946
                
                
                1,149
                
                
                1,063
                
                
                1,317Non-interest
                    expenses
                
                
                4,820
                
                
                5,184
                
                
                5,017
                
                
                5,358**Income
                    before income taxes**
                
                
                **1,874**
                
                
                **2,173**
                
                
                **2,317**
                
                
                **1,753**Income
                    taxes
                
                
                340
                
                
                607
                
                
                686
                
                
                453**Net
                    income**
                
                **$**
                **1,534**
                
                **$**
                **1,566**
                
                **$**
                **1,631**
                
                **$**
                **1,300****Earnings
                    per common share:**Basic
                
                $
                .23
                
                $
                .24
                
                $
                .24
                
                $
                .21Diluted
                
                
                .23
                
                
                .24
                
                
                .24
                
                
                .19**Year
                    Ended December 31, 2006**Interest
                    income
                
                $
                8,126
                
                $
                8,763
                
                $
                9,765
                
                $
                9,790Interest
                    expense
                
                
                2,493
                
                
                2,864
                
                
                3,510
                
                
                3,710**Net
                    interest income**
                
                
                **5,633**
                
                
                **5,899**
                
                
                **6,255**
                
                
                **6,080**Provision
                    for credit losses
                
                
                —
                
                
                —
                
                
                550
                
                
                75Non-interest
                    income
                
                
                946
                
                
                1,089
                
                
                1,091
                
                
                1,050Non-interest
                    expenses
                
                
                4,314
                
                
                4,466
                
                
                4,636
                
                
                4,702**Income
                    before income taxes**
                
                
                **2,265**
                
                
                **2,522**
                
                
                **2,160**
                
                
                **2,353**Income
                    taxes
                
                
                675
                
                
                777
                
                
                617
                
                
                680**Net
                    income**
                
                **$**
                **1,590**
                
                **$**
                **1,745**
                
                **$**
                **1,543**
                
                **$**
                **1,673****Earnings
                    per common share:**Basic
                
                $
                .25
                
                $
                .27
                
                $
                .24
                
                $
                .25Diluted
                
                
                .24
                
                
                .27
                
                
                .23
                
                
                .25
  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 14 th day of
      March, 2008.




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 14 th day of
      March, 2008.


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/
                  Duane E. HagstromJoseph
                  A. Malik
              
              Duane
                  E. Hagstrom/s/
                  Steward L. Thomas
              
              /s/
                  John FerlinSteward
                  L. Thomas
              
              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/s/
                  Randy Rust
              
              /s/
                  Edwin KetelRandy
                  Rust
              
              Edwin
                  Ketel


42




Exhibit
        Index





EXHIBIT
                NO.
            
            EXHIBIT3.1
            
            Restated
                Articles 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*
            
            Employment
                Agreement with Dennis A. Long dated July 1, 2005. Incorporated by
reference
                to Exhibit 10.1 to the Company's Annual Report on Form 10-K for the
                year
                ended
                December 31, 2006 (the "2005 10-K").*10.2
            
            Employment
                Agreement with John Van Dijk dated July 1, 2005. Incorporated by
reference
                to Exhibit 10.2 to the 2005 10-K.*10.3
            
            Employment
                Agreement with Bruce D. MacNaughton dated July 1, 2005. Incorporated
by
                reference to Exhibit 10.3 to the 2005 10-K.*10.4
            
            Employment
                Agreement with Denise Portmann dated July 1, 2005.Incorporated
                by reference
                to Exhibit 10.4 to the 2005 10-K.*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
            
            Senior
                Officer Incentive Plan.*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
                law23.1
            
            Consent
                of Deloitte & Touche, LLP, Independent Registered Public Accounting
                Firm23.2
            
            Consent
                of McGladrey & Pullen, LLP, Independent Registered Public Accounting
                Firm31.1
            
            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
            
            Certifications
                Under 18 U.S.C. 135099
            
            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.




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