**UNITEDSTATES SECURITIES AND EXCHANGE COMMISSON**Washington D.C.,20549

**FORM 10-Q**

**x****                             ****QuarterlyReport Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934**

**For the quarterly period ended June 30, 2006**

**o****                                ****TransitionReport Under Section 13 or 15(d) of the Exchange Act**

**For the transition period from                         to**

**Commission File Number  000-52096**

**SKAGIT STATE BANCORP, INC.**

(ExactName of Registrant as Specified in Its Charter)
| **WASHINGTON**                   | ** ** | **91-0681718**          |
|----------------------------------|------------|-------------------------|
| (State or Other  Jurisdiction of |       | (I.R.S. Employer        |
| Incorporation or  Organization   |       | Identification  Number) |

 

**301 East Fairhaven AvenueBurlington, Washington  98233**(Addressof Principal Executive Offices) (Zip Code)

**(360) 755-0411**(Registrant’sTelephone Number, Including Area Code)

Indicate by check mark whether theregistrant:  (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Exchange Act during thepreceding 12 months (or for such shorter period that the registrantwas required to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.

Yes    x        No   o

Indicate by check mark whether the registrant is a large acceleratedfiler, an accelerate filer, or a non-accelerate.

Large accelerated filer   o            Accelerated filer    o            Non-accelerated filer  x

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

Yes    o        No   x

Indicate the number of sharesoutstanding of each of the issuer’s classes of common stock, as of the latestpracticable date:

The number of shares of the issuer’s Common Stockoutstanding at August 10, 2006 was 676,030.

 

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**SKAGITSTATE BANCORP, INC.TABLE OF CONTENTS**
| **PART I.**   | **FINANCIAL INFORMATION** |                                                                                                                      |   |
|---------------|---------------------------|---------------------------------------------------------------------------------------------------------------------------|--------|
| ** **    | ** **                |                                                                                                                      |   |
|          | Item 1.                   | Financial  Statements                                                                                                     |   |   |
|          |                      |                                                                                                                      |   |   |
|          |                      | Consolidated Balance Sheet as of June 30, 2006 and  December 31, 2005                                                     |   |   |
|          |                      |                                                                                                                      |   |   |
|          |                      | Consolidated Statement of Income for the three and six  months ended June 30, 2006 and 2005                               |   |   |
|          |                      |                                                                                                                      |   |   |
|          |                      | Consolidated Statement of Changes in Stockholders’  Equity for the three and six months ended June 30, 2006 and 2005 |   |   |
|          |                      |                                                                                                                      |   |   |
|          |                      | Consolidated Statement of Cash Flows for the six  months ended June 30, 2006 and 2005                                     |   |   |
|          |                      |                                                                                                                      |   |   |
|          |                      | Notes to Consolidated Financial Statements                                                                                |   |   |
|          |                      |                                                                                                                      |   |   |
|          | Item 2.                   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                               |   |   |
|          |                      |                                                                                                                      |   |   |
|          | Item 3.                   | Quantitative and Qualitative Disclosures About Market  Risk                                                               |   |   |
|          |                      |                                                                                                                      |   |   |
|          | Item 4.                   | Controls and Procedures                                                                                                   |   |   |
|          |                      |                                                                                                                      |   |   |
| **PART  II.** | **OTHER  INFORMATION**    |                                                                                                                      |   |
| ** **    | ** **                |                                                                                                                      |   |
|          | Item  1.                  | Legal  Proceedings                                                                                                        |   |   |
|          |                      |                                                                                                                      |   |   |
|          | Item 1 A.                 | Risk Factors                                                                                                              |   |   |
|          |                      |                                                                                                                      |   |   |
|          | Item 2.                   | Unregistered Sales of Equity Securities and Use of  Proceeds                                                              |   |   |
|          |                      |                                                                                                                      |   |   |
|          | Item 3.                   | Defaults Upon Senior Securities                                                                                           |   |   |
|          |                      |                                                                                                                      |   |   |
|          | Item 4.                   | Submission of Matters to a Vote of Security Holders                                                                       |   |   |
|          |                      |                                                                                                                      |   |   |
|          | Item  5.                  | Other  Information                                                                                                        |   |   |
|          |                      |                                                                                                                      |   |   |
|          | Item 6.                   | Exhibits                                                                                                                  |   |   |
|          |                      |                                                                                                                      |   |   |
|          |                      | Signatures                                                                                                                |   |   |

 

2

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**Item 1.    Financial Statements**

**SKAGIT STATE BANCORP, INC. AND SUBSIDIARYCONSOLIDATED BALANCE SHEET (Unaudited)**
| **(dollars in thousands except share data)**                                                                                                                     | ** ** | **June 30, 2006** | ** ** | **December 31, 2005** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| **ASSETS**                                                                                                                                                       | ** ** | ** **        | ** ** | ** **            | ** ** |
| ** **                                                                                                                                                       | ** ** | ** **        | ** ** | ** **            | ** ** |
| **ASSETS**                                                                                                                                                       | ** ** | ** **        | ** ** | ** **            | ** ** |
| Cash and due  from banks                                                                                                                                         |       | $                 | 21,048     |                  | $          | 24,975 |   |
| Federal funds  sold                                                                                                                                              |       | 47,165            |       | 88,090                |       |
| Investment  securities                                                                                                                                           |       |              |       |                  |       |
| Available-for-sale,  at fair value                                                                                                                               |       | 95,624            |       | 69,853                |       |
| Held-to-maturity,  at amortized cost                                                                                                                             |       | 32,119            |       | 29,197                |       |
| Loans                                                                                                                                                            |       | 303,614           |       | 300,614               |       |
| Allowance for  loan losses                                                                                                                                       |       | (4,820            | )          | (5,178                | )          |
| Net loans                                                                                                                                                        |       | 298,794           |       | 295,436               |       |
| Bank premises  and equipment, net                                                                                                                                |       | 10,886            |       | 10,734                |       |
| Accrued interest  receivable                                                                                                                                     |       | 3,260             |       | 2,371                 |       |
| Other assets                                                                                                                                                     |       | 2,185             |       | 1,223                 |       |
| **TOTAL ASSETS**                                                                                                                                                 |       | $                 | 511,081    |                  | $          | 521,879 |   |
|                                                                                                                                                             |       |              |       |                  |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                   | ** ** | ** **        | ** ** | ** **            | ** ** |
| ** **                                                                                                                                                       | ** ** | ** **        | ** ** | ** **            | ** ** |
| **LIABILITIES**                                                                                                                                                  | ** ** | ** **        | ** ** | ** **            | ** ** |
| Deposits                                                                                                                                                         |       |              |       |                  |       |
| Interest-bearing                                                                                                                                                 |       | $                 | 359,098    |                  | $          | 366,193 |   |
| Non-interest-bearing                                                                                                                                             |       | 74,850            |       | 76,872                |       |
| Total deposits                                                                                                                                                   |       | 433,948           |       | 443,065               |       |
| Securities sold  under agreements to repurchase                                                                                                                  |       | 11,517            |       | 11,298                |       |
| Other  liabilities                                                                                                                                               |       | 2,545             |       | 2,143                 |       |
| Total  liabilities                                                                                                                                               |       | 448,010           |       | 456,506               |       |
|                                                                                                                                                             |       |              |       |                  |       |
| **STOCKHOLDERS’ EQUITY**                                                                                                                                    | ** ** | ** **        | ** ** | ** **            | ** ** |
| Common stock, no  par value, 5,000,000 shares authorized 675,930 and 707,237 shares issued and  outstanding at June 30, 2006 and December 31, 2005, respectively |       | 14,291            |       | 14,604                |       |
| Retained  earnings                                                                                                                                               |       | 49,634            |       | 51,139                |       |
| Accumulated  other comprehensive loss, net of tax                                                                                                                |       | (854              | )          | (370                  | )          |
| Total  stockholders’ equity                                                                                                                                 |       | 63,071            |       | 65,373                |       |
| **TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                              |       | $                 | 511,081    |                  | $          | 521,879 |   |

*Seeaccompanying notes to these consolidated financial statements*

3

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**SKAGIT STATE BANCORP, INC. AND SUBSIDIARYCONSOLIDATED STATEMENT OF INCOME (Unaudited)**
| ** **                                                            | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|-----------------------------------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| **(dollars in thousands except share data)** | ** ** | **2006**                                            | ** ** | **2005**                                          | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                                  |       |                                                |       |                                              |       |   |   |   |   |
| **INTEREST  INCOME**                                                  | ** ** | ** **                                          | ** ** | ** **                                        | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest and fees on loans                                            |       | $                                                   | 6,106      |                                              | $          | 6,260 |   | $ | 12,240 |   | $ | 12,365 |   |
| Investment securities                                                 |       |                                                |       |                                              |       |   |   |   |   |
| Taxable                                                               |       | 1,077                                               |       | 258                                               |       | 1,859 |   | 465 |   |
| Exempt from federal income tax                                        |       | 191                                                 |       | 197                                               |       | 376 |   | 396 |   |
| Federal funds sold                                                    |       | 644                                                 |       | 409                                               |       | 1,618 |   | 685 |   |
| Total interest income                                                 |       | 8,018                                               |       | 7,124                                             |       | 16,093 |   | 13,911 |   |
| **INTEREST  EXPENSE**                                                 | ** ** | ** **                                          | ** ** | ** **                                        | ** ** | ** ** | ** ** | ** ** | ** ** |
| Deposits                                                              |       | 2,280                                               |       | 1,388                                             |       | 4,407 |   | 2,620 |   |
| Securities sold under agreements to repurchase                        |       | 117                                                 |       | 33                                                |       | 220 |   | 51 |   |
| Total interest expense                                                |       | 2,397                                               |       | 1,421                                             |       | 4,627 |   | 2,671 |   |
| **NET  INTEREST INCOME**                                              |       | 5,621                                               |       | 5,703                                             |       | 11,466 |   | 11,240 |   |
| Provision for loan losses                                             |       | —                                              |       | 50                                                |       | — |   | 350 |   |
| **NET  INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES**              |       | 5,621                                               |       | 5,653                                             |       | 11,466 |   | 10,890 |   |
| **NON-INTEREST  INCOME**                                              | ** ** | ** **                                          | ** ** | ** **                                        | ** ** | ** ** | ** ** | ** ** | ** ** |
| Service charges on deposits                                           |       | 556                                                 |       | 561                                               |       | 1,067 |   | 1,067 |   |
| Other                                                                 |       | 227                                                 |       | 120                                               |       | 396 |   | 354 |   |
| Total non-interest income                                             |       | 783                                                 |       | 681                                               |       | 1,463 |   | 1,421 |   |
| **NON-INTEREST  EXPENSES**                                            | ** ** | ** **                                          | ** ** | ** **                                        | ** ** | ** ** | ** ** | ** ** | ** ** |
| Salaries                                                              |       | 1,691                                               |       | 1,628                                             |       | 3,345 |   | 3,131 |   |
| Payroll taxes and employee benefits                                   |       | 400                                                 |       | 348                                               |       | 796 |   | 680 |   |
| Bank premises and equipment                                           |       | 326                                                 |       | 282                                               |       | 619 |   | 548 |   |
| Occupancy                                                             |       | 159                                                 |       | 181                                               |       | 335 |   | 354 |   |
| State business taxes                                                  |       | 112                                                 |       | 102                                               |       | 224 |   | 201 |   |
| Advertising                                                           |       | 180                                                 |       | 135                                               |       | 326 |   | 265 |   |
| Other                                                                 |       | 704                                                 |       | 912                                               |       | 1,411 |   | 1,739 |   |
| Total non-interest expenses                                           |       | 3,572                                               |       | 3,588                                             |       | 7,056 |   | 6,918 |   |
| **INCOME  BEFORE PROVISION FOR INCOME TAX**                           |       | 2,832                                               |       | 2,746                                             |       | 5,873 |   | 5,393 |   |
| **PROVISION  FOR INCOME TAX**                                         | ** ** | ** **                                          | ** ** | ** **                                        | ** ** | ** ** | ** ** | ** ** | ** ** |
| Current                                                               |       | 686                                                 |       | 630                                               |       | 1,556 |   | 1,360 |   |
| Deferred                                                              |       | 51                                                  |       | —                                            |       | 51 |   | — |   |
| Total provision for income tax                                        |       | 737                                                 |       | 630                                               |       | 1,607 |   | 1,360 |   |
| **NET  INCOME**                                                       |       | $                                                   | 2,095      |                                              | $          | 2,116 |   | $ | 4,266 |   | $ | 4,033 |   |
| **BASIC AND DILUTED EARNINGS PER  SHARE**                             |       | $                                                   | 3.07       |                                              | $          | 2.99 |   | $ | 6.14 |   | $ | 5.70 |   |

*See accompanying notes to theseconsolidated financial statements*

4

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**SKAGIT STATEBANCORP, INC. AND SUBSIDIARYCONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY (Unaudited)**
| ** **                                                                                            | ** ** | **Common Stock** | ** ** | **Retained** | ** ** | **Comprehensive** | ** ** | **Stockholders’** | ** ** | **Comprehensive** | ** ** |
|-------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|--------------|------------|-------------------|------------|------------------------|------------|-------------------|------------|
| **(dollars in thousands except share and per share amounts)** | ** ** | **Shares**            | ** ** | **Amount**   | ** ** | **Earnings**      | ** ** | **Income (Loss)** | ** ** | **Equity**        | ** ** | **Income** | ** ** |
| **BALANCE,**January 1, 2005                                                                           |       | 707,137               |       | $            | 14,591     |              | $          | 44,165                 |       | $                 | (23)       |   | $ | 58,733 |   |   |   |
| Comprehensive  income                                                                                 |       |                  |       |         |       |              |       |                   |       |              |       |   |   |
| Net income                                                                                            |       | —                |       | —       |       | 4,033             |       | —                 |       | 4,033             |       | $ | 4,033 |   |
| Other comprehensive income                                                                            |       |                  |       |         |       |              |       |                   |       |              |       |   |   |
| Unrealized gains on available-for-sale securities,  net of taxes of $25                               |       | —                |       | —       |       | —            |       | 50                     |       | 50                |       | 50 |   |
| Unrealized loss on available-for-sale securities, net  of tax benefit of $76                          |       | —                |       | —       |       | —            |       | (149                   | )          | (149              | )          | (149 | ) |
| Total other comprehensive loss                                                                        |       |                  |       |         |       |              |       |                   |       |              |       | (99 | ) |
| Comprehensive  income                                                                                 |       |                  |       |         |       |              |       |                   |       |              |       | $ | 3,934 |   |
| Cash dividend  declared, $1.10 per share                                                              |       |                  |       |         |       | (778              | )          |                   |       | (778              | )          |   |   |
| **BALANCE,**June 30, 2005                                                                             |       | 707,137               |       | $            | 14,591     |              | $          | 47,420                 |       | $                 | (122)      |   | $ | 61,889 |   |   |   |
|                                                                                                  |       |                  |       |         |       |              |       |                   |       |              |       |   |   |
| **BALANCE,**January 1, 2006                                                                           |       | 707,237               |       | $            | 14,604     |              | $          | 51,139                 |       | $                 | (370)      |   | $ | 65,373 |   |   |   |
| Comprehensive  income                                                                                 |       |                  |       |         |       |              |       |                   |       |              |       |   |   |
| Net income                                                                                            |       | —                |       | —       |       | 4,266             |       | —                 |       | 4,266             |       | $ | 4,266 |   |
| Other comprehensive income                                                                            |       |                  |       |         |       |              |       |                   |       |              |       |   |   |
| Unrealized gains on available-for-sale securities,  net of taxes of $90                               |       | —                |       | —       |       | —            |       | 175                    |       | 175               |       | 175 |   |
| Unrealized loss on available-for-sale securities, net  of tax benefit of $340                         |       | —                |       | —       |       | —            |       | (659                   | )          | (659              | )          | (659 | ) |
| Total other comprehensive loss                                                                        |       |                  |       |         |       |              |       |                   |       |              |       | (484 | ) |
| Comprehensive  income                                                                                 |       |                  |       |         |       |              |       |                   |       |              |       | $ | 3,782 |   |
| Cash dividend  declared, $1.25 per share                                                              |       |                  |       |         |       | (849              | )          |                   |       | (849              | )          |   |   |
| Common stock  redemption                                                                              |       | (31,307               | )          | (313         | )          | (4,922            | )          |                   |       | (5,235            | )          |   |   |
| **BALANCE,**June 30, 2006                                                                             |       | 675,930               |       | $            | 14,291     |              | $          | 49,634                 |       | $                 | (854)      |   | $ | 63,071 |   |   |   |

*Seeaccompanying notes to these consolidated financial statements*

5

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**SKAGIT STATE BANCORP,INC. AND SUBSIDIARYSTATEMENT OF CASH FLOWS (Unaudited**)
| **(dollars in thousands)**                                               | ** ** | ** ** | ** ** | ** ** | ** ** |
|------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| **Six months ended June 30,**                                  | ** ** | **2006**   | ** ** | **2005**   | ** ** |
| **CASH  FLOWS FROM OPERATING ACTIVITIES**                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income                                                                         |       | $          | 4,266      |       | $          | 4,033 |   |
| *Adjustments  to reconcile net income to net cash flows from operating activities* | * *   | * *   | * *   | * *   | * *   |
| Provision for loan losses                                                          |       | —     |       | 350        |       |
| Provision for other real estate owned losses                                       |       | —     |       | 27         |       |
| Depreciation                                                                       |       | 413        |       | 385        |       |
| Gain on sale of premises and equipment                                             |       | (8         | )          | (7         | )          |
| Amortization of investment security premiums and discounts,  net                   |       | (30        | )          | (6         | )          |
| Provision for deferred income taxes                                                |       | 51         |       | —     |       |
| *Changes  in operating assets and liabilities*                                     | * *   | * *   | * *   | * *   | * *   |
| Increase in interest receivable                                                    |       | (889       | )          | (279       | )          |
| Increase in other assets                                                           |       | (763       | )          | (534       | )          |
| Decrease in other liabilities                                                      |       | 402        |       | 218        |       |
| Net cash flows from operating activities                                           |       | 3,442      |       | 4,187      |       |
| **CASH  FLOWS FROM INVESTING ACTIVITIES**                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Proceeds from maturities of investment securities –  available-for-sale       |       | 14,508     |       | 4,000      |       |
| Purchases of investment securities –  available-for-sale                      |       | (40,983    | )          | (12,303    | )          |
| Proceeds from maturities of investment securities –  held-to-maturity         |       | 2,304      |       | 5,461      |       |
| Purchases of investment securities –  held-to-maturity                        |       | (5,226     | )          | (8,237     | )          |
| Net decrease (increase) in federal funds sold                                      |       | 40,925     |       | (53,075    | )          |
| Net (increase) decrease in loans                                                   |       | (3,358     | )          | 46,880     |       |
| Purchase of premises and equipment                                                 |       | (565       | )          | (172       | )          |
| Proceeds from sale of premises and equipment                                       |       | 8          |       | 7          |       |
| Proceeds from sale of other real estate owned                                      |       | —     |       | 1,114      |       |
| Net cash flows from investing activities                                           |       | 7,613      |       | (16,325    | )          |
| **CASH  FLOWS FROM FINANCING ACTIVITIES**                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net decrease in demand deposits, money market, NOW  and savings accounts           |       | (15,353    | )          | (64        | )          |
| Net increase in time deposits                                                      |       | 6,236      |       | 390        |       |
| Amount paid for redemption of common stock                                         |       | (5,235     | )          | —     |       |
| Net increase in securities sold under agreements to  repurchase                    |       | 219        |       | 212        |       |
| Cash dividends                                                                     |       | (849       | )          | —     |       |
| Net cash flows from financing activities                                           |       | (14,982    | )          | 538        |       |
| **NET  CHANGE IN CASH AND DUE FROM BANKS**                                         |       | (3,927     | )          | (11,600    | )          |
| **CASH  AND DUE FROM BANKS,** beginning of year                                    |       | 24,975     |       | 27,243     |       |
| **CASH AND  DUE FROM BANKS,** end of period                                        |       | $          | 21,048     |       | $          | 15,643 |   |
| **SUPPLEMENTAL  DISCLOSURES OF CASH FLOW INFORMATION**                             | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash paid during the year for income taxes                                         |       | $          | 1,702      |       | $          | 1,796 |   |
| Cash paid during the year for interest                                             |       | 4,597      |       | 2,606      |       |
| **NONCASH  FINANCING AND INVESTING TRANSACTIONS**                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Dividends declared not paid                                                        |       | —     |       | 778        |       |
| Unrealized loss on available-for-sale securities                                   |       | 484        |       | 99         |       |
| Property taken  in settlement of loans                                             |       | —     |       | 224        |       |

*See accompanying notes to theseconsolidated financial statements*

6

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**SKAGITSTATE BANCORP, INC. ANDSUBSIDIARY**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**Note 1:   BASIS OF PRESENTATION**

As the successor holding company and subsidiary Bankrepresent only a reorganization of corporate structure, there was no effectfrom the reorganization upon previously issued financial statements other thana recapitalization from $10 par value to no par value common stock.  As a result, the reorganization has beenaccounted for on a retrospective basis as if the current structure hadpreviously existed.  On June 30, 2006 atthe completion of the corporate reorganization, pursuant to the Plan andAgreement of Reorganization and Merger dated January 17, 2006, Skagit StateBank became a wholly-owned subsidiary of Skagit State Bancorp, Inc. Inaccordance with the plan, each outstanding whole share of Skagit State Bankcommon stock (675,930 shares) immediately before completion of thereorganization, was exchanged for one share of Skagit State Bancorp, Inc.common stock.

The accompanying consolidatedfinancial statements include the accounts of Skagit State Bancorp, Inc. and itssubsidiary Skagit State Bank, (collectively, “Company” or “Bank”). Allsignificant inter-company accounts and transactions have been eliminated. Theconsolidated financial statements have been prepared in conformity withaccounting principles generally accepted in the United States of America forinterim financial information and with instructions to Form 10-Q. Accordinglythey do not include all of the information and footnotes required by accountingprinciples generally accepted in the United States of America for completefinancial statements. In the opinion of management, all adjustments (consistingof normal recurring accruals) considered necessary for a fair presentation havebeen included. Operating results for the six months ended June 30, 2006, arenot necessarily indicative of the results anticipated for the year endingDecember 31, 2006. For additional information, refer to the audited financialstatements and footnotes for the most recent annual period ended December 31,2005 contained in the Annual Report on Form 10-K.

All dollar amounts in tables,except share and per share information, are stated in thousands.

**Note 2:CRITICAL ACCOUNTING POLICIES AND ESTIMATES**

The preparation of financialstatements in conformity with accounting principles generally accepted in theUnited States of America requires management to make estimates and assumptionsthat affect amounts reported in the financial statements.  Changes in these estimates and assumptionsare considered reasonably possible and may have a material impact on thefinancial statements and thus actual results could differ from the amountsreported and disclosed herein. 

In particular, management has identified several accounting policiesthat we believe, due to judgments, estimates and assumptions inherent in thosepolicies are important to an understanding of the Company’s financialstatement.  These policies relate to thedetermination of the allowance for loan losses, the valuation of real estateacquired in connection with foreclosures or in satisfaction of loans anddeferred income taxes.  These policiesare described in more detail in the Annual Report on Form 10-K for the yearended December 31, 2005. 

**Note 3:   RECLASSIFICATIONS**

Certain reclassifications havebeen made to the 2005 financial statements to conform to the 2006 presentation.Such classifications have no effect on net income. 

**Note 4:   EARNINGSPER SHARE**

Basic earnings per shareare computed based on the weighted average number of shares outstanding.Diluted earnings per share are computed by dividing net income by the dilutedweighted average number of shares outstanding, which includes common stockequivalents outstanding using the treasury stock method.  At June 30, 2006 and 2005, the Company had nocommon stock equivalents. The following is information regarding thecalculation of basic and diluted earnings per share for the periods indicated.

7

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| ** **                                                                                            | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|-------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| **(dollars in thousands except share and per share amounts)** | ** ** | **2006**                                            | ** ** | **2005**                                          | ** ** | **2006** | ** ** | **2005** | ** ** |
| Numerator:                                                                                            |       |                                                |       |                                              |       |   |   |   |   |
| Net income                                                                                            |       | $                                                   | 2,095      |                                              | $          | 2,116 |   | $ | 4,266 |   | $ | 4,033 |   |
| Denominator:                                                                                          |       |                                                |       |                                              |       |   |   |   |   |
| Denominator for  basic and diluted earnings per share -  Weighted average shares outstanding          |       | 683,604                                             |       | 707,137                                           |       | 694,930 |   | 707,137 |   |
| Basic and diluted  earnings per share                                                                 |       | $                                                   | 3.07       |                                              | $          | 2.99 |   | $ | 6.14 |   | $ | 5.70 |   |

 

**Note 5:   ALLOWANCE FOR LOAN LOSSES**

The allowance forloan losses is maintained at a level deemed adequate to provide for estimatedfuture losses. The Company has a systematic methodology for evaluating theadequacy of the allowance for loan losses and the allowance is evaluated on aquarterly basis. The allowance is based upon the Company’s periodic evaluationof the pertinent factors underlying the quality of the loan portfolio,including changes in size and composition of the loan portfolio, levels andtrends in losses and delinquencies, actual loan loss experience, currenteconomic conditions, specific industry conditions, loan concentrations,detailed analysis of individual loans for which full collectibility may not beassured and the determination of the existence and the realizable value of thecollateral securing the loans. A portion of the allowance is then established,by applying a loss percentage factor to the different loan types and thedifferent risk gradings. In addition, as part of the process for determiningthe adequacy of the allowance for loan losses, the Company reviews the loanportfolio for specific weaknesses and evaluates classified loans for impairmentand loss exposure. 

Additions to theallowance, in the form of provisions, are reflected in current operatingresults, while charge-offs to the allowance are made when a loss is determinedto have occurred.  The ultimaterecovery of loans is susceptible to future market factors beyond the Company’scontrol. These factors may result in losses or recoveries differingsignificantly from those provided in the Company’s financial statements. The Company’s periodic evaluation of theallowance for loan losses is inherently subjective as it requires estimatesthat are susceptible to significant revision as more information becomesavailable. In addition, regulatory agencies, as an integralpart of their examinationprocess, periodically review theestimated losses on loans.  Such agenciesmay require the Company to recognize additional provisions or adjustments toits allowance for loan losses based on their judgment using informationavailable to them at the time of their examination. 

**Note 6:   FINANCIALINSTRUMENTS**

The Company is aparty to financial instruments with off-balance-sheet risk in the normal courseof business to meet the financing needs of its customers. These financialinstruments include commitments to originate loans, provide funds underexisting lines of credit and standby letters of credit. Those instrumentsinvolve, to varying degrees, elements of credit and interest-rate risk inexcess of the amount recognized in the balance sheet. The contract amounts ofthose instruments reflect the extent of the Company’s involvement in particularclasses of financial instruments. The Company uses the same credit policies inmaking commitments and conditional obligations as it does for on-balance-sheetinstruments. The distribution of commitments to extend credit approximates thedistribution of loans outstanding. 

Commitments to originate loans or provide funds underexisting lines of credit are agreements to lend to a customer as long as thereis no violation of any condition established in the contract. Commitmentsgenerally have fixed expiration dates or other termination clauses and mayrequire payment of a fee and may be either fixed or variable interest rates.The Company generally expects commitments to be drawn upon, however, some of thesecommitments may not be drawn upon prior to expiration. Total commitment amountsmay not necessarily represent future cash-flow requirements. The amount ofcollateral obtained, if it is deemed necessary by the Company upon extension ofcredit, is based on management’s credit evaluation of the counterparty.Collateral held varies but may include accounts receivable, inventory,property, plant, and equipment, and income-producing commercial properties.

8

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Standby letters of credit are conditional commitmentsissued by the Company to guarantee the performance of a customer to a thirdparty. Commercial and standby letters of credit were granted primarily tocommercial borrowers. Those guarantees are primarily issued to support publicand private borrowing arrangements, including commercial paper, bond financing,and similar transactions. Except for certain long-term guarantees, the majorityof guarantees expire in one year. The credit risk involved in issuing lettersof credit is essentially the same as that involved in extending loan facilitiesto customers. Collateral supporting those commitments, for which collateral isdeemed necessary, varies. 

The following is a summary of the off-balance-sheet financialinstruments or contracts outstanding as of June 30, 2006: (dollars inthousands)

| Unfunded commitments to  extend credit  |   | $      | 60,738 |   |
|-----------------------------------------|--------|--------|--------|--------|
| Credit card  arrangements               |   | 13,707 |   |
| Commitments to  fund municipal warrants |   | 25     |   |
| Standby letters of  credit              |   | 3,628  |   |

 

**Note 7:   NEW ACCOUNTING PRONOUNCEMENTS**

On December 16,2004, FASB issued SFAS 123(R), “Share-Based Payment”, which is a revision ofFASB Statement No. 123, “Accounting for Stock-Based Compensation”. SFAS 123 (R)supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees” andamends FASB Statement No. 95, “Statement of Cash Flows”.  Generally, the approach in SFAS 123 (R) issimilar to the approach described in SFAS No. 123.  However, SFAS 123 (R) requires allshare-based payments to employees, including grants of employee stock options,to be recognized in the income statement based on their fair values.  A share-based payment plan was approved atthe 2005 Shareholder meeting, held on April 20, 2005.  At June 30, 2006, no options or restrictedstock have been granted under the share-based payment plan.  The Company does not currently anticipate theadoption of SFAS No. 123 (R) will have a material impact on its financialstatements.

In May 2005,the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections”.This statement replaces APB Opinion No. 20, “Accounting Changes”, and SFASNo. 3, “Reporting Accounting Changes in Interim Financial Statements”, andchanges the requirements for the accounting for and reporting of a change inaccounting principle. SFAS No. 154 is effective for accounting changes andcorrections of errors made in fiscal years beginning after December 15,2005. The adoption of this Statement did not have a material impact on theCompany’s financial statements. 

In February 2006,the FASB issued SFAS No. 155, “Accounting for Certain Hybrid FinancialInstruments”, an amendment of SFAS No. 133 and SFAS No. 140.  This statement addresses the accounting forcertain hybrid financial instruments (a financial instrument with an embeddedderivative).  This Statement is effectivefor the Company as of January 1, 2007. The Company does not anticipate the adoption of SFAS No. 155 willhave a material impact on its financial statements.

 In March 2006, the FASB issued SFAS No. 156,“Accounting for Servicing of Financial Assets”, which requires that servicingassets and liabilities be initially measured at fair value, ifpracticable.  SFAS No. 156 also requiresan entity to choose one of two methods when subsequently measuring itsservicing assets and liabilities: the amortization method or the fair valuemethod. SFAS No. 156 Statement permits a one-time reclassification ofavailable-for-sale securities to the trading classification. This Statement iseffective for the Company as of January 1, 2007. The Company does notanticipate the adoption of SFAS No. 156 will have a material impact on itsfinancial statements.

9

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**Item 2.****           MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIALCONDITION AND RESULTS OF OPERATIONS**

*Thefollowing discussion should be read in conjunction with the consolidatedfinancial statements and notes thereto presented elsewhere in this report.  For additional information, refer to thefinancial statements and footnotes for the year ended December 31, 2005 in theAnnual Report on Form 10-K.*

**FORWARD LOOKINGSTATEMENTS**

In addition tohistorical information, this report contains certain “forward lookingstatements” within the meaning of the Private Securities Litigation Reform Actof 1995 (PSLRA).  This statement isincluded for the express purpose of availing the Company of the protections ofthe safe harbor provision of the PSLRA. The forward-looking statements contained in this report are subject tofactors, risk, and uncertainties that may cause actual results to differmaterially from those projected.  Importantfactors that might cause such a material difference include, but are notlimited to, those discussed in this section of the report.  In addition, the following items are amongthe factors that could cause actual results to differ materially from theforward looking statements in this report: general economic conditions,including the effects of recent world events; business conditions in thebanking industry; the regulatory environment; new legislation; vendor qualityand efficiency; employee retention factors; rapidly changing technology andevolving banking industry standards; competitive factors, including increasedcompetition with community, regional, and national financial institutions;fluctuating interest rate environments; and similar matters.  Readers are cautioned not to place unduereliance on these forward-looking statements, which reflect management’sanalysis only as of the date of the statement. The Company undertakes no obligation to publicly review or update theseforward-looking statements to reflect events or circumstances that arise afterthe date of this report.  Readers shouldcarefully review any risk factors described in this and other documents we filefrom time to time with the Securities and Exchange Commission. 

**OVERVIEW**

OnJune 30, 2006, at the completion of the corporate reorganization, pursuant tothe Plan and Agreement of Reorganization and Merger dated January 17,2006, Skagit State Bank became a wholly-owned subsidiary of Skagit StateBancorp, Inc. Management and the Board of Directors believe that thecorporate reorganization with the holding company will provide additionalflexibility to satisfy changing and expanding needs for financial services andadditional alternatives for securing funds that may be required to meet thoseneeds in a rapidly changing environment in the financial services industry. 

SkagitState Bancorp, Inc. (the “Company”) is a bank holding company with one whollyowned subsidiary - Skagit State Bank (the “Bank”). Skagit State Bank beganoperations in 1958 and is headquartered in Burlington (Skagit County),Washington.  The Company provides a fullrange of banking services and products to both businesses and individualsthrough 13 full service banking offices located in Skagit, Snohomish and Whatcomcounties. The Company’s objective is to expand its geographical market share inWhatcom and Snohomish Counties, while maintaining or increasing its marketshare in Skagit County. Additional expansion will be considered if probablecustomer demand exists and experienced managers and lending officers with apresence in the area and existing relationships are available. 

Net income was$2.1 million for the quarters ended June 30, 2006 and 2005 with net incomedeclining by $21,000 in the 2006 quarter. This decrease was primarilyattributed to a decrease in net interest income.  Earnings per share were $3.07 and $2.99 forthe quarters ended June 30, 2006 and 2005, respectively. Net income was $4.3million for the six months ended June 30, 2006 compared to $4.0 million for thesix months ended June 30, 2005 with earnings per share at $6.14 and $5.70,respectively. The increase in net income for the six months ended June 30, 2006compared to the six months ended June 30, 2005 was primarily attributed to theincrease in net interest income and the decrease in provision for loan losses.For the quarter and six months ended June 30, 2006, the Company had noprovision for loan losses compared to $50,000 and $350,000 for the like periodsin 2005. This decrease in the provision was primarily related to overallimproved credit quality in the loan portfolio and a reduction in the loanportfolio balance.  

Annualized returnon average assets was 1.62 percent and 1.65 percent for the quarter and sixmonths ending June 30, 2006 compared to 1.75 percent and 1.65 percent duringthe same time periods in 2005. Annualized return on average equity was 13.09 percent and 13.15 percentfor the quarter and six months ending June 30, 2006 compared to 13.78 percentand 13.33 percent, respectively, for the same time periods in 2005.

10

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Total assetsdecreased to $511.1 million at June 30, 2006 compared to $521.9 million atDecember 31, 2005.  The decrease wasprimarily due to a decrease in total deposits and a decrease in stockholders’equity as a result of stock repurchases of $5.2 million. 

**RESULTSOF OPERATIONS**

The Company’sresults of operations are dependent to a large degree on net interest income,operating efficiency and the level of the provision for loan losses. TheCompany’s operations are sensitive to interest rate changes and the resultingimpact on net interest income.   TheCompany generates non-interest income primarily through service charges andfees.  The Company’s non-interestexpenses consist primarily of salaries and employee benefits expense, andoccupancy expense.

**NETINTEREST INCOME**Netinterest income is the difference between interest earned on loans andinvestment securities and the Company’s cost of funds, primarily interestexpense on deposits and borrowings. Several factors contribute to the changesin net interest income including the effects of changes in average balances ofinterest-earning assets and interest-bearing liabilities, changes in rates oninterest-earning assets and rates paid on interest bearing liabilities, thelevel of non-interest bearing deposits and the level of non-accrual loans. Thenet interest margin is net interest income expressed as a percent of averageinterest-earning assets.

Net interestincome was $5.6 million for the quarter ended June 30, 2006 and $5.7 millionfor 2005.  This decrease was primarilythe result of a $28.3 million decrease in the average loan balance and theincrease in the average cost of interest-bearing liabilities from 1.63 percentto 2.56 percent for 2005 to 2006, respectively. These changes were partiallyoffset by the increase in loan yield from 7.74 percent in 2005 to 8.27 percentin 2006. 

Net interestincome for the six months ended June 30, 2006 increased $226,000 to $11.5million compared to $11.2 million for 2005. This increase was primarily attributable to the favorable impact fromincreased market rates which were partially offset by $41.7 million decrease inthe average loan balance.  The yield onloans increased from 7.46 percent to 8.44 percent.  The increase in loan yield was primarily dueto the repricing of variable rate loans and higher rates on loan originations.Average interest-bearing liabilities increased $20.8 million and the averagecost of these interest-bearing liabilities increased from 1.51 percent to 2.48percent.  

The Company’s netinterest margin was 4.69 percent and 4.82 percent for the quarter and sixmonths ended June 30, 2006 compared to 5.08 percent and 5.01 percent for thesame time periods a year ago.  Thesedecreases in net interest margin were primarily due to the decreases in theaverage loan balance and increases in the average cost of funds oninterest-bearing liabilities which was partially offset by increases in theyield earned on loans and the increases in the average balance on investmentsecurities from 2005 to 2006. 

During the firsttwo quarters of 2006, prime rate increased 100 basis points and for the year2005, prime rate increased 200 basis points. The Company has historically considered its balance sheet asset sensitive,due to the assumption that its liabilities (primarily liquid deposits) wouldreprice less rapidly than its assets (variable rate loans).  When assets reprice faster than liabilitiesit tends to increase net interest margins in an increasing interest rateenvironment for the near term. For the quarter and six months ended June 30,2006 and 2005, the increase in market interest rates had a favorable impact onthe Company’s net interest income. During 2006, due primarily to the current market interest rateenvironment, competition among financial institutions for quality loans and thepayoff of certain variable rate adversely classified assets during 2005, thepercentage of variable rate loans in the loan portfolio decreased fromapproximately 77 percent at December 31, 2004 to approximately 66 percent as ofDecember 31, 2005. This trend continued for the six months ended June 30, 2006,as the percentage of variable rate loans decreased to approximately 50 percentof the loan portfolio. 

The volume or originationof fixed or variable rate loans, the interest rate sensitivity of deposits, theoverall level of interest rates and general economic conditions can have asignificant effect on the Company’s performance in a changing interest rateenvironment. If interest rates stabilize or otherwise change in the future,and/or if the level and relative mix of interest-earning assets andinterest-bearing liabilities change, the Company may not see the same benefitas resulted from the increase in interest rates in the past. 

11

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The followingtables present information regarding average balances of assets and liabilitiesas well as the total amounts of interest income from average interest-earningassets and interest expense on average interest- bearing liabilities, resultingyield and cost ratios, interest rate spread and net interest margin.

**Condensed Average Balance Sheets**

(dollars in thousandsexcept share data)

 
| ** **                                          | ** ** | **2006**    | ** ** | **2005**           | ** ** |
|-----------------------------------------------------|------------|-------------|------------|--------------------|------------|
| ** **                                          | ** ** | **Average** | ** ** | ** **         | ** ** | ** ** | ** ** | **Average** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Three months ended June 30,** | ** ** | **Balance** | ** ** | **Interest ** | ** ** | **Yield /Cost** | ** ** | **Balance** | ** ** | **Interest** | ** ** | **Yield /Cost** | ** ** |
| **Assets**                                          |       |        |       |               |       |   |   |   |   |   |   |   |   |
| Federal funds  sold                                 |       | $           | 57,041     |               | $          | 644 |   | 4.53 | % | $ | 56,794 |   | $ | 409 |   | 2.89 | % |
| Taxable  investment securities                      |       | 92,343      |       | 1,077              |       | 4.68 |   | 37,215 |   | 258 |   | 2.78 |   |
| Tax exempt  securities                              |       | 34,880      |       | 191                |       | 2.20 |   | 31,664 |   | 197 |   | 2.50 |   |
| Loans                                               |       | 296,002     |       | 6,106              |       | 8.27 |   | 324,344 |   | 6,260 |   | 7.74 |   |
| Total  interest-earning assets                      |       | 480,266     |       | 8,018              |       | 6.70 | % | 450,017 |   | 7,124 |   | 6.35 | % |
| Non-interest  earning assets                        |       | 37,583      |       |               |       |   |   | 34,693 |   |   |   |   |   |
| Total assets                                        |       | $           | 517,849    |               |       |   |   |   | $ | 484,710 |   |   |   |   |   |
|                                                |       |        |       |               |       |   |   |   |   |   |   |   |   |
| **Liabilities  and Stockholders’ Equity**      |       |        |       |               |       |   |   |   |   |   |   |   |   |
| Interest-bearing  demand                            |       | $           | 89,314     |               | $          | 285 |   | 1.28 | % | $ | 91,863 |   | $ | 236 |   | 1.03 | % |
| Savings and  money market                           |       | 149,790     |       | 771                |       | 2.06 |   | 158,603 |   | 555 |   | 1.40 |   |
| Certificates of  deposit                            |       | 123,290     |       | 1,224              |       | 3.98 |   | 93,950 |   | 597 |   | 2.55 |   |
| Total  interest-bearing deposits                    |       | 362,394     |       | 2,280              |       | 2.52 |   | 344,416 |   | 1,388 |   | 1.62 |   |
| Securities sold  under agreement to repurchase      |       | 13,266      |       | 117                |       | 3.54 |   | 6,301 |   | 33 |   | 2.10 |   |
| Total  interest-bearing deposits & liabilities  |       | 375,660     |       | 2,397              |       | 2.56 |   | 350,717 |   | 1,421 |   | 1.63 |   |
| Non interest-bearing  demand deposits               |       | 74,997      |       |               |       |   |   | 70,056 |   |   |   |   |   |
| Other  non-interest-bearing liabilities             |       | 3,151       |       |               |       |   |   | 2,533 |   |   |   |   |   |
| Total  liabilities                                  |       | 453,808     |       |               |       |   |   | 423,306 |   |   |   |   |   |
| Stockholders’  equity                          |       | 64,041      |       |               |       |   |   | 61,404 |   |   |   |   |   |
| Total  liabilities and stockholders’ equity    |       | $           | 517,849    |               |       |   |   |   | $ | 484,710 |   |   |   |   |   |
| Net interest  income                                |       |        |       | $                  | 5,621      |   |   |   |   |   | $ | 5,703 |   |   |   |
| Interest rate  spread                               |       |        |       |               |       | 4.14 | % |   |   |   |   | 4.72 | % |
| Net interest margin                                 |       |        |       |               |       | 4.69 | % |   |   |   |   | 5.08 | % |

 

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**Condensed Average Balance Sheets**

(dollars in thousandsexcept share data)
| ** **                                         | ** ** | **2006**    | ** ** | **2005**           | ** ** |
|----------------------------------------------------|------------|-------------|------------|--------------------|------------|
| ** **                                         | ** ** | **Average** | ** ** | ** **         | ** ** | ** ** | ** ** | **Average** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Six months ended June 30,**  | ** ** | **Balance** | ** ** | **Interest ** | ** ** | **Yield /Cost** | ** ** | **Balance** | ** ** | **Interest ** | ** ** | **Yield /Cost** | ** ** |
| **Assets**                                         |       |        |       |               |       |   |   |   |   |   |   |   |   |
| Federal funds  sold                                |       | $           | 69,619     |               | $          | 1,618 |   | 4.69 | % | $ | 52,604 |   | $ | 685 |   | 2.63 | % |
| Taxable  investment securities                     |       | 83,882      |       | 1,859              |       | 4.47 |   | 33,097 |   | 465 |   | 2.83 |   |
| Tax exempt  securities                             |       | 34,036      |       | 376                |       | 2.23 |   | 32,935 |   | 396 |   | 2.42 |   |
| Loans                                              |       | 292,443     |       | 12,240             |       | 8.44 |   | 334,181 |   | 12,365 |   | 7.46 |   |
| Total  interest-earning assets                     |       | 479,980     |       | 16,093             |       | 6.76 | % | 452,817 |   | 13,911 |   | 6.20 | % |
| Non-interest  earning assets                       |       | 38,385      |       |               |       |   |   | 36,481 |   |   |   |   |   |
| Total assets                                       |       | $           | 518,365    |               |       |   |   |   | $ | 489,298 |   |   |   |   |   |
|                                               |       |        |       |               |       |   |   |   |   |   |   |   |   |
| **Liabilities  and Stockholders’ Equity**     |       |        |       |               |       |   |   |   |   |   |   |   |   |
| Interest-bearing  demand                           |       | $           | 89,592     |               | $          | 573 |   | 1.29 | % | $ | 89,123 |   | $ | 406 |   | 0.92 | % |
| Savings and  money market                          |       | 151,577     |       | 1,505              |       | 2.00 |   | 166,074 |   | 1,115 |   | 1.35 |   |
| Certificates of  deposit                           |       | 122,457     |       | 2,329              |       | 3.84 |   | 94,504 |   | 1,099 |   | 2.35 |   |
| Total  interest-bearing deposits                   |       | 363,626     |       | 4,407              |       | 2.44 |   | 349,701 |   | 2,620 |   | 1.51 |   |
| Securities sold  under agreement to repurchase     |       | 12,983      |       | 220                |       | 3.42 |   | 6,126 |   | 51 |   | 1.68 |   |
| Total  interest-bearing deposits & liabilities |       | 376,609     |       | 4,627              |       | 2.48 |   | 355,827 |   | 2,671 |   | 1.51 |   |
| Non  interest-bearing demand deposits              |       | 74,020      |       |               |       |   |   | 70,448 |   |   |   |   |   |
| Other  non-interest-bearing liabilities            |       | 2,857       |       |               |       |   |   | 2,508 |   |   |   |   |   |
| Total  liabilities                                 |       | 453,486     |       |               |       |   |   | 428,783 |   |   |   |   |   |
| Stockholders’  equity                         |       | 64,879      |       |               |       |   |   | 60,515 |   |   |   |   |   |
| Total  liabilities and stockholders’ equity   |       | $           | 518,365    |               |       |   |   |   | $ | 489,298 |   |   |   |   |   |
| Net interest  income                               |       |        |       | $                  | 11,466     |   |   |   |   |   | $ | 11,240 |   |   |   |
| Interest rate  spread                              |       |        |       |               |       | 4.28 | % |   |   |   |   | 4.69 | % |
| Net interest margin                                |       |        |       |               |       | 4.82 | % |   |   |   |   | 5.01 | % |

 

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The following table sets forth information on changesin net interest income which are attributable to changes in interest rates andchanges in volume for the periods indicated. Tax exempt securities, included in investment securities below arestated at their contractual interest rate. Loan fees of $578,000 and $926,000respectively are included in interest earned on loans for the six months endedJune 30, 2006 and 2005.  Non-accruingloans have been included in the computation of average loans. Changesattributable to the combined effect of volume and interest rates have beenallocated proportionately. 

**Analysis of Changes in InterestIncome and Expense Due to Changes in Volume and Rate**
| ** **                                                                        | ** ** | **Three months ended June 30,  2006 vs. 2005  Increase (Decrease) Due to** | ** ** | **Six months ended June 30,  2006 vs. 2005  Increase (Decrease) Due to** | ** ** |
|-----------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------|------------|
| **(dollars in thousands except per share amounts)** | ** ** | **Rate**                                                                                                                | ** ** | **Volume**                                                                                                            | ** ** | **Total** | ** ** | **Rate** | ** ** | **Volume** | ** ** | **Total** | ** ** |
| **Interest-Earning Assets**                                                       |       |                                                                                                                    |       |                                                                                                                  |       |   |   |   |   |   |   |   |   |
|                                                                              |       |                                                                                                                    |       |                                                                                                                  |       |   |   |   |   |   |   |   |   |
| Federal funds sold                                                                |       | $                                                                                                                       | 233        |                                                                                                                  | $          | 2 |   | $ | 235 |   | $ | 661 |   | $ | 272 |   | $ | 933 |   |
| Investment securities                                                             |       | 168                                                                                                                     |       | 645                                                                                                                   |       | 813 |   | 329 |   | 1,045 |   | 1,374 |   |
| Loans                                                                             |       | 1,865                                                                                                                   |       | (2,019                                                                                                                | )          | (154 | ) | 3,127 |   | (3,252 | ) | (125 | ) |
| Total net change in  income on Interest-earning assets                            |       | 2,266                                                                                                                   |       | (1,372                                                                                                                | )          | 894 |   | 4,117 |   | (1,935 | ) | 2,182 |   |
| **Interest-Bearing Liabilities**                                                  |       |                                                                                                                    |       |                                                                                                                  |       |   |   |   |   |   |   |   |   |
|                                                                              |       |                                                                                                                    |       |                                                                                                                  |       |   |   |   |   |   |   |   |   |
| Deposits                                                                          |       | 909                                                                                                                     |       | (17                                                                                                                   | )          | 892 |   | 1,666 |   | 121 |   | 1,787 |   |
| Securities sold under agreements  to repurchase                                   |       | 32                                                                                                                      |       | 52                                                                                                                    |       | 84 |   | 81 |   | 88 |   | 169 |   |
| Total net change in  expense on Interest-bearing liabilities                      |       | 941                                                                                                                     |       | 35                                                                                                                    |       | 976 |   | 1,747 |   | 209 |   | 1,956 |   |
| Net change in net interest income                                                 |       | $                                                                                                                       | 1,325      |                                                                                                                  | $          | (1,407 | ) | $ | (82 | ) | $ | 2,370 |   | $ | (2,144 | ) | $ | 226 |   |

 

**NON-INTEREST INCOME        **Non-interest income, which consistsprimarily of fees and service charges on deposits and other income, was$783,000 and $1.5 million for the quarter and six months ended June 30, 2006compared to $681,000 and $1.4 million for the same periods in 2005. The largestcomponent of these increases related to an increase in late charges collectedon non-performing loans. 

**NON-INTEREST EXPENSE       **Non-interest expense was $3.6 million forthe quarter ended June 30, 2006 and 2005. For the six months ended June 30,2006, non-interest expense increased 2.0 percent to $7.1 million compared to$6.9 million for the same time period a year ago.  This increase was primarily attributable tohigher salaries, overall growth in employment and increased healthcarecosts.  The Company’s full timeequivalent employees increased to 174 from 166 for June 30, 2006 and 2005,respectively.  

To measureoperating expenses, a computation called the “efficiency ratio” is computed bydividing total operating expenses by net interest income and non-interestincome.  An increase in the efficiencyratio indicates that more resources are being utilized to generate the same orgreater volume of income. The efficiency ratio for the quarter and six monthsended June 30, 2006 was 55.78 percent and 54.57 percent compared to 56.65percent and 56.19 percent during the same time period in 2005. For the threemonths ended June 30, 2006, the improvement in the efficiency ratio from 2005was primarily due to controlling the growth in expenses. For the six monthsended June 30, 2006, the improvement was primarily due to the increase in netinterest income from 2005 to 2006 while controlling the growth in expenses. 

**INCOME TAX EXPENSE **Incometax expense for the quarter and six months ended June 30, 2006 was $737,000 and$1.6 million compared to $630,000 and $1.4 million for the quarter and sixmonths ended June 30, 2005. The Company’s effective tax rates were 27.4 percentand 25.2 percent for the six months ended June 30, 2006 and 2005, respectively.The effective tax rate is lower than the federal statutory rate due to taxcredits from tax-exempt bonds and tax-exempt municipal bonds and loans. 

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**REVIEW OFFINANCIAL CONDITION**

Assets totaled $511.1 million atJune 30, 2006, compared to $521.9 million at December 31, 2005.  The decrease was primarily due to a decreaseof $9.1 million in deposits. 

**INVESTMENT SECURITIES AND FEDERALFUNDS SOLD**   Totalinvestment securities and federal funds decreased $12.2 million to $174.9million at June 30, 2006 compared to $187.1 million at December 31, 2005. Thisdecrease was primarily due to a $40.9 million decrease in federal funds soldwhich was partially offset by increase in US Agency investments.

Securities classified asavailable-for-sale are reported at estimated fair value, with unrealized gainsand losses (net of income taxes) reported in accumulated other comprehensiveincome, as a separate component of stockholders’ equity.  

The following tablepresents the carrying value of the portfolio of investment securities as of thedates indicated. 

**Investment Securities Composition**
| **(dollars in thousands)**              | ** ** | **June 30, 2006** | ** ** | **December 31, 2005** | ** ** |
|---------------------------------------------------|------------|-----------------------------|------------|---------------------------------|------------|
| **Held-to-maturity**                              | ** ** | ** **                  | ** ** | ** **                      | ** ** |
| State and  political subdivisions                 |       | $                           | 32,119     |                            | $          | 29,197 |   |
| Total                                             |       | $                           | 32,119     |                            | $          | 29,197 |   |
| **Available-for-sale**                            | ** ** | ** **                  | ** ** | ** **                      | ** ** |
| U.S. Treasury  and other U.S. government agencies |       | $                           | 91,680     |                            | $          | 66,322 |   |
| State and  political subdivisions                 |       | 3,944                       |       | 3,531                           |       |
| Total                                             |       | $                           | 95,624     |                            | $          | 69,853 |   |

 

**LOANS       **Netloans were $298.8 million at June 30, 2006 compared to $295.4 million atDecember 31, 2005.  This increase wasprimarily due to a $9.9 million increase in residential and commercial realestate loans and a $3.2 million increase in consumer loans which was partiallyoffset by an $11.4 million decrease in real estate construction loans. 

Mostof the Company’s business activity is with customers located within Skagit,Snohomish and Whatcom Counties. The Company originates commercial, real estateand consumer loans. Generally, loans are secured by accounts receivable,inventory, deposit accounts, personal property or real estate. Rights tocollateral vary and are legally documented to the extent practicable. TheCompany concentrates on five areas of lending: loans to individuals, small andmedium-sized business loans, agricultural loans, loans to commercialenterprises for real estate transactions and residential mortgage loans.  The Company’s primary lending activitiesincludes commercial real estate loans, commercial loans which includesagriculture production loans, residential mortgage loans and consumer loans. 

Loans secured byreal estate comprise the largest category of loans with a total of $216.4million or 70.8 percent and $217.9 million or 72.0 percent as of June 30, 2006and December 31, 2005, respectively. The Company is committed to providingcompetitive commercial real estate lending within our primary marketareas.  Our real estate portfolioconsists of commercial and residential loans. These loans are secured by property such as office buildings, commercialbusiness properties, healthcare buildings, agricultural land, timber land andresidential properties. While the Company has significant balances secured byreal estate, the Company does not have concentrations in any specific area ofreal estate and the Company believes that its lending policies are sufficientto minimize risks.  Also, local economicconditions may affect a borrower’s ability to meet the stated repayment terms.Fixed-rate and variable rate residential mortgage loans are offered through theCompany’s home loan department. The Company places a majority of these loansthrough Countrywide Mortgage and Washington Mutual.

Commercial loanswere $72.7 million as of June 30, 2006 and $70.9 million as of December 31,2005.    Commercial loans, secured andunsecured, are made primarily to small and medium-sized businesses operatingwithin Skagit, Snohomish and Whatcom Counties. These loans are available for general operating purposes, acquisition offixed assets, purchases of equipment and machinery, financing of inventory andaccounts receivable, and other business purposes.  The Company originates Small BusinessAdministration (SBA) loans, including 504 and 7A loans.  

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Consumer loanswere $12.0 million at June 30, 2006 and $8.9 million at December 31, 2005. TheCompany makes secured and unsecured consumer loans including loans toindividuals, primarily customers of the Company, for various purposes,including home equity loans, purchases of automobiles, mobile homes, boats andother recreational vehicles and loans for education and personal investments. 

The Board ofDirectors has approved specific lending policies and procedures for the Companyand is responsible for implementation of the policies.  The lending policies and procedures includeguidelines for loan terms, loan-to-value ratios, collateral appraisals andinterest rates.  The loan policies alsovest varying levels of loan authority in management, the Company’s loanofficers and the Board of Directors. Management of the Company monitors lending activities through periodicloan committee meetings, monthly reporting and periodic review of loans.

The following table presents the compositionof loans for the Company as of the dates indicated. 

**Loan Composition**
| ** **                                       | ** ** | **June 30, 2006** | ** ** | **December 31, 2005** | ** ** |
|--------------------------------------------------|------------|-----------------------------|------------|---------------------------------|------------|
| **(dollars in thousands)**             | ** ** | **Amount**                  | ** ** | **%**                           | ** ** | **Amount** | ** ** | **%** | ** ** |
| Real estate –  residential & commercial |       | $                           | 204,160    |                            | 66.8       | % | $ | 194,273 |   | 64.2 | % |
| Real estate  construction                        |       | 12,221                      |       | 4.0                             | %          | 23,597 |   | 7.8 | % |
| Commercial,  industrial & agricultural       |       | 72,702                      |       | 23.8                            | %          | 70,923 |   | 23.4 | % |
| Consumer                                         |       | 12,035                      |       | 3.9                             | %          | 8,867 |   | 2.9 | % |
| Other loans                                      |       | 4,307                       |       | 1.5                             | %          | 4,857 |   | 1.7 | % |
| Total loans                                      |       | 305,425                     |       | 100                             | %          | 302,517 |   | 100 | % |
| Less:                                            |       |                        |       |                            |       |   |   |   |   |
| Allowance for  loan losses                       |       | 4,820                       |       |                            |       | 5,178 |   |   |   |
| Deferred loan  fees                              |       | 1,811                       |       |                            |       | 1,903 |   |   |   |
| Net loans                                        |       | $                           | 298,794    |                            |       |   | $ | 295,436 |   |   |   |

 

**PROVISION AND ALLOWANCE FOR LOAN LOSSES**         The allowance for loan losses was $4.8million as of June 30, 2006 compared to $5.2 million at December 31, 2005. Whenavailable information confirms that specific loans, or portions thereof, areuncollectible, those amounts are charged off against the allowance for loanlosses.  Net charges-offs for the threemonths and six months ended June 30, 2006 were $534,000 and $358,000 comparedto $209,000 and $208,000 for the three and six months ended June 30, 2005. Theincrease in net charge-offs from 2005 to 2006 was primarily due to a $600,000charge-off relating to one loan relationship. 

The Company had noprovision for loan losses for the quarter and six months ended June 30, 2006compared to $50,000 and $350,000 for the quarter and six months ended June 30,2005.  The decrease in the provision from2006 to 2005 was primarily related to overall improved credit quality in theloan portfolio year over year.  Totalnon-accrual loans increased year over year, however loans risk-rated assubstandard loans and total loans past due (excluding non-accruing loans)decreased year over year. In the future, normal growth of the loan portfoliomay require an increase in the allowance for loan losses. 

The allowance for loanlosses is evaluated on a quarterly basis by management and is maintained at alevel deemed adequate to provide for estimated future losses. The Company has a systematic methodology forevaluating the adequacy of allowance for loan losses and the allowance isevaluated on a quarterly basis. The allowance is based upon the Company’speriodic evaluation of the pertinent factors underlying the quality of the loanportfolio, including change in size and composition of the loan portfolio,levels and trends in losses and delinquencies, actual loan loss experience,current economic conditions, specific industry conditions, loan concentrations,detailed analysis of individual loans for which full collectibility may not beassured and the determination of the existence and the realizable value of thecollateral securing the loans. A portion of the allowance is then established,by applying a loss percentage factor to the different loan types and thedifferent risk gradings. In addition, as part of the process for determiningthe adequacy of the allowance for loan losses, the Company reviews the loanportfolio for specific weaknesses and evaluates classified loans for impairment and loss exposure.  

The Company iscurrently monitoring its loan portfolio for potential risk of loss according toa loan risk-grading system. Additionally, loans are subject to examinations byregulators, who, based upon their judgment, may require the Company to make additionalprovisions or adjustments to its allowance for loan losses.  The Company has assessed and will continue toassess on an on-going basis, the impact of the economy on the credit risk inthe loan 

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portfolio.  Currently, management is not aware of anyunusually large loan concentrations in industries negatively impacted by thecurrent economy. Management continues to closely monitor the Company’s creditquality and focuses on identifying potential problem credits and any lossexposure in a timely manner.  

The followingtable presents the activity in the allowance for loan losses for the datesindicated.

**Allowance for Loan Loss Activity**
| ** **                                                                | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|---------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| **(dollars in  thousands)**                                               | ** ** | **2006**                                            | ** ** | **2005**                                          | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                                      |       |                                                |       |                                              |       |   |   |   |   |
| Allowance as of  beginning of period                                      |       | $                                                   | 5,354      |                                              | $          | 6,131 |   | $ | 5,178 |   | $ | 5,830 |   |
| Provision for  loan losses                                                |       | —                                              |       | 50                                                |       | — |   | 350 |   |
| Charge-offs                                                               |       | (709                                                | )          | (256                                              | )          | (923 | ) | (384 | ) |
| Recoveries                                                                |       | 175                                                 |       | 47                                                |       | 565 |   | 176 |   |
| Net charge-offs                                                           |       | (534                                                | )          | (209                                              | )          | (358 | ) | (208 | ) |
| Balance at end  of period                                                 |       | $                                                   | 4,820      |                                              | $          | 5,972 |   | $ | 4,820 |   | $ | 5,972 |   |
| Ratio of net  charge-offs (annualized) to average loans during the period |       | 0.72                                                | %          | 0.26                                              | %          | 0.24 | % | 0.12 | % |
| Ratio of allowance to  net loans at end of period                         |       | 1.61                                                | %          | 1.96                                              | %          | 1.61 | % | 1.96 | % |

 

**NON-PERFORMING ASSETS        **Non-performing assets increased to $6.9million as of June 30, 2006 compared to $4.1 million as of December 31, 2005.At June 30, 2006, four relationships comprised $6.0 million of the non-accrualbalance.  Generally, these loans are wellcollateralized though loss of principal on certain types of these loans willremain in question until the loans are paid or collateral is liquidated.  

The followingtable presents non-performing asset information related to loans accounted foron a non-accrual basis, accruing loans 90 days or more past due and other realestate owned for the dates indicated.

**Non-Performing Assets**
| **(dollars in thousands)**                      | ** ** | **June 30, 2006** | ** ** | **December 31, 2005** | ** ** |
|-----------------------------------------------------------|------------|-----------------------------|------------|---------------------------------|------------|
| Non-accrual  loans                                        |       | $                           | 6,913      |                            | $          | 4,116 |   |
| Loans past due  90 days or more, still accruing           |       | —                      |       | —                          |       |
| Total  non-performing loans                               |       | 6,913                       |       | 4,116                           |       |
| Other real  estate owned                                  |       | —                      |       | —                          |       |
| Total  non-performing assets                              |       | $                           | 6,913      |                            | $          | 4,116 |   |
| Total  non-performing loans to net loans                  |       | 2.31                        | %          | 1.39                            | %          |
| Total  non-performing loans to total assets               |       | 1.35                        | %          | 0.79                            | %          |
| Total non-performing  assets to total assets              |       | 1.35                        | %          | 0.79                            | %          |
| Total  non-performing assets to allowance for loan losses |       | 143.42                      | %          | 79.49                           | %          |

 

**DEPOSITS     **TheCompany offers a full range of deposit services including checking accounts,savings accounts, money market accounts and various types of certificates ofdeposit.  Transaction accounts andcertificates of deposit are tailored to the Company’s primary market area atrates competitive with those offered in the area.  At June 30, 2006, total deposits were $433.9million compared to $443.1 million at December 31, 2005.  As outlined in the following table, timedeposits increased $6.2 million while interest-bearing demand and savingsdecreased $13.8 million. The following table presents the balance and percentof total deposits in the various categories of deposits offered by the Companyas of the dates indicated.  

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**Deposit Composition**
| ** **                           | ** ** | **June 30, 2006** | ** ** | **December 31, 2005** | ** ** |
|--------------------------------------|------------|-----------------------------|------------|---------------------------------|------------|
| **(dollars in thousands)** | ** ** | **Amount**                  | ** ** | **% of Total**        | ** ** | **Amount** | ** ** | **% of Total** | ** ** |
| Non-interest  bearing demand         |       | $                           | 74,850     |                            | 17.2       | % | $ | 76,872 |   | 17.3 | % |
| Interest bearing  demand             |       | 88,358                      |       | 20.4                            | %          | 93,779 |   | 21.2 | % |
| Money market                         |       | 61,887                      |       | 14.3                            | %          | 61,454 |   | 13.9 | % |
| Savings                              |       | 81,958                      |       | 18.9                            | %          | 90,301 |   | 20.4 | % |
| Time                                 |       | 126,895                     |       | 29.2                            | %          | 120,659 |   | 27.2 | % |
| Total deposits                       |       | $                           | 433,948    |                            | 100.0      | % | $ | 443,065 |   | 100.0 | % |

 

**SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE              **As of June 30,2006 and December 31, 2005, securities sold under agreements to repurchase were$11.5 million and $11.3 million, respectively. These borrowings decrease orincrease primarily based on the availability of funds and current competitiveinterest rates offered.  These borrowingsare collateralized by securities with an estimated fair value exceeding theface value of the borrowings.

**CAPITAL RESOURCES**         Stockholders’ equity decreased to $63.1million at June 30, 2006 from $65.4 million at December 31, 2005.  This decrease was primarily due to stockrepurchases of $5.2 million and payment of cash dividends of $849,000 which waspartially offset by net income of $4.3 million. Book value per share at June 30,2006 was $93.31 compared to book value of $92.43 at December 31, 2005.   

The Company’sstock is not actively traded and no broker currently makes a market in theCompany’s stock.  To facilitate trading,the Bank acts as transfer agent for the Company and maintains a list of personsinterested in either purchasing or selling Company shares. From time to time,the Company repurchases shares of its common stock. The number of shares ofstock that will be repurchased and the price that will be paid is the result ofmany factors including market and economic conditions, the number of sharesavailable, the Company’s liquidity and capital needs and regulatoryrequirements. For the six months ended June 30, 2006, the Company repurchased31,307 shares of stock for $5.2 million with a range of prices from a low of$135 to a high of $171 per share. 

Bankingregulations require bank holding companies and banks to maintain certainminimum capital levels.  As the followingtable indicates as of June 30, 2006, Skagit State Bancorp, Inc. and SkagitState Bank both exceeded the well-capitalized requirements.   The following table sets forth theirrespective capital positions as of June 30, 2006. 
|                                      | ** ** | ** ** | ** ** | ** **                 | ** ** | ** **                 | ** ** | ** **                 | ** ** | **To Be Well**   | ** ** |
|--------------------------------------|------------|------------|------------|----------------------------|------------|----------------------------|------------|----------------------------|------------|----------------------------|------------|
| ** **                           | ** ** | ** ** | ** ** | ** **                 | ** ** | ** **                 | ** ** | ** **                 | ** ** | **Capitalized Under** | ** ** |
| ** **                           | ** ** | ** ** | ** ** | ** **                 | ** ** | **For Capital**       | ** ** | **Prompt Corrective** | ** ** |
| ** **                           | ** ** | **Actual** | ** ** | **Adequacy Purposes** | ** ** | **Action Provisions** | ** ** |
| **(dollars in thousands)** | ** ** | **Amount** | ** ** | **Ratio**                  | ** ** | **Amount**                 | ** ** | **Ratio**                  | ** ** | **Amount**                 | ** ** | **Ratio** | ** ** |
| As of June 30, 2006                  |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| Total Capital                        |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| (to Risk-Weighted Assets)            |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| Skagit State Bank                    |       | $          | 68,315     |                       | 19.18      | %                          | $          | 28,491                     | >  | 8.00                       | %          | $ | 35,614 | >  | 10.00 | % |
| Skagit State Bancorp, Inc.           |       | $          | 68,382     |                       | 19.20      | %                          | $          | 28,493                     | >  | 8.00                       | %          | $ | 35,616 | >  | 10.00 | % |
| Tier I Capital                       |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| (to Risk-Weighted Assets)            |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| Skagit State Bank                    |       | $          | 63,859     |                       | 17.93      | %                          | $          | 14,246                     | >  | 4.00                       | %          | $ | 21,368 | >  | 6.00 | % |
| Skagit State Bancorp, Inc.           |       | $          | 63,925     |                       | 17.95      | %                          | $          | 14,246                     | >  | 4.00                       | %          | $ | 21,369 | >  | 6.00 | % |
| Tier I Capital                       |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| (to Average Assets)                  |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| Skagit State Bank                    |       | $          | 63,859     |                       | 12.30      | %                          | $          | 20,771                     | >  | 4.00                       | %          | $ | 25,963 | >  | 5.00 | % |
| Skagit State  Bancorp, Inc.          |       | $          | 63,925     |                       | 12.31      | %                          | $          | 20,771                     | >  | 4.00                       | %          | $ | 25,963 | >  | 5.00 | % |

 

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**LIQUIDITY**

The Company’sliquidity management focuses on the need to meet both short-term fundingrequirements and long-term strategies and goals.  The Company’s objective is to ensure there isadequate liquidity to accommodate fluctuations in deposit levels, fundoperations, and provide for customer credit needs and to meet other obligationsand commitments on a timely basis. The Company structures the balance sheet tomeet those objectives. The Company’s sources of funds are customer deposits,loan repayments, current earnings, cash and demand balances due from otherbanks, federal funds, short-term investments and investment securitiesavailable for sale with a majority of funding coming from customer depositswithin the Company’s market area. The Company has generally been a net sellerof federal funds.  At June 30, 2006 andDecember 31, 2005, the Company’s federal funds sold were $47.2 million and$88.1 million, respectively. As of June 30, 2006, the Company had $500,000 inapproved credit lines from the Federal Reserve Bank and $35.0 million fromother financial institutions. 

**Item 3.    QUANTITATIVE AND QUALITATIVE DISCLOSURESABOUT MARKET RISK**

The Company’sresults of operations are largely dependent upon its ability to manage marketrisks which includes interest rate risk. Interest rate risk refers to the exposure of earnings and capitalarising from changes in interest rates. The Company is sensitive to potentialchanges in interest rates and the resulting impact on net interest income.Changes in interest rates can have a significant effect on the Company’sfinancial condition and results of operations. The Company does not useinterest rate risk management products such as interest rate swaps, hedges orderivatives nor does it have a trading portfolio of investment securities.   Other types of market risk such as foreigncurrency exchange rate risk and commodity price risk do not arise in the normalcourse of the Company’s business activities. 

The Company hashistorically considered its balance sheet asset sensitive, due to the assumptionthat its liabilities (primarily liquid deposits) would reprice less rapidlythan its assets (variable rate loans). When assets reprice faster than liabilities it tends to increase netinterest margins in an increasing interest rate environment for the near term.During 2005 and 2004 and for the six months ended June 30, 2006, the increasein market interest rates had a favorable impact on the Company’s net interestincome. For the six months ended June 30, 2006 compared to the same period in2005, the yield earned on loans increased more than the increase in the cost ofinterest-bearing liabilities.  However,due to the change in the composition of interest-earning assets with a greaterpercent of investment securities, the Company experienced a higher increase inthe cost of interest-bearing liabilities compared to the yield oninterest-earning assets. When interest rates increased during 2005 and 2004,the Company experienced a greater increase in the earning asset yield incomparison to the increase in the cost of funds of interest bearingliabilities.  A majority of the Company’svariable rate loans immediately float with prime while the rate on theCompany’s liquid deposits may not immediately change or if so, not at the samelevel.  

During 2005, dueprimarily to the current market interest rate environment and competition amongfinancial institutions for quality loans, the percentage of variable rate loansin the loan portfolio decreased from approximately 77 percent to approximately66 percent as of December 31, 2005. This trend continued for the six monthsended June 30, 2006 as the percentage of variable rate loans decreased toapproximately 50 percent of the loan portfolio. 

The volume ororigination of fixed or variable rate loans, the interest rate sensitivity ofdeposits, the overall level of interest rates and general economic conditionscan have a significant effect on the Company’s performance in a changinginterest rate environment. If interest rates stabilize or otherwise in the futureand/or if the level and relative mix of interest-earning assets andinterest-bearing liabilities change, the Company may not see the same benefitas resulted from the increase in interest rates during 2005, 2004 and the firstsix months of 2006.  

The Companybelieves that there have not been any other material changes in informationabout the Company’s market risk that was provided in the Form 10-K for the yearended December 31, 2005.

# **Item 4.    CONTROLSAND PROCEDURES**

Evaluation of Disclosure Controls and Procedures

The Company’s Chief Executive Officer and Chief Financial Officer havereviewed and evaluated the effectiveness of our disclosure controls andprocedures, required by Exchange Act Rules 13(a) - 15(b), as of the end of theperiod covered by this quarterly report. Based on that evaluation, the Chief Executive Officer and ChiefFinancial Officer have concluded that the Company’s current disclosure controlsand procedures are effective and timely, providing them with materialinformation relating to the Company required to be disclosed in the reports wefile or submit under the Exchange Act. 

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Changes in Internal Controls

There have not been any significant changes in our internal controls orin other factors that could significantly affect these controls subsequent tothe date of their evaluation.  TheCompany did not implement any corrective actions with regard to any significantdeficiencies or material weaknesses in its internal controls. 

**PART II -               OTHERINFORMATION**

**Item 1.                    Legal Proceedings**

From time to time,the Company may be a plaintiff and/or defendant in certain claims and legalactions arising in the ordinary course of commercial banking involving realestate lending transactions and other ordinary routine litigation incidental tothe business of the Company.  The Companyis not a party to any pending legal proceedings that the Company believes wouldhave a material adverse effect on the financial condition of the Company. 

**Item 1A. Risk Factors**

There have been nomaterial changes in the Company’s risk factors from those disclosed in the 2005Annual Report on Form 10-K.  Forinformation regarding risk factors, refer to the Company’s 2005 Annual Reporton Form 10-K. 

**Item 2.                    Unregistered Sales of EquitySecurities and Use of Proceeds**

None

**Item 3.                    Defaults Upon SeniorSecurities**

None

# **Item 4.****                                                           Submissionof Matters to a Vote of Security Holders**

(a)                                  Skagit State Bank’s Annual Shareholder’s Meetingwas held on April 19, 2006.

(b)                                 Not Applicable

(c)                                  A brief description of each matter voted upon atthe Annual Meeting and number of votes cast for, against or withheld, includinga separate tabulation with respect to each nominee to serve on the Board ispresented below:

(1)                                  Election of three (3) Directors for termsexpiring in 2008 or until their successor is nominated and has qualified.

| Directors:            |   |    |   |
|-----------------------|--------|---------|--------|
| Gerald W. Christensen |   |    |   |
| Votes For:            |   | 597,006 |   |
| Votes Withheld:       |   | 8,591   |   |
| Richard Nelson        |   |    |   |
| Votes For:            |   | 597,006 |   |
| Votes Withheld:       |   | 8,591   |   |
| Michael Janicki       |   |    |   |
| Votes For:            |   | 596,008 |   |
| Votes Withheld:       |   | 9,589   |   |

(2)                                  Approval of Plan and Agreement of Reorganizationand Merger dated January 17, 2006. 
| Votes For:     |   | 592,227 |   |
|----------------|--------|---------|--------|
| Votes Against: |   | 7,551   |   |
| Votes Abstain: |   | 5,819   |   |

(d)                                 None

**Item 5.****                                                           Other Information**

None

**Item 6.****                                                           Exhibits**

(a)                                  Exhibits.

| 31.1 |   | Certification of CEO, Pursuant to Exchange Act Rule  13a-14 (as adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002)                  |
|------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------|
| 31.2 |   | Certification Chief  Financial Officer Pursuant to Exchange Act Rule 13a-14 (as adopted  Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002) |
| 32   |   | Certifications Pursuant to 18 U.S.C. Section 1350,  As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002                            |

 

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**SIGNATURES**

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

 
|        |            | SKAGIT STATE BANCORP, INC. |   |             |
|--------|-----------------|----------------------------|--------|------------------|
|   |            | (Registrant)               |   |             |
|   |            |                       |   |             |
|   |            |                       |   |             |
| Dated: | August 10, 2006 |                       |   | Cheryl R. Bishop |   |   |
|   |            | Cheryl R. Bishop           |   |             |
|   |            | Chief Executive Officer    |   |             |
|   |            |                       |   |             |
|   |            |                       |   |             |
| Dated: | August 10, 2006 |                       |   | Carla F. Tucker  |   |   |
|   |            | Carla F. Tucker            |   |             |
|   |            | Senior Vice-President      |   |             |
|   |            | Chief Financial Officer    |   |             |

 

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