**Table of Contents**

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**UNITED STATES SECURITIES AND EXCHANGE COMMISSION**

**WashingtonD.C., 20549**

** **

**FORM 10-Q**

 

**x****     ****Quarterly Report Pursuant to Section 13 or 15(d) of theSecurities Exchange Act of 1934**

 

**For the quarterly period ended September 30, 2009**

 

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

 

**For the transition period from                                to**

 

**Commission File Number  000-52096**

 

**SKAGITSTATE BANCORP, INC.**

(Exact Name of Registrant as Specified in Its Charter)

 

| **WASHINGTON**                  | ** ** | **20-5048602**         |
|---------------------------------|------------|------------------------|
| (State or Other Jurisdiction of |       | (I.R.S. Employer       |
| Incorporation or Organization)  |       | Identification Number) |

 

**301 East Fairhaven Avenue**

**Burlington, Washington  98233**

(Address of Principal Executive Offices) (Zip Code)

 

**(360) 755-0411**

(Registrant’s Telephone Number, Including Area Code)

 

Indicateby check mark whether the registrant:  (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days.    YesxNoo

 

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerate filer, or a non-accelerated. See the definitions of “large accelerated filer,” “accelerated filer”and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

| Large  accelerated filer o |   | Accelerated filer  o         |
|----------------------------|--------|------------------------------|
|                       |   |                         |
| Non-accelerated  filer o   |   | Smaller  Reporting Company x |

 

Indicateby check mark whether the registrant is a shell company (as defined in Rule 12b-2of the Exchange    YesoNo x

 

Indicateby check mark whether the registrant has submitted electronically and posted onits corporate Web site, if any, every Interactive Data File required to besubmitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 ofthis chapter) during the preceding 12 months (or for such shorter period thatthe registrant was required to submit and post such files).   YesoNo o

 

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

 

Thenumber of shares of the issuer’s Common Stock outstanding at November 13,2009 was 588,469.

 

 

 

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**SKAGIT STATE BANCORP, INC.**

**TABLE OFCONTENTS**

 
| **PART I.**  | **FINANCIAL INFORMATION** | ** **                                                                                                                                           | ** ** |
|-------------------|---------------------------|------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
|              |                      |                                                                                                                                                 |       |
|              | Item 1.                   | Financial Statements                                                                                                                                 |       |   |
|              |                      |                                                                                                                                                 |       |   |
|              |                      | Consolidated  Balance Sheet as of September 30, 2009 and December 31, 2008                                                                 |       | Page 3 |
|              |                      |                                                                                                                                                 |       |   |
|              |                      | Consolidated  Statement of Income for the three and nine months ended September 30,  2009 and 2008                                              |       | Page 4 |
|              |                      |                                                                                                                                                 |       |   |
|              |                      | Consolidated  Statement of Changes in Stockholders’ Equity and Comprehensive Income for the  nine months ended September 30, 2009 and 2008 |       | Page 5 |
|              |                      |                                                                                                                                                 |       |   |
|              |                      | Consolidated  Statement of Cash Flows for the nine months ended September 30, 2009 and  2008                                                    |       | Page 6 |
|              |                      |                                                                                                                                                 |       |   |
|              |                      | Notes to Consolidated Financial Statements                                                                                                           |       | Pages 7-14 |
|              |                      |                                                                                                                                                 |       |   |
|              | Item 2.                   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                                          |       | Pages 14-27 |
|              |                      |                                                                                                                                                 |       |   |
|              | Item 3.                   | Quantitative  and Qualitative Disclosures About Market Risk                                                                                          |       | Page 27 |
|              |                      |                                                                                                                                                 |       |   |
|              | Item 4T.                  | Controls and  Procedures                                                                                                                             |       | Page 27 |
|              |                      |                                                                                                                                                 |       |
| **PART II.** | **OTHER INFORMATION**     |                                                                                                                                                 |       |
|              |                      |                                                                                                                                                 |       |
|              | Item 1.                   | Legal Proceedings                                                                                                                                    |       | Page 27 |
|              |                      |                                                                                                                                                 |       |   |
|              | Item 1 A.                 | Risk Factors                                                                                                                                         |       | Page 27-31 |
|              |                      |                                                                                                                                                 |       |   |
|              | Item 2.                   | Unregistered  Sales of Equity Securities and Use of Proceeds                                                                                         |       | Page 31 |
|              |                      |                                                                                                                                                 |       |   |
|              | Item 3.                   | Defaults  Upon Senior Securities                                                                                                                     |       | Page 31 |
|              |                      |                                                                                                                                                 |       |   |
|              | Item 4.                   | Submission  of Matters to a Vote of Security Holders                                                                                                 |       | Page 31 |
|              |                      |                                                                                                                                                 |       |   |
|              | Item 5.                   | Other Information                                                                                                                                    |       | Page 31 |
|              |                      |                                                                                                                                                 |       |   |
|              | Item 6.                   | Exhibits                                                                                                                                             |       | Page 31 |
|              |                      |                                                                                                                                                 |       |   |
|              |                      | Signatures                                                                                                                                           |       | Page 32 |

 

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**Item 1.    Financial Statements**

 

**SKAGIT STATE BANCORP, INC. ANDSUBSIDIARY**

**CONSOLIDATED BALANCE SHEET(Unaudited)**

 
| **(dollars in thousands except  share data)**                                                                                                                                   | ** ** | **September 30, 2009** | ** ** | **December 31, 2008** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|----------------------------|------------|
| **ASSETS**                                                                                                                                                                      | ** ** |
| ** **                                                                                                                                                                      | ** ** | ** **                  | ** ** | ** **                 | ** ** |
| **ASSETS**                                                                                                                                                                      | ** ** | ** **                  | ** ** | ** **                 | ** ** |
| Cash  and due from banks                                                                                                                                                        |       | $                           | 11,047     |                       | $          | 11,954 |   |
| Federal  funds sold and interest-bearing bank balances                                                                                                                          |       | 41,108                      |       | —                     |       |
| Investment  securities                                                                                                                                                          |       |                        |       |                       |       |
| Available-for-sale,  at fair value                                                                                                                                              |       | 109,145                     |       | 102,647                    |       |
| Held-to-maturity,  at amortized cost                                                                                                                                            |       | 40,011                      |       | 36,518                     |       |
| Loans  held for sale                                                                                                                                                            |       | 413                         |       | 350                        |       |
| Loans                                                                                                                                                                           |       | 382,401                     |       | 399,225                    |       |
| Allowance  for loan losses                                                                                                                                                      |       | (5,798                      | )          | (5,450                     | )          |
| Net  loans                                                                                                                                                                      |       | 376,603                     |       | 393,775                    |       |
| Bank  premises and equipment, net                                                                                                                                               |       | 10,631                      |       | 11,480                     |       |
| Other  real estate owned                                                                                                                                                        |       | 6,537                       |       | 5,667                      |       |
| Accrued  interest receivable                                                                                                                                                    |       | 2,606                       |       | 2,430                      |       |
| Other  assets                                                                                                                                                                   |       | 1,354                       |       | 2,055                      |       |
| **TOTAL ASSETS**                                                                                                                                                                |       | $                           | 599,455    |                       | $          | 566,876 |   |
| ** **                                                                                                                                                                      | ** ** |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY**                                                                                                                                  | ** ** |
| ** **                                                                                                                                                                      |       |                        |       |                       |       |
| **LIABILITIES**                                                                                                                                                                 |       |                        |       |                       |       |
| Deposits                                                                                                                                                                        |       |                        |       |                       |       |
| Interest-bearing                                                                                                                                                                |       | $                           | 454,217    |                       | $          | 394,422 |   |
| Non-interest-bearing                                                                                                                                                            |       | 64,004                      |       | 75,116                     |       |
| Total  deposits                                                                                                                                                                 |       | 518,221                     |       | 469,538                    |       |
| Other  borrowings                                                                                                                                                               |       | 15,826                      |       | 32,665                     |       |
| Other  liabilities                                                                                                                                                              |       | 2,018                       |       | 2,872                      |       |
| Total  liabilities                                                                                                                                                              |       | 536,065                     |       | 505,075                    |       |
|                                                                                                                                                                            |       |                        |       |                       |       |
| **STOCKHOLDERS’ EQUITY**                                                                                                                                                   |       |                        |       |                       |       |
| Common  stock no par value, 5,000,000 shares authorized, 586,695 and 586,285 shares  issued and outstanding at September 30, 2009 and December 31, 2008  respectively |       | 12,238                      |       | 12,042                     |       |
| Accumulated  other comprehensive income, net of tax                                                                                                                             |       | 2,655                       |       | 2,325                      |       |
| Retained  earnings                                                                                                                                                              |       | 48,497                      |       | 47,434                     |       |
| Total  stockholders’ equity                                                                                                                                                |       | 63,390                      |       | 61,801                     |       |
| **TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                             |       | $                           | 599,455    |                       | $          | 566,876 |   |

 

*Seeaccompanying notes to these consolidated financial statements*

 

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**SKAGIT STATE BANCORP, INC. ANDSUBSIDIARY**

**CONSOLIDATED STATEMENT OF INCOME(Unaudited)**

** **
| ** **                                                  | ** ** | **Three months ended Sept. 30,** | ** ** | **Nine months ended Sept. 30,** | ** ** |
|-------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| **(dollars in thousands except  share data)**               | ** ** | **2009**                         | ** ** | **2008**                        | ** ** | **2009** | ** ** | **2008** | ** ** |
| ** **                                                  |       |                             |       |                            |       |   |   |   |   |
| **INTEREST INCOME**                                         |       |                             |       |                            |       |   |   |   |   |
| Interest  and fees on loans                                 |       | $                                | 5,791      |                            | $          | 6,516 |   | $ | 17,458 |   | $ | 19,187 |   |
| Investment  securities                                      |       |                             |       |                            |       |   |   |   |   |
| Taxable                                                     |       | 1,051                            |       | 1,225                           |       | 3,165 |   | 4,094 |   |
| Exempt  from federal income tax                             |       | 282                              |       | 290                             |       | 844 |   | 924 |   |
| Federal  funds sold                                         |       | 22                               |       | 12                              |       | 34 |   | 285 |   |
| Total  interest income                                      |       | 7,146                            |       | 8,043                           |       | 21,501 |   | 24,490 |   |
| **INTEREST EXPENSE**                                        |       |                             |       |                            |       |   |   |   |   |
| Deposits                                                    |       | 1,736                            |       | 2,213                           |       | 5,213 |   | 7,636 |   |
| Other  borrowings                                           |       | 70                               |       | 131                             |       | 223 |   | 384 |   |
| Total  interest expense                                     |       | 1,806                            |       | 2,344                           |       | 5,436 |   | 8,020 |   |
| **NET INTEREST INCOME**                                     |       | 5,340                            |       | 5,699                           |       | 16,065 |   | 16,470 |   |
| Provision  for loan losses                                  |       | 1,320                            |       | 760                             |       | 2,220 |   | 760 |   |
| **NET INTEREST INCOME AFTER****PROVISION FOR  LOAN LOSSES** |       | 4,020                            |       | 4,939                           |       | 13,845 |   | 15,710 |   |
| **NON-INTEREST INCOME**                                     |       |                             |       |                            |       |   |   |   |   |
| Service  charges on deposits                                |       | 770                              |       | 797                             |       | 2,259 |   | 2,322 |   |
| Other                                                       |       | 184                              |       | 166                             |       | 563 |   | 546 |   |
| Gain  on sale of assets                                     |       | 74                               |       | 327                             |       | 193 |   | 455 |   |
| Total  non-interest income                                  |       | 1,028                            |       | 1,290                           |       | 3,015 |   | 3,323 |   |
| **NON-INTEREST EXPENSES**                                   |       |                             |       |                            |       |   |   |   |   |
| Salaries                                                    |       | 1,897                            |       | 2,058                           |       | 5,769 |   | 5,938 |   |
| Payroll  taxes and employee benefits                        |       | 447                              |       | 445                             |       | 1,426 |   | 1,400 |   |
| Write-down  of other real estate owned                      |       | 541                              |       | 1,369                           |       | 914 |   | 1,369 |   |
| Bank  premises and equipment                                |       | 234                              |       | 253                             |       | 718 |   | 782 |   |
| Occupancy                                                   |       | 179                              |       | 187                             |       | 592 |   | 573 |   |
| State  business taxes                                       |       | 93                               |       | 111                             |       | 285 |   | 337 |   |
| Advertising                                                 |       | 163                              |       | 229                             |       | 536 |   | 598 |   |
| Other                                                       |       | 1,163                            |       | 1,016                           |       | 3,953 |   | 2,870 |   |
| Total  non-interest expenses                                |       | 4,717                            |       | 5,668                           |       | 14,193 |   | 13,867 |   |
| **INCOME BEFORE PROVISION (BENEFIT) FOR INCOME TAX**        |       | 331                              |       | 561                             |       | 2,667 |   | 5,166 |   |
| **PROVISION (BENEFIT) FOR INCOME TAX**                      |       |                             |       |                            |       |   |   |   |   |
| Provision  (benefit) for income tax                         |       | 30                               |       | (83                             | )          | 280 |   | 918 |   |
| Deferred                                                    |       | —                           |       | —                          |       | — |   | (7 | ) |
| Total  provision (benefit) for income tax                   |       | 30                               |       | (83                             | )          | 280 |   | 911 |   |
| **NET INCOME**                                              |       | $                                | 301        |                            | $          | 644 |   | $ | 2,387 |   | $ | 4,255 |   |
| **BASIC EARNINGS PER SHARE**                                |       | $                                | 0.51       |                            | $          | 1.10 |   | $ | 4.07 |   | $ | 6.94 |   |
| **DILUTED EARNINGS PER SHARE**                              |       | $                                | 0.51       |                            | $          | 1.09 |   | $ | 4.04 |   | $ | 6.89 |   |
| **DIVIDENDS DECLARED PER SHARE**                            |       | $                                | 0.00       |                            | $          | 0.00 |   | $ | 2.25 |   | $ | 2.25 |   |

 

*See accompanying notes to theseconsolidated financial statements*

 

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**SKAGIT STATE BANCORP, INC. ANDSUBSIDIARY**

**CONSOLIDATED STATEMENT OF CHANGESIN STOCKHOLDERS’ EQUITY AND COMPREHENSIVE INCOME (Unaudited)**

Nine months endedSeptember 30, 2009 and 2008

* *
| ** **                                                                      | ** ** | ** **        | ** ** | ** **        | ** ** | **Accum.  Other** | ** ** | ** **             | ** ** | **Total**         | ** ** | ** ** | ** ** |
|---------------------------------------------------------------------------------|------------|-------------------|------------|-------------------|------------|-------------------|------------|------------------------|------------|-------------------|------------|------------|------------|
| ** **                                                                      | ** ** | **Common  Stock** | ** ** | **Comprehensive** | ** ** | **Retained**      | ** ** | **Stockholders’** | ** ** | **Comprehensive** | ** ** |
| **(dollars in thousands except share and per share  amounts)**                  | ** ** | **Shares**        | ** ** | **Amount**        | ** ** | **Income**        | ** ** | **Earnings**           | ** ** | **Equity**        | ** ** | **Income** | ** ** |
| **BALANCE,**January 1, 2008                                                |       | 670,997           |       | $                 | 13,564     |              | $          | 694                    |       | $                 | 58,425     |       | $          | 72,683 |   |   |   |
| Comprehensive  income:                                                          |       |              |       |              |       |              |       |                   |       |              |       |       |       |
| Net  income                                                                     |       | —            |       | —            |       | —            |       | 4,255                  |       | 4,255             |       | $          | 4,255      |   |
| Other  comprehensive income:                                                    |       |              |       |              |       |              |       |                   |       |              |       |       |       |
| Unrealized  losses on available-for-sale securities, net of tax benefit of $178 |       | —            |       | —            |       | (347              | )          | —                 |       | (347              | )          | (347       | )          |
| Total  other comprehensive loss                                                 |       |              |       |              |       |              |       |                   |       |              |       | (347       | )          |
| Comprehensive  income                                                           |       |              |       |              |       |              |       |                   |       |              |       | $          | 3,908      |   |
| Cash  dividend declared, $2.25 per share                                        |       | —            |       | —            |       | —            |       | (1,323                 | )          | (1,323            | )          |       |       |
| Common  stock redemption                                                        |       | (85,022           | )          | (1,721            | )          | —            |       | (13,583                | )          | (15,304           | )          |       |       |
| Stock  compensation expense and restricted stock awards                         |       | 100               |       | 146               |       | —            |       | —                 |       | 146               |       |       |       |
| **BALANCE,**September 30, 2008                                             |       | 586,075           |       | $                 | 11,989     |              | $          | 347                    |       | $                 | 47,774     |       | $          | 60,110 |   |   |   |
|                                                                            |       |              |       |              |       |              |       |                   |       |              |       |       |       |
| **BALANCE,**January 1, 2009                                                |       | 586,285           |       | $                 | 12,042     |              | $          | 2,325                  |       | $                 | 47,434     |       | $          | 61,801 |   |   |   |
| Comprehensive  income:                                                          |       |              |       |              |       |              |       |                   |       |              |       |       |       |
| Net  income                                                                     |       | —            |       | —            |       | —            |       | 2,387                  |       | 2,387             |       | $          | 2,387      |   |
| Other  comprehensive income:                                                    |       |              |       |              |       |              |       |                   |       |              |       |       |       |
| Unrealized  gain on available-for-sale securities, net of taxes of $170         |       | —            |       | —            |       | 330               |       | —                 |       | 330               |       | 330        |       |
| Total  other comprehensive income                                               |       |              |       |              |       |              |       |                   |       |              |       | 330        |       |
| Comprehensive  income                                                           |       |              |       |              |       |              |       |                   |       |              |       | $          | 2,717      |   |
| Cash  dividend declared, $2.25 per share                                        |       | —            |       | —            |       | —            |       | (1,324                 | )          | (1,324            | )          |       |       |
| Stock  options exercised                                                        |       | 25                |       | 4                 |       | —            |       | —                 |       | 4                 |       |       |       |
| Stock  compensation expense and restricted stock awards                         |       | 385               |       | 192               |       | —            |       | —                 |       | 192               |       |       |       |
| **BALANCE,**September 30, 2009                                             |       | 586,695           |       | $                 | 12,238     |              | $          | 2,655                  |       | $                 | 48,497     |       | $          | 63,390 |   |   |   |

 

*Seeaccompanying notes to these consolidated financial statements*

 

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**SKAGIT STATE BANCORP, INC. ANDSUBSIDIARY**

**CONSOLIDATED STATEMENT OF CASHFLOWS**

**(Unaudited**)

 
| **(dollars in thousands)**                                                               | ** ** | ** ** | ** ** | ** ** | ** ** |
|------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| **Nine months ended  September 30,**                                                | ** ** | **2009**   | ** ** | **2008**   | ** ** |
| **CASH FLOWS FROM OPERATING  ACTIVITIES**                                                |       |       |       |       |       |
| Net income                                                                               |       | $          | 2,387      |       | $          | 4,255 |   |
| *Adjustments to reconcile net  income to net cash flows from operating activities*       |       |       |       |       |       |
| Provision for loan losses                                                                |       | 2,220      |       | 760        |       |
| Write-down of other real estate owned                                                    |       | 914        |       | 1,369      |       |
| Depreciation                                                                             |       | 632        |       | 663        |       |
| (Gain) loss on sale of premises and equipment                                            |       | 8          |       | (232       | )          |
| Gains on sale of loans held-for-sale                                                     |       | (193       | )          | (223       | )          |
| Amortization of investment security premiums and  discounts, net                         |       | (139       | )          | (178       | )          |
| Provision for deferred income taxes                                                      |       | —     |       | (7         | )          |
| Stock compensation for employee services                                                 |       | 192        |       | 146        |       |
| *Changes in operating assets and  liabilities*                                           |       |       |       |       |       |
| Originations of loans held for sale                                                      |       | (14,133    | )          | (15,892    | )          |
| Proceeds for sales of loans held for sale                                                |       | 14,263     |       | 16,115     |       |
| Decrease (increase) in interest receivable                                               |       | (176       | )          | 352        |       |
| Decrease (increase) in other assets                                                      |       | 532        |       | (173       | )          |
| Decrease in other liabilities                                                            |       | (854       | )          | (1,939     | )          |
| Net cash flows from operating activities                                                 |       | 5,653      |       | 5,016      |       |
| **CASH FLOWS FROM INVESTING  ACTIVITIES**                                                |       |       |       |       |       |
| Proceeds from maturities of investment securities –  available-for-sale             |       | 21,087     |       | 38,841     |       |
| Purchases of investment securities –  available-for-sale                            |       | (26,946    | )          | (20,445    | )          |
| Proceeds from maturities of investment securities –  held-to-maturity               |       | 5,584      |       | 5,872      |       |
| Purchases of investment securities –  held-to-maturity                              |       | (9,077     | )          | (2,127     | )          |
| Net decrease (increase) in federal funds  sold & interest-bearing bank balances |       | (41,108    | )          | 41,195     |       |
| Net decrease (increase) in loans                                                         |       | 13,643     |       | (46,028    | )          |
| Purchase of premises and equipment                                                       |       | (131       | )          | (289       | )          |
| Capitalized expenditures for improvements to other  real estate owned                    |       | (136       | )          | (39        | )          |
| Proceeds from sale or disposal of premises and  equipment                                |       | —     |       | 301        |       |
| Net cash flows from investing activities                                                 |       | (37,084    | )          | 17,281     |       |
| **CASH FLOWS FROM FINANCING  ACTIVITIES**                                                |       |       |       |       |       |
| Net increase (decrease) in demand deposits, money  market, NOW and savings accounts      |       | 18,333     |       | (1,242     | )          |
| Net increase (decrease) in time deposits                                                 |       | 30,350     |       | (32,273    | )          |
| Amount paid for redemption of common stock                                               |       | —     |       | (15,304    | )          |
| Net increase (decrease) in other borrowings                                              |       | (16,839    | )          | 27,001     |       |
| Proceeds from exercise of stock options                                                  |       | 4          |       | —     |       |
| Cash dividends                                                                           |       | (1,324     | )          | (1,323     | )          |
| Net cash flows from financing activities                                                 |       | 30,524     |       | (23,141    | )          |
| **NET CHANGE IN CASH AND DUE FROM  BANKS**                                               |       | (907       | )          | (844       | )          |
| **CASH AND DUE FROM BANKS,**beginning of  period                                         |       | 11,954     |       | 16,641     |       |
| **CASH AND DUE FROM BANKS,** end of period                                               |       | $          | 11,047     |       | $          | 15,797 |   |
| **SUPPLEMENTAL DISCLOSURES OF CASH  FLOW INFORMATION**                                   | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash paid during the period for income taxes                                             |       | $          | 266        |       | $          | 1,417 |   |
| Cash paid during the period for interest                                                 |       | 5,364      |       | 8,293      |       |
| **NONCASH FINANCING AND INVESTING  TRANSACTIONS**                                        |       |       |       |       |       |
| Property taken in settlement of loans                                                    |       | 1,309      |       | 6,946      |       |

 

* See accompanying notes to these consolidatedfinancial statements*

 

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** **

**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

**Note 1:   BASIS OF PRESENTATION**

 

The accompanyingconsolidated financial statements include the accounts of Skagit State Bancorp, Inc.and its subsidiary Skagit State Bank, (collectively, “Company” or “Bancorp”).All significant inter-company accounts and transactions have been eliminated.The consolidated 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.Accordingly they do not include all of the information and footnotes requiredby accounting principles generally accepted in the United States of America forcomplete financial statements. In the opinion of management, all adjustments(consisting of normal recurring accruals) considered necessary for a fairpresentation have been included. Operating results for the nine months ended September 30,2009 are not necessarily indicative of the results anticipated for the yearending December 31, 2009. For additional information, refer to the auditedfinancial statements and footnotes for the most recent annual period ended December 31,2008 contained in the Annual Report on Form 10-K.  All dollar amounts in tables, except shareand per share information, are stated in thousands.

 

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

 

Bancorp’s financialstatements are based upon the selection and application of significantaccounting policies which by their nature are inherently subject to estimationtechniques, valuation assumptions and other subjective assessments. Managementhas identified specific accounting policies that due to judgments, estimatesand assumptions and economic assumptions which may prove inaccurate or aresubject to variation that may significantly affect our reported results ofoperations and financial positions for the periods presented or in futureperiods.  These policies relate to thedetermination of the allowance for loan losses and the valuation of real estateowned. These policies and the judgments, estimates and assumptions aredescribed in the Annual Report on Form 10-K for the year ended December 31,2008.

 

**Note 3:   RECLASSIFICATIONS**

 

Certain reclassificationshave been made to the 2008 financial statements to conform to the 2009presentation. Such classifications have no affect on net income.

 

**Note 4:   SUBSEQUENT EVENTS**

 

Subsequent events areevents or transactions that occur after the balance sheet date, but beforefinancial statements are issued.  Bancorphas evaluated subsequent events for potential recognition or disclosure throughNovember 13, 2009, which is the date the financial statements were issued.

 

**Note 5:   NEW ACCOUNTING PRONOUNCEMENTS**

 

On July 1, 2009, theFASB launched the Accounting Standards Codification (ASC), a structuraloverhaul to U.S. GAAP that changes from a standards-based model to a topically basedmodel.  The topics are organized by ASCnumber and are updated with an Accounting Standards Update (ASU). TheCodification is the single source of nongovernmental authoritative U.S. GAAPfor interim and annual periods ending after September 15, 2009.  It supersedes all authoritative literature inLevels A-D of the U.S. GAAP hierarchy.

 

FASB ASC Topic 820-10-50,“Interim Disclosures about Fair Value of Financial Instruments”.  Theguidance requires publically traded companies to disclose the fair value offinancial instruments in interim periods previously required in annualfinancial statements.  The guidance was effective for interim and annualperiods ending after June 15, 2009. The implementation of this guidancedid not have a material impact on the consolidated financial statements.

 

FASB ASC Topic 320, “Recognitionand Presentation of Other-Than-Temporary Impairments”.  This guidanceamends the other-than-temporary impairment guidance in U.S. GAAP for debtsecurities to make the guidance more operational and to improve thepresentation and disclosure of other-than- temporary impairments on debt andequity securities in the financial statements. The guidance was effectivefor interim and annual periods ending after June 15, 2009. Theimplementation of this guidance did not have a material impact on theconsolidated financial statements.

 

**Note 6:   EARNINGSPER SHARE**

 

Basic earnings per share amounts are computed based on the weightedaverage number of shares outstanding. Diluted earnings per share is calculatedby dividing net income by diluted weighted average shares outstanding, whichincludes common stock equivalents outstanding using the treasury stock method.

 

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**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

** **
| ** **                                                                       | ** ** | **Three months ended Sept. 30,** | ** ** | **Nine months ended Sept. 30,** | ** ** |
|----------------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| **(dollars in thousands except  share and per share amounts)**                   | ** ** | **2009**                         | ** ** | **2008**                        | ** ** | **2009** | ** ** | **2008** | ** ** |
| Numerator:                                                                       |       |                             |       |                            |       |   |   |   |   |
| Net  income                                                                      |       | $                                |  301  |                            | $          |  644 |   | $ |  2,387 |   | $ |  4,255 |   |
| Denominator:                                                                     |       |                             |       |                            |       |   |   |   |   |
| Denominator  for basic earnings per share - Weighted average shares outstanding  |       | 586,658                          |       | 586,038                         |       | 586,566 |   | 612,682 |   |
| Effect  of dilutive securities:                                                  |       |                             |       |                            |       |   |   |   |   |
| Stock  options and unvested restricted stock grants                              |       | 3,141                            |       | 5,112                           |       | 4,168 |   | 4,902 |   |
| Denominator  for diluted earning per share - Weighted average shares outstanding |       | 589,799                          |       | 591,150                         |       | 590,734 |   | 617,584 |   |
| Basic  earnings per share                                                        |       | $                                |  0.51 |                            | $          |  1.10 |   | $ |  4.07 |   | $ |  6.94 |   |
| Diluted  earnings per share                                                      |       | $                                |  0.51 |                            | $          |  1.09 |   | $ |  4.04 |   | $ |  6.89 |   |

 

**Note 7:   STOCK-BASEDCOMPENSATION**

 

Bancorp has one share-based payment plan, which is shareholderapproved, and permits the grant of share-based awards to its employees anddirectors up to 100,000 shares and at September 30, 2009, there were68,710 common shares available for grant. Total equity compensation expense was$192,000 and $146,000 for the nine months ended September 30, 2009 and2008, respectively.

 

**Stock Options**: All options granted during 2009 and 2008 wereIncentive Stock Options and were granted at a price equal to the market valueof the stock on the grant date, have a term of 10 years and vest over a fiveyear period.  Bancorp measures the fairvalue of each stock option at the date of the grant, using the Black Scholesoption valuation model.  The applicationof this valuation model involves assumptions that are judgmental and sensitivein the determination of compensation expense.

 

The following assumptions were used in arriving at the fair value ofoptions granted for the nine months ended September 30, 2009:

 
| ** **                               | ** ** | **Employee options** | ** ** |
|------------------------------------------|------------|----------------------|------------|
| Expected  price volatility               |       | 18.41                | %          |
| Risk-free  interest rate                 |       | 2.05                 | %          |
| Dividend  yield on underlying stock      |       | 2.30                 | %          |
| Weighted-average  expected life in years |       | 7.00                 |       |

 

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**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

The following tablesummarizes the activity related to options outstanding during the nine monthsended September 30, 2009. The aggregate intrinsic value represents thetotal pretax intrinsic value (amount by which the fair value of the underlyingstock exceeds the exercise price of an option or award, times the number ofshares):

 
| **(dollars in thousands except  share and per share amounts)** | ** ** | **Shares** | ** ** | **Weighted   Average   Exercise/Grant   Price** | ** **   | **Weighted   Average   Remaining   Contractual Terms** | ** ** | **Aggregate   Intrinsic Value** | ** ** |
|----------------------------------------------------------------|------------|------------|------------|-------------------------------------------------|--------------|--------------------------------------------------------|------------|---------------------------------|------------|
| Outstanding  at January 1, 2009                           |       | 18,331     |       | $                                               |  170.48 |                                                   | 7.69       |                            | $          |  541 |   |
| Granted                                                        |       | 10,455     |       | 195.00                                          |         | 10.00                                                  |       | —                          |       |
| Exercised                                                      |       | 25         |       | —                                          |         | —                                                 |       | —                          |       |
| Forfeited                                                      |       | —     |       | —                                          |         | —                                                 |       | —                          |       |
| Outstanding  at September 30, 2009                        |       | 28,761     |       | $                                               |  179.40 |                                                   | 7.83       |                            | $          |  161 |   |
| Exercisable  at September 30, 2009                        |       | 6,282      |       | $                                               |  167.54 |                                                   | 6.71       |                            | $          |  110 |   |

 

The unrecognized share-based compensation cost relating to stock optionexpense at September 30, 2009 is $597,000, which will be recognized overthe remaining vesting schedule through 2014. The weighted average grant datefair value of options granted during 2009 was $30.78 per share.

 

**Stock Awards**: Recipients of restricted stock awards do not pay anycash consideration to Bancorp for the shares and receive all dividends withrespect to all such shares, whether or not shares have vested.  The awards vest over a five year period.  Bancorp measures the fair value of each stockaward at the date of the grant and recognizes compensation based on the amountthe market price of Bancorp’s common stock exceeds the exercise price.  The unrecognized share-based compensationcost relating to restricted stock awards expense at September 30, 2009 was$180,000, which will be recognized over the remaining years of the originalfive year vesting period of the awards. There were no awards granted for the nine months ended September 30,2009.   The total intrinsic value ofstock awards exercised and vested during the nine months ended September 30,2009 was $73,000.

 

The aggregate intrinsic value in the table above and followingrepresents the total pretax intrinsic value (amount by which the fair value ofthe underlying stock exceeds the exercise price of an option or award, timesthe number of shares).  The followingtable summarizes the activity relating to restricted stock awards outstandingfor the nine months ended September 30, 2009.

 
| **(dollars in thousands except  share and per share amounts)** | ** ** | **Shares** | ** ** | **Weighted Average   Remaining   Contractual Terms (in   years)** | ** ** | **Aggregate   Intrinsic Value** | ** ** |   |   |
|----------------------------------------------------------------|------------|------------|------------|-------------------------------------------------------------------|------------|---------------------------------|------------|--------|--------|
| Outstanding  at January 1, 2009                           |       | 2,159      |       | 3.61                                                              |       | $                               |  432  |   |   |   |
| Granted                                                        |       | —     |       | —                                                            |       | —                          |       |   |   |
| Vested                                                         |       | 385        |       | —                                                            |       | 73                              |       |   |   |
| Forfeited                                                      |       | —     |       | —                                                            |       | —                          |       |   |   |
| Outstanding  at September 30, 2009                        |       | 1,774      |       | 2.95                                                              |       | $                               |  328  |   |   |   |
| Exercisable  at September 30, 2009                        |       | —     |       | —                                                            |       | —                          |       |   |   |

 

For additional information on the stock-basedequity compensation plan, refer to Bancorp’s audited financial statements andfootnotes for the most recent annual period ended December 31, 2008contained in the Annual Report on Form 10-K.

 

**Note 8:   INVESTMENT SECURITIES**

 

The following tablessummarize the aggregate amortized cost and estimated fair value of investmentsecurities as of the dates indicated.

 

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**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

**September 30, 2009**

** **
| ** **                        | ** ** | **Amortized** | ** **    | **Gross Unrealized** | ** ** | **Estimated** | ** ** |
|-----------------------------------|------------|---------------|---------------|----------------------|------------|---------------|------------|
| **(dollars in thousands)**        | ** ** | **Cost**      | ** **    | **Gains**            | ** ** | **Losses**    | ** ** | **Fair Value** | ** ** |
| *Available-For-Sale Securities*   |       |          |          |                 |       |          |       |   |   |
| U.S.  government agencies         |       | $             |  35,526  |                 | $          |  386     |       | $ |  — |   | $ |  35,912 |   |
| Mortgage-backed  securities       |       | 58,870        |          | 3,200                |       | —        |       | $ |  62,070 |   |
| State  and political subdivisions |       | 10,726        |          | 448                  |       | 11            |       | $ |  11,163 |   |
| Total  available-for-sale         |       | 105,122       |          | 4,034                |       | 11            |       | 109,145 |   |
| *Held-To-Maturity Securities*     |       |          |          |                 |       |          |       |   |   |
| State  and political subdivisions |       | 40,011        |          | 999                  |       | 441           |       | 40,569 |   |
| Total  held-to-maturity           |       | 40,011        |          | 999                  |       | 441           |       | 40,569 |   |
| Total  investment securities      |       | $             |  145,133 |                 | $          |  5,033   |       | $ |  452 |   | $ |  149,714 |   |

 

**December 31, 2008**

** **
| ** **                        | ** ** | **Amortized** | ** **    | **Gross Unrealized** | ** ** | **Estimated** | ** ** |
|-----------------------------------|------------|---------------|---------------|----------------------|------------|---------------|------------|
| **(dollars in thousands)**        | ** ** | **Cost**      | ** **    | **Gains**            | ** ** | **Losses**    | ** ** | **Fair Value** | ** ** |
| *Available-For-Sale Securities*   |       |          |          |                 |       |          |       |   |   |
| U.S.  government agencies         |       | $             |  28,669  |                 | $          |  857     |       | $ |  — |   | $ |  29,526 |   |
| Mortgage-backed  securities       |       | 59,316        |          | 2,525                |       | —        |       | 61,841 |   |
| State  and political subdivisions |       | 11,140        |          | 218                  |       | 78            |       | 11,280 |   |
| Total  available-for-sale         |       | 99,125        |          | 3,600                |       | 78            |       | 102,647 |   |
| *Held-To-Maturity Securities*     |       |          |          |                 |       |          |       |   |   |
| State  and political subdivisions |       | 36,518        |          | 167                  |       | 87            |       | 36,598 |   |
| Total  held-to-maturity           |       | 36,518        |          | 167                  |       | 87            |       | 36,598 |   |
| Total  investment securities      |       | $             |  135,643 |                 | $          |  3,767   |       | $ |  165 |   | $ |  139,245 |   |

 

The following tables showthe aggregate gross unrealized losses and fair value of securities with anamortized cost greater than the fair value as of the dates indicated;

 

**September 30, 2009**

** **
| ** **                        | ** ** | **Less Than 12 Months** | ** ** | **12 Months or Greater** | ** ** | **Total**      | ** ** |
|-----------------------------------|------------|-------------------------|------------|--------------------------|------------|----------------|------------|
| **(dollars in thousands)**        | ** ** | **Fair Value**          | ** ** | **Unrealized  Losses**   | ** ** | **Fair Value** | ** ** | **Unrealized   Losses** | ** ** | **Fair Value** | ** ** | **Unrealized   Losses** | ** ** |
| *Available-For-Sale Securities*   |       |                    |       |                     |       |           |       |   |   |   |   |   |   |
| State  and political subdivisions |       | $                       | —     |                     | $          | —         |       | $ | 486 |   | $ | 11 |   | $ | 486 |   | $ | 11 |   |
| Total  available-for-sale         |       | —                  |       | —                   |       | 486            |       | 11 |   | 486 |   | 11 |   |
| *Held-To-Maturity Securities*     |       |                    |       |                     |       |           |       |   |   |   |   |   |   |
| State  and political subdivisions |       | 14,010                  |       | 441                      |       | —         |       | — |   | 14,010 |   | 441 |   |
| Total  held-to-maturity           |       | 14,010                  |       | 441                      |       | —         |       | — |   | 14,010 |   | 441 |   |
| Total  investment securities      |       | $                       | 14,010     |                     | $          | 441            |       | $ | 486 |   | $ | 11 |   | $ | 14,496 |   | $ | 452 |   |

 

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**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

 

**December 31, 2008**

** **
| ** **                        | ** ** | **Less Than 12 Months** | ** ** | **12 Months or Greater** | ** ** | **Total**      | ** ** |
|-----------------------------------|------------|-------------------------|------------|--------------------------|------------|----------------|------------|
| **(dollars in thousands)**        | ** ** | **Fair Value**          | ** ** | **Unrealized   Losses**  | ** ** | **Fair Value** | ** ** | **Unrealized   Losses** | ** ** | **Fair Value** | ** ** | **Unrealized   Losses** | ** ** |
| *Available-For-Sale Securities*   |       |                    |       |                     |       |           |       |   |   |   |   |   |   |
| State  and political subdivisions |       | $                       | 904        |                     | $          | 78             |       | $ | — |   | $ | — |   | $ | 904 |   | $ | 78 |   |
| Total  available-for-sale         |       | 904                     |       | 78                       |       | —         |       | — |   | 904 |   | 78 |   |
| *Held-To-Maturity Securities*     |       |                    |       |                     |       |           |       |   |   |   |   |   |   |
| State  and political subdivisions |       | 6,547                   |       | 74                       |       | 4,544          |       | 13 |   | 11,091 |   | 87 |   |
| Total  held-to-maturity           |       | 6,547                   |       | 74                       |       | 4,544          |       | 13 |   | 11,091 |   | 87 |   |
| Total  investment securities      |       | $                       | 7,451      |                     | $          | 152            |       | $ | 4,544 |   | $ | 13 |   | $ | 11,995 |   | $ | 165 |   |

 

At September 30,2009, management does not have the intent to sell any of the securitiesclassified as available for sale and believes that it is more likely than notthat Bancorp will not have to sell any such securities before a recovery ofcost.  The unrealized losses are largelydue to increases in market interest rates over the yields available at the timethe underlying securities were purchased.  The fair value is expected torecover as the bonds approach their maturity date or repricing date or ifmarket yields for such investments decline.  Bancorp believes that thedecline in fair value is temporary, with no permanent sector or issuer creditconcerns or impairments.  Accordingly, Bancorp did not recognize anyother-than-temporary impairment losses for the nine months ended September 30,2009.  Any declines in the fair value ofavailable for sale and held to maturity securities below their cost that aredeemed to be other-than-temporary would be reflected in earnings as realizedlosses. At September 30, 2009, Bancorp held 1 security in theavailable-for-sale portfolio and no security in the held-to-maturity portfoliothat had an unrealized loss for more than one year.

 

**Note 9:   ALLOWANCE FOR LOAN LOSSES**

 

The following tablepresents the activity in the allowance for loan losses for the dates indicated.

 

**Allowance for Loan LossesActivity**

** **
| ** **                                                   | ** ** | **Three  months ended,** | ** ** | **Nine  months ended,** | ** ** |
|--------------------------------------------------------------|------------|--------------------------|------------|-------------------------|------------|
| **(dollars in thousands)**                                   | ** ** | **2009**                 | ** ** | **2008**                | ** ** | **2009** | ** ** | **2008** | ** ** |
| Allowance  as of beginning of period                         |       | $                        | 5,629      |                    | $          | 4,051 |   | $ | 5,450 |   | $ | 4,535 |   |
| Provision  for loan losses                                   |       | 1,320                    |       | 760                     |       | 2,220 |   | 760 |   |
| Charge-offs                                                  |       | (1,221                   | )          | (465                    | )          | (2,031 | ) | (1,099 | ) |
| Recoveries                                                   |       | 70                       |       | 27                      |       | 159 |   | 177 |   |
| Net  charge-offs                                             |       | (1,151                   | )          | (438                    | )          | (1,872 | ) | (922 | ) |
| Balance  at end of period                                    |       | $                        | 5,798      |                    | $          | 4,373 |   | $ | 5,798 |   | $ | 4,373 |   |
| Ratio  of net charge-offs to average loans during the period |       | (1.22                    | )%         | (0.46                   | )%         | (0.65 | )% | (0.34 | )% |
| Ratio  of allowance to net loans at end of period            |       | 1.54                     | %          | 1.12                    | %          | 1.54 | % | 1.12 | % |
| Ratio  of non-performing loans to allowance                  |       | 184.58                   | %          | 14.43                   | %          | 184.58 | % | 14.43 | % |

 

Impaired loans were $12.4million and $5.5 million, respectively at September 30, 2009 and December 31,2008.

 

**Note 10: FINANCIALINSTRUMENTS**

 

In the ordinarycourse of business, Bancorp has entered into off-balance-sheet financialinstruments consisting of commitments to extend credit, commitments undercredit-card arrangements, commercial letters of credit, and standby letters ofcredit. Such financial instruments are recorded in the financial statementswhen they are funded or related fees are incurred or received.

 

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**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

 

The following is a summary of the off-balance-sheet financialinstruments or contracts outstanding as of September 30, 2009: (dollars inthousands)

 
| Unfunded  commitments to extend credit  |   | $      | 64,255 |   |
|-----------------------------------------|--------|--------|--------|--------|
| Credit  card arrangements               |   | 11,353 |   |
| Commitments  to fund municipal warrants |   | 4,083  |   |
| Standby  letters of credit              |   | 2,147  |   |

** **

**Note 11:   INCOMETAXES**

 

Bancorp files a consolidated federal income tax return.  Bancorp accounts for income taxes using theliability method and deferred taxes are reflected at currently enacted incometax rates applicable to the period in which the deferred tax assets orliabilities are expected to be realized or settled.  Deferred taxes result from temporarydifferences in the recognition of certain income and expense amounts betweenBancorp’s financial statements and its tax returns.As changes in tax laws or rates are enacted, deferredtax assets and liabilities are adjusted through the provision for income taxes.

 

FASB ASC 740, “Accountingfor Uncertainty in Income Taxes” — seeks to reduce the diversity in practiceassociated with certain aspects of measurement and recognition in accountingfor income taxes. ASC 740 provides guidance on de-recognition, classification,interest and penalties and accounting in interim periods and requires expandeddisclosure with respect to uncertainty in income taxes.  Our accounting policy with respect tointerest and penalties arising from income tax settlements is to recognize themas non-interest expense.

 

**Note 12:  FAIR VALUE OF FINANCIAL INSTRUMENTS**

 

FASB ASC 820-10-50, “Interim Disclosures About Fair Value of FinancialInstruments” requires disclosures of the fair value of financial asset andliabilities, including those financial assets and liabilities that are notmeasured and reported at fair value on a recurring basis or non-recurringbasis.  The estimated fair values havebeen determined by Bancorp using available market information and appropriatevaluation methodologies and considerable judgment is necessary to interpretmarket data in the development of the estimates of fair value.  The use of different market assumptionsand/or estimation methodologies may have a material effect on the estimatedfair value amounts. In that regard, the fair value estimates cannot besubstantiated by comparison to independent markets and, in many cases, couldnot be realized in immediate settlement on the instrument. Accordingly, theaggregate fair value amounts presented do not represent the underlying value ofBancorp.

 

*Cash, Due FromBanks, Federal Funds Sold, Interest-bearing bank balances, Other Borrowings andAccrued Interest Receivable and Payable —*The carrying amount of these financial assets andliabilities approximates fair value.

 

*InvestmentSecurities —*The securities classified as available for sale arereported at fair value utilizing Level 2 inputs. The fair values of fixed rate warrants and qualifiedzone academy bonds, included in state and political subdivisions investmentsecurities, are estimated using discounted cash flow analysis using interestrates currently being offered for warrants of similar terms or the currentqualified zone academy bond interest rates.

 

*Loans —* The fair values for variable-rate loansthat reprice frequently are based on carrying values. The fair values offixed-rate commercial, real estate mortgage, installment, and other loans areestimated using discounted cash flow analysis, using interest rates currentlybeing offered for loans with similar terms to borrowers.

 

*Deposits —* The fair values disclosed for demand,savings, and money market accounts are equal to their carrying amounts. Thefair values for fixed-rate time deposits are estimated using a discounted cashflow analysis that applies interest rates currently being offered oncertificates to a schedule of aggregated expected maturities on time deposits.

 

*Off-Balance-SheetInstruments —*Commitments to extend credit and standby letters of credit represent theprincipal categories of off-balance financial instruments (See Note 10).  The fair value of these instruments is notconsidered material since they are for relatively short periods of time and aresubject to customary credit terms, which would not include terms that would exposeBancorp to significant gains or losses.

 

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**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

 

The carrying amounts and estimated fair values of Bancorp’s financialinstruments at September 30, 2009 are as follows:

** **
| ** **                                             | ** ** | **September 30, 2009** | ** ** |
|--------------------------------------------------------|------------|-----------------------------|------------|
| ** **                                             | ** ** | **Carrying**                | ** ** | ** ** | ** ** |
| **(dollars in thousands)**                             | ** ** | **Amount**                  | ** ** | **Fair Value** | ** ** |
| *Financial Assets*                                     | * *   | * *                    | * *   | * * | * * |
| Cash  and due from banks                               |       | $                           | 11,047     |   | $ | 11,047 |   |
| Federal  funds sold and Interest-bearing bank balances |       | 41,108                      |       | 41,108 |   |
| Investment  securities                                 |       | 149,156                     |       | 149,714 |   |
| Net  loans                                             |       | 376,603                     |       | 376,656 |   |
| Accrued  interest receivable                           |       | 2,606                       |       | 2,606 |   |
| * *                                               |       |                        |       |   |   |
| *Financial Liabilities*                                |       |                        |       |   |   |
| Demand  and savings deposits                           |       | 326,734                     |       | 326,734 |   |
| Time  deposits                                         |       | 191,487                     |       | 193,065 |   |
| Other  borrowings                                      |       | 15,826                      |       | 15,826 |   |
| Accrued  interest payable                              |       | 413                         |       | 413 |   |
|                                                        |            |                             |            |  |  |  |  |

 

**Note 13:  FAIR VALUE MEASUREMENTS**

 

FASB ASC 820 establishesa hierarchy that prioritizes the use of fair value inputs used in the valuationmethodologies into the following three levels:

 

Level 1 — Quoted pricesfor identical instruments in active markets that Bancorp has the ability toaccess at the measurement date.

 

Level 2 — Significantother observable inputs other than Level 1 prices such as quoted prices forsimilar instruments in active markets, quoted prices for identical or similarinstruments in markets that are not active, or other inputs that are observableor can be derived from or corroborated by observable market data by correlationor other means.

 

Level 3 — Significantunobservable inputs that reflect the Bancorp’s own assumption about theassumptions that market participants would use in pricing an asset orliability.

 

In general, Bancorpdetermines fair value based upon quoted prices when available or through theuse of alternative approaches, such as matrix or model pricing, when marketquotes are not readily accessible or available. The valuation techniques usedare based on observable and unobservable inputs.  Valuation adjustments may be made to ensurethat financial instruments are recorded at fair value.  While management believes Bancorp’s valuationmethodologies are appropriate and consistent with other market participants, theuse of different methodologies or assumptions used to determine the fair valueof certain financial instruments could result in a different estimate of fairvalue at the reporting date.

 

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** **

**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

 

The table below showsassets measured at fair value on a recurring basis as of September 30,2009.

 
| **(dollars  in thousands)****Description** | ** ** | **Total** | ** ** | **Quoted Prices   in Active   Markets for  Identical Assets****(Level  1)** | ** ** | **Significant   Other   Observable   Inputs****(Level  2)** | ** ** | **Significant   Unobservable   Inputs****(Level  3)** | ** ** |
|--------------------------------------------|------------|-----------|------------|-----------------------------------------------------------------------------|------------|-------------------------------------------------------------|------------|-------------------------------------------------------|------------|
| Available-for-sale  securities             |       | $         | 109,145    |                                                                        | $          | —                                                      |       | $                                                     | 109,145    |   | $ | — |   |
| Total                                      |       | $         | 109,145    |                                                                        | $          | —                                                      |       | $                                                     | 109,145    |   | $ | — |   |

 

Investment SecuritiesAvailable for Sale — Securities classified as available for sale are reportedat fair value utilizing Level 2 inputs. For these securities, Bancorp obtainsfair value measurements from an independent pricing service.  The fair value measurements includesconsiderable observable data that may include dealer quotes, market spreads,cash flows, the treasury yield curve, yield/spread relationships, consensusprepayment rates, and the bonds terms and conditions,  among other things.

 

The table below showsassets measured at fair value on a non-recurring basis as of September 30,2009.

 
| **(dollars in thousands)**

**Description** | ** ** | **Total** | ** ** | **Quoted Prices  in Active   Markets for   Identical Assets**

**(Level 1)** | ** ** | **Significant   Other   Observable   Inputs  (Level 2)** | ** ** | **Significant   Unobservable   Inputs  (Level 3)** | ** ** |
|---------------------------------------------|------------|-----------|------------|------------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|----------------------------------------------------|------------|
| Impaired  loans                             |       | $         | 12,049     |                                                                         | $          | —                                                   |       | $                                                  | —     |   | $ | 12,049 |   |
| Other  real estate owned                    |       | $         | 6,537      |                                                                         | $          | —                                                   |       | $                                                  | —     |   | $ | 6,537 |   |
| Total                                       |       | $         | 18,586     |                                                                         | $          | —                                                   |       | $                                                  | —     |   | $ | 18,586 |   |

 

Impaired Loans — Impairedloans are reported at the lower of the recorded amount of the loan or fairvalue of the underlying collateral, if the loan is collateral dependent.  Impaired loans with a carrying amount of$13.6 million were written down to their fair value to $12.0 million, resultingin a $1.6 million charge or reserve allocation to the allowance for loan lossesfor the nine months ended September 30, 2009.

 

Other Real Estate Owned —Other real estate owned includes properties acquired through foreclosure.  These properties are recorded at the lower ofthe recorded amount of the loan, or estimated fair value less estimated coststo sell based on periodic evaluations using Level 3 inputs.  Valuation of the property occurs when it isforeclosed upon and at least annually thereafter.  Write-downs arising from the acquisition ofproperty, in full or partial satisfaction of loans, are charged to theallowance for loan losses.  Subsequentwrite-downs after acquisition, identified through management’s periodic valuations,are written down through non-interest expenses. Other real estate owned with acarrying amount of $7.5 million, were written down to their fair value of $6.5million, resulting in write-downs of $914,000, which was charged againstearnings for the nine months ended September 30, 2009.

 

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

 

*The following discussion shouldbe read in conjunction with the consolidated financial statements and notesthereto presented elsewhere in this report. For additional information, refer to the financial statements andfootnotes for the year ended December 31, 2008 in the Annual Report on Form 10-K.*

 

**FORWARD LOOKING STATEMENTS**

** **

This Form 10-Q maycontain forward-looking statements within the meaning of the Private SecuritiesLitigation Reform Act of 1995.  Theseforward-looking statements include, but are not limited to, statements aboutmanagement’s plans, objectives, expectations and intentions that are nothistorical facts, and other statements 

 

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identified by words suchas “expects,” “anticipates,” “intends,” “plans,” “believes,” “should,” “projects,”“seeks,” “estimates” or words of similar meaning. These forward-lookingstatements are based on current beliefs and expectations of management and areinherently subject to significant business, economic and competitiveuncertainties and contingencies, many of which are beyond Bancorp’s control. Inaddition, these forward-looking statements are subject to assumptions withrespect to future business strategies and decisions that are subject to change.The following factors, among others, could cause actual results to differmaterially from the anticipated results or other expectations in theforward-looking statements, including those set forth in this Form 10-Q,or the documents incorporated by reference:

 
| · | the risks associated  with lending and potential adverse changes in credit quality;                                                                                                       |
|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| · | increased loan  delinquency rates;                                                                                                                                                        |
| · | the risks presented by  a continued economic slowdown, which could adversely affect credit quality,  loan collateral values, investment values, liquidity levels, and loan  originations; |
| · | changes in market  interest rates, which could adversely affect our net interest income and  profitability;                                                                               |
| · | legislative or  regulatory changes that adversely affect our business or our ability to  complete pending or prospective future acquisitions;                                             |
| · | reduced demand for  banking products and services;                                                                                                                                        |
| · | competition from other  financial services companies in our markets; and                                                                                                                  |
| · | Bancorp’s success in  managing risks involved in the foregoing.                                                                                                                      |

 

Additional factors thatcould cause actual results to differ materially from those expressed in theforward-looking statements are discussed in Risk Factors in Item 1A. Pleasetake into account that forward-looking statements speak only as of the date ofthis Form 10-Q or documents incorporated by reference. Bancorp does notundertake any obligation to publicly correct or update any forward-lookingstatement if we later become aware that it is not likely to be achieved.

 

**BUSINESS**

 

Skagit State Bancorp, Inc.is a bank holding company with one wholly owned subsidiary - Skagit State Bank(collectively, “Company” or “Bancorp”). Skagit State Bank began operations in 1958 and is headquartered inBurlington (Skagit County), Washington. The Bank provides a full range of banking services and products to bothbusinesses and individuals through 12 full service banking offices located inSkagit, Snohomish and Whatcom counties.

 

**OVERVIEW**

 

Net income was $301,000and $644,000 for the quarters ended September 30, 2009 and 2008 withdiluted earnings per share at $0.51 and $1.09, respectively. Net income was$2.4 million and $4.3 million for the nine months ended September 30, 2009and 2008 with diluted earnings per share at $4.04 and $6.89, respectively.  The decreases in net income were primarilyattributable to decreased net interest income, increased FDIC insurancepremiums and increased provisions for loan losses partially offset by decreasesin write-downs on other real estate owned.

 

Annualized return onaverage assets was 0.20 percent and 0.55 percent for the quarter and ninemonths ending September 30, 2009 compared to 0.45 percent and 0.99 percentduring the same time periods in 2008. Annualized return on average equity was 1.90 percent and 5.04 percentfor the quarter and nine months ending September 30, 2009 compared to 4.33percent and 8.87 percent, respectively, for the same time periods in 2008.

 

The provision for loanlosses was $1.3 million and $2.2 million for the quarter and nine months ended September 30,2009 compared to $760,000 for both periods in 2008. The increase in theprovision is primarily attributable to the deteriorating economy, internaldowngrades of credit within the loan portfolio and increased charge-offs.  The provisionsincreased Bancorp’s total allowance for loan losses to 1.54 percent of netloans at September 30, 2009 compared to 1.12 percent at September 30,2008.  For the quarter and ninemonths ended September 30, 2009, respectively, net charge-offs were $1.2 million and $1.9 million compared to $438,000 and$922,000 for the like periods in 2008.

 

Non-interest expense was$4.7 million and $14.2 million for the quarter and nine months ended September 30,2009 compared to $5.7 million and $13.9 million in the like periods in2008.  For the 2009 quarter compared tothe 2008 quarter, the decrease was attributable to an $828,000 decrease inwrite-downs of other real estate owned and a $161,000 decrease in salarieswhich was partially offset by a $202,000 increase in FDIC insurance premiums.  For the nine months ended September 30,2009, compared to the like period in 2008, the increase was attributable to a$211,000 increase in other costs related to other real estate owned and a$936,000 increase in FDIC insurance 

 

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premium assessmentsincluding a $260,000 special assessment which was partially offset by a$455,000 decrease in write-downs of other real estate owned and a $169,000decrease in salaries.

 

Total assets increased to$599.5 million at September 30, 2009, compared to $566.9 million at December 31,2008.  The increase was primarily due todeposit growth of $48.7 million.  Netloans decreased by $17.2 million or 4.4 percent to $376.6 million at September 30,2009, compared to $393.8 million at December 31, 2008.  This decrease was primarily in commercial andagricultural loans.

 

**RESULTS OF OPERATIONS**

 

Bancorp’s results ofoperations are dependent to a large degree on net interest income, operatingefficiency and the level of the provision for loan losses. Bancorp’s operationsare sensitive to interest rate changes and the resulting impact on net interestincome. In addition, changes in net interest income are influenced by thevolume of assets and liabilities and the rates earned and paidrespectively.  Bancorp generatesnon-interest income primarily through service charges and other deposit relatedfees. Bancorp’s non-interest expenses consist primarily of salaries andemployee benefits expense, bank premises and equipment expenses and otheroperating expenses.

 

**NET INTEREST INCOME  **Net interest income is Bancorp’s principal source ofrevenue and is comprised of interest income on earnings assets (loans andinvestment securities) less interest expense on interest-bearing liabilities(deposits and borrowings). Interest income and expense are affectedsignificantly by general economic conditions, particularly changes in marketinterest rates, and by government policies and the actions of regulatoryauthorities.

 

Net interest income was$5.3 million and $16.1 million for the quarter and nine months ended September 30,2009 compared to $5.7 million and $16.5 million for the like periods in2008.  The net interest margin is netinterest income expressed as a percent of average interest-earning assets. Netinterest margin is influenced by the level and relative mix of interest-earningassets and interest-bearing liabilities as well as levels of non-interestbearing liabilities.  For the quarterended September 30, 2009, the net interest margin decreased to 3.81percent from 4.29 percent for the like period in 2008.  For the nine months ended September 30,2009, the net interest margin decreased to 3.94 percent from 4.08 percent forthe like period in 2008.

 

*Interest-earning assets*

 

The largest component ofinterest income is interest earned on loans. Total interest income earned from loans was $5.8 million and $17.5million for the quarter and nine months ended September 30, 2009 comparedto $6.5 million and $19.2 for the like periods in 2008.  For the current quarter, this decrease wasprimarily a result of the current interest rate environment which decreased theloan yield from 6.82 percent to 6.06 percent. For the nine months ended September 30,2009, loan yields decreased to 6.06 percent from 7.00 percent compared to thelike period in 2008. This was partially offset by an $18.9 million increase inthe average loan balance.

 

Interest earned oninvestments, interest-bearing bank balances and federal funds sold decreased$172,000 and $1.3 million for the quarter and nine months ended September 30,2009 compared to the like periods in 2008. For the quarter ended September 30,2009, the decrease was attributable to a decrease in yield partially offset byan increase in average balances.  Thedecrease in the average yield resulted as Bancorp had a larger proportion ofsecurities invested in lower-yielding federal funds sold.  For the nine months ended September 30,2009, the decrease was the result of both decreases in yield and in averagebalances.

 

*Interest- bearing liabilities*

 

Interest expensedecreased to $1.8 million and $5.4 million from $2.3 million and $8.0 millionfor the quarter and nine months ended September 30, 2009 and 2008. Thesedecreases were a result of a 60 basis point and an 83 basis point decrease inthe cost of funds for the quarter and nine months ended September 30, 2009compared to 2008. The majority of our deposits are short term and re-pricewithin a twelve month period.

 

The following tablespresent information regarding average balances of assets and liabilities aswell 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. Tax exemptsecurities, included in investment securities below are stated at theircontractual interest rate.  Loan fees of$207,000 and $646,000 for the quarter and nine months ended September 30,2009, and $243,000 and $787,000 for the quarter and nine months

 

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ended September 30,2008, respectively, are included in interest earned on loans. Non-accruingloans have been included in the computation of average loans.

 

**Condensed Average Balance Sheets**

(dollars in thousandsexcept share data)

 
| ** **                                              | ** ** | **2009**    | ** ** | **2008**     | ** ** |
|---------------------------------------------------------|------------|-------------|------------|--------------|------------|
| ** **                                              | ** ** | **Average** | ** ** | ** **   | ** ** | **Yield** | ** ** | **Average** | ** ** | ** ** | ** ** | **Yield** | ** ** |
| **Three months ended Sept. 30,**                        | ** ** | **Balance** | ** ** | **Interest** | ** ** | **/Cost** | ** ** | **Balance** | ** ** | **Interest** | ** ** | **/Cost** | ** ** |
| **Assets**                                              |       |        |       |         |       |   |   |   |   |   |   |   |   |
| Federal funds sold and interest- bearing bank  balances |       | $           | 34,140     |         | $          | 22 |   | 0.26 | % | $ | 1,085 |   | $ | 12 |   | 4.40 | % |
| Taxable investment securities                           |       | 93,918      |       | 1,051        |       | 4.44 |   | 99,282 |   | 1,225 |   | 4.91 |   |
| Tax exempt securities                                   |       | 49,314      |       | 282          |       | 2.27 |   | 48,490 |   | 290 |   | 2.38 |   |
| Loans                                                   |       | 378,955     |       | 5,791        |       | 6.06 |   | 380,087 |   | 6,516 |   | 6.82 |   |
| Total interest-earning assets                           |       | 556,327     |       | 7,146        |       | 5.10 | % | 528,944 |   | 8,043 |   | 6.05 | % |
| Non-interest earning assets                             |       | 32,278      |       |         |       |   |   | 37,384 |   |   |   |   |   |
| Total assets                                            |       | $           | 588,605    |         |       |   |   |   | $ | 566,328 |   |   |   |   |   |
|                                                    |       |        |       |         |       |   |   |   |   |   |   |   |   |
| **Liabilities and Stockholders’  Equity**          |       |        |       |         |       |   |   |   |   |   |   |   |   |
| Interest-bearing demand                                 |       | $           | 89,187     |         | $          | 81 |   | 0.36 | % | $ | 87,414 |   | $ | 120 |   | 0.55 | % |
| Savings and money market                                |       | 165,315     |       | 405          |       | 0.97 |   | 149,802 |   | 523 |   | 1.39 |   |
| Certificates of deposit                                 |       | 188,232     |       | 1,250        |       | 2.63 |   | 170,368 |   | 1,570 |   | 3.67 |   |
| Total interest-bearing deposits                         |       | 442,734     |       | 1,736        |       | 1.56 |   | 407,584 |   | 2,213 |   | 2.16 |   |
| Other borrowings                                        |       | 16,117      |       | 70           |       | 1.72 |   | 24,324 |   | 131 |   | 2.14 |   |
| Total interest-bearing deposits & liabilities       |       | 458,851     |       | 1,806        |       | 1.56 | % | 431,908 |   | 2,344 |   | 2.16 | % |
| Non interest-bearing demand deposits                    |       | 64,353      |       |         |       |   |   | 72,464 |   |   |   |   |   |
| Other non-interest-bearing liabilities                  |       | 2,055       |       |         |       |   |   | 2,482 |   |   |   |   |   |
| Total liabilities                                       |       | 525,259     |       |         |       |   |   | 506,854 |   |   |   |   |   |
| Stockholders’ equity                               |       | 63,346      |       |         |       |   |   | 59,474 |   |   |   |   |   |
| Total liabilities and stockholders equity               |       | $           | 588,605    |         |       |   |   |   | $ | 566,328 |   |   |   |   |   |
| Net interest income                                     |       |        |       | $            | 5,340      |   |   |   |   |   | $ | 5,699 |   |   |   |
| Interest rate spread                                    |       |        |       |         |       | 3.53 | % |   |   |   |   | 3.89 | % |
| Net interest margin                                     |       |        |       |         |       | 3.81 | % |   |   |   |   | 4.29 | % |

 

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**Condensed Average Balance Sheets**

(dollars in thousandsexcept share data)

 
| ** **                                              | ** ** | **2009**    | ** ** | **2008**     | ** ** |
|---------------------------------------------------------|------------|-------------|------------|--------------|------------|
| ** **                                              | ** ** | **Average** | ** ** | ** **   | ** ** | **Yield** | ** ** | **Average** | ** ** | ** ** | ** ** | **Yield** | ** ** |
| **Nine months ended Sept. 30,**                         | ** ** | **Balance** | ** ** | **Interest** | ** ** | **/Cost** | ** ** | **Balance** | ** ** | **Interest** | ** ** | **/Cost** | ** ** |
| **Assets**                                              |       |        |       |         |       |   |   |   |   |   |   |   |   |
| Federal funds sold and interest- bearing bank  balances |       | $           | 20,798     |         | $          | 34 |   | 0.22 | % | $ | 13,476 |   | $ | 285 |   | 2.82 | % |
| Taxable investment securities                           |       | 90,765      |       | 3,165        |       | 4.66 |   | 110,224 |   | 4,094 |   | 4.96 |   |
| Tax exempt securities                                   |       | 48,499      |       | 844          |       | 2.33 |   | 49,775 |   | 924 |   | 2.48 |   |
| Loans                                                   |       | 385,071     |       | 17,458       |       | 6.06 |   | 366,155 |   | 19,187 |   | 7.00 |   |
| Total interest-earning assets                           |       | 545,133     |       | 21,501       |       | 5.27 | % | 539,630 |   | 24,490 |   | 6.06 | % |
| Non-interest earning assets                             |       | 32,525      |       |         |       |   |   | 36,168 |   |   |   |   |   |
| Total assets                                            |       | $           | 577,658    |         |       |   |   |   | $ | 575,798 |   |   |   |   |   |
|                                                    |       |        |       |         |       |   |   |   |   |   |   |   |   |
| **Liabilities and Stockholders’  Equity**          |       |        |       |         |       |   |   |   |   |   |   |   |   |
| Interest-bearing demand                                 |       | $           | 88,327     |         | $          | 230 |   | 0.35 | % | $ | 89,157 |   | $ | 373 |   | 0.56 | % |
| Savings and money market                                |       | 161,385     |       | 1,193        |       | 0.99 |   | 147,282 |   | 1,561 |   | 1.42 |   |
| Certificates of deposit                                 |       | 176,718     |       | 3,790        |       | 2.87 |   | 179,971 |   | 5,702 |   | 4.23 |   |
| Total interest-bearing deposits                         |       | 426,430     |       | 5,213        |       | 1.63 |   | 416,410 |   | 7,636 |   | 2.46 |   |
| Other borrowings                                        |       | 18,562      |       | 223          |       | 1.61 |   | 19,769 |   | 384 |   | 2.59 |   |
| Total interest-bearing deposits & liabilities       |       | 444,992     |       | 5,436        |       | 1.63 | % | 436,179 |   | 8,020 |   | 2.46 | % |
| Non interest-bearing demand deposits                    |       | 67,476      |       |         |       |   |   | 72,775 |   |   |   |   |   |
| Other non-interest-bearing liabilities                  |       | 2,042       |       |         |       |   |   | 2,888 |   |   |   |   |   |
| Total liabilities                                       |       | 514,510     |       |         |       |   |   | 511,842 |   |   |   |   |   |
| Stockholders’ equity                               |       | 63,148      |       |         |       |   |   | 63,956 |   |   |   |   |   |
| Total liabilities and stockholders equity               |       | $           | 577,658    |         |       |   |   |   | $ | 575,798 |   |   |   |   |   |
| Net interest income                                     |       |        |       | $            | 16,065     |   |   |   |   |   | $ | 16,470 |   |   |   |
| Interest rate spread                                    |       |        |       |         |       | 3.64 | % |   |   |   |   | 3.61 | % |
| Net interest margin                                     |       |        |       |         |       | 3.94 | % |   |   |   |   | 4.08 | % |

 

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The following table setsforth information on changes in net interest income which are attributable tochanges in interest rates and changes in volume for the periods indicated.  Changes attributable to the combined effectof volume and interest rates have been allocated proportionately.

 

**Analysis of Changes in InterestIncome and Expense Due to Changes in Volume and Rate**

 
| ** **                                                   | ** ** | **Three months ended Sept. 30,** | ** ** | **Nine months ended Sept. 30,** | ** ** |
|--------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                   | ** ** | **2009 vs. 2008**                | ** ** | **2009 vs. 2008**               | ** ** |
| ** **                                                   | ** ** | **Increase (Decrease) Due to**   | ** ** | **Increase (Decrease) Due to**  | ** ** |
| **(dollars in thousands except  per share amounts)**         | ** ** | **Rate**                         | ** ** | **Volume**                      | ** ** | **Total** | ** ** | **Rate** | ** ** | **Volume** | ** ** | **Total** | ** ** |
| **Interest-Earning Assets**                                  | ** ** | ** **                       | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Federal funds sold and interest- bearing bank  balances      |       | $                                | (87        | )                               | $          | 97 |   | $ | 10 |   | $ | (418 | ) | $ | 167 |   | $ | (251 | ) |
| Investment securities                                        |       | (146                             | )          | (36                             | )          | (182 | ) | (294 | ) | (715 | ) | (1,009 | ) |
| Loans                                                        |       | (706                             | )          | (19                             | )          | (725 | ) | (3,159 | ) | 1,430 |   | (1,729 | ) |
| Total net change in income on Interest-earning  assets       |       | (939                             | )          | 42                              |       | (897 | ) | (3,871 | ) | 882 |   | (2,989 | ) |
| **Interest-Bearing Liabilities**                             |       |                             |       |                            |       |   |   |   |   |   |   |   |   |
| Deposits                                                     |       | (1,161                           | )          | 684                             |       | (477 | ) | (2,455 | ) | 32 |   | (2,423 | ) |
| Other borrowings                                             |       | (22                              | )          | (39                             | )          | (61 | ) | (139 | ) | (22 | ) | (161 | ) |
| Total net change in expense on Interest-bearing  liabilities |       | (1,183                           | )          | 645                             |       | (538 | ) | (2,594 | ) | 10 |   | (2,584 | ) |
| Net change in net interest income                            |       | $                                | 244        |                            | $          | (603 | ) | $ | (359 | ) | $ | (1,277 | ) | $ | 872 |   | $ | (405 | ) |

 

***PROVISIONFOR LOAN LOSSES*****        **The provision for loan losses was $1.3million and $2.2 million for the quarter and nine months ended September 30,2009 compared to $760,000 for loan losses for both periods in 2008. Theincrease in provision is primarily attributable to the deteriorating economy,internal downgrades of credit within the loan portfolio and increasedcharge-offs.

 

For the quarter and ninemonths ended September 30, 2009, net charge-offs were $1.2 million and $1.9 million compared to $438,000 and$922,000 for the like periods in 2008. For the nine months ended, September 30, 2009, netcharge-offs were comprised of $1.2 million charge-offs on construction and landdevelopment projects, $235,000 on commercial and industrial loans, and $227,000on loans to individuals.  Charge-offs on4 credit relationships accounted for 63 percent of charge-offs for the ninemonths ended September 30, 2009.

 

The provision for loanlosses is highly dependent upon Bancorp’s ability to manage asset quality andcontrol the level of net charge-offs through prudent underwriting standards. Inthe future, continued growth of the loan portfolio may or further declines ineconomic conditions and real estate values could increase future provisions forloan losses and impact Bancorp’s net income. Additional discussion on loanquality and the allowance for loan losses is provided under Allowance for LoanLosses and Asset Quality.

 

**NON-INTEREST INCOME               **Non-interest income, which consists primarily of feesand service charges on deposits and other income, was $1.0 million and $3.0million for the quarter and nine months ended September 30, 2009 comparedto $1.3 million and $3.3 million for the same time periods in 2008. Thedecreases were primarily attributable to a gain on the sale of bank ownedproperty recognized in the third quarter of 2008.

 

**NON-INTEREST EXPENSE             **Non-interest expense was $4.7 million and $14.2million for the quarter and nine months ended September 30, 2009 comparedto $5.7 million and $13.9 million in the like periods in 2008.  For the 2009 quarter, the decrease wasattributable to an $828,000 decrease in write-downs of other real estate ownedand a $161,000 decrease in salaries which was partially offset by a $202,000 increasein FDIC insurance premiums.

 

For the nine months endedSeptember 30, 2009, the increase was attributable to a $211,000 increasein other costs related to other real estate owned and a $936,000 increase inFDIC insurance premium assessments including a $260,000 special assessmentwhich was partially offset by a $455,000 decrease in write-downs of other realestate 

 

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owned and a $169,000decrease in salaries. Increased FDIC insurance premium assessments are theresult of losses incurred by the Deposit Insurance Fund and not directlycorrelated to Bancorp’s performance.

 

The efficiency ratio iscomputed by dividing total operating expenses by non-interest income and netinterest income before provision for loan losses.  An increase in the efficiency ratio indicatesthat more resources are being utilized to generate the same or greater volumeof income. The efficiency ratio for the quarter and nine months ended September 30,2009 was 74.1 percent and 74.4 percent compared to 81.1 percent and 70.1percent for the same time periods in 2008.

 

**INCOME TAX EXPENSE        **Income tax expense for the quarter andnine months ended September 30, 2009 was $30,000 and $280,000 compared toan $83,000 benefit and $911,000 expense for the quarter and nine months ended September 30,2008, respectively. Bancorp’s effective tax rates were 10.5 percent and 17.6percent for the nine months ended September 30, 2009 and 2008,respectively. The effective tax rate is lower than the federal statutory ratedue to tax credits from tax-exempt bonds and tax-exempt interest from municipalbonds and loans.  As of September 30,2009, Bancorp had $51.2 million in tax-exempt securities compared to $48.4million as of September 30, 2008.

 

**REVIEW OF FINANCIAL CONDITION**

 

Total assets increased to$599.5 million at September 30, 2009 compared to $566.9 million at December 31,2008.  This increase was primarily due toa $48.7 million increase in deposits to $518.2 million. Net loans decreased$17.2 million to $376.6 million during the same time period.

 

**INVESTMENT SECURITIES,INTEREST-BEARING BANK BALANCES AND FEDERAL FUNDS SOLD     **Total investment securities, includingfederal funds sold and interest-bearing bank balances increased to $190.3million at September 30, 2009 compared to $139.2 million at December 31,2008. Interest-bearing account balances at the Federal Reserve increased to$41.1 million at September 30, 2009. This increase resulted primarily fromthe growth in deposits.

 

The available-for-saleinvestment portfolio is comprised of 56.9 percent Government Sponsored Agenciesand Government Agencies mortgage-backed pass-through securities, 10.2 percentof state and municipals and 32.9 percent of Government Sponsored Agencies andGovernment Agencies securities.  Theheld-to-maturity portfolio is concentrated in municipal securities andQualified Zone Academy Bonds. Security purchases for the quarter and ninemonths ended September 30, 2009, respectively, were $24.5 million and$36.0 million.  Security maturities,calls, and pay-downs were $11.4 million and $26.7 million for the quarter andnine months ended September 30, 2009, respectively.

 

The amortized cost andestimated fair value of investment securities at September 30, 2009, bycontractual maturity, are show in the following table.  Actual maturities may differ from contractualmaturities because issuers may have the right to call or prepay obligationswith or without call or prepayments penalties. Mortgage-backed securities are not all due at a single maturity date,therefore, they are disclosed separately.

 
| ** **                   | ** ** | **Available-For-Sale** | ** ** | **Held-To-Maturity** | ** ** |
|------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                   | ** ** | **Amortized**          | ** ** | **Estimated**        | ** ** | **Amortized** | ** ** | **Estimated** | ** ** |
| **(dollars in thousands)**   | ** ** | **Cost**               | ** ** | **Fair Value**       | ** ** | **Cost** | ** ** | **Fair Value** | ** ** |
| 0-1  year                    |       | $                      | 3,702      |                 | $          | 3,791 |   | $ | 4,081 |   | $ | 4,103 |   |
| 1-5  years                   |       | 24,814                 |       | 25,298               |       | 14,646 |   | 15,033 |   |
| 5-10  years                  |       | 15,832                 |       | 16,047               |       | 9,115 |   | 9,161 |   |
| Over  10 years               |       | 1,904                  |       | 1,939                |       | 12,169 |   | 12,272 |   |
| Mortgage-backed  securities  |       | 58,870                 |       | 62,070               |       | — |   | — |   |
| Total  investment securities |       | $                      | 105,122    |                 | $          | 109,145 |   | $ | 40,011 |   | $ | 40,569 |   |

 

**LOANS        **Net loans decreased 4.4 percent to $376.6million at September 30, 2009 compared to $393.8 million at December 31,2008.  This decrease was primarily incommercial and agricultural loans. Net loans represented 62.8 percent of totalassets at September 30, 2009.

 

Bancorp concentrates onfive areas of lending: loans to individuals for business purposes, loans forsmall and medium-sized businesses, agricultural loans, loans to commercialenterprises for real estate transactions and consumer purpose loans.  Bancorp’s primary lending activities includecommercial real estate loans, commercial 

 

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loans which includeagriculture production loans and consumer purpose loans. Most of Bancorp’sbusiness activity is with customers located within Skagit, Snohomish andWhatcom Counties. Bancorp originates commercial, real estate and consumerloans.

 

*Real Estate Loans:* Real estate loans comprise the largestcategory of loans and our real estate portfolio consists of commercial andresidential loans which are secured by property such as office buildings,retail buildings, owner occupied commercial business properties, farm land,timber land, residential land development properties and residentialproperties.  Real estate loanscompromised 69.1% of total loans at September 30, 2009.  The primary repayment source of thesespecific loan types are from the cash flows generated by the occupant business,occupant farm operation, or the sale of properties. While Bancorp hassignificant balances secured by real estate, Bancorp believes that its lendingpolicies and concentration policies are sufficient to minimize risks.  However, economic conditions may affect aborrower’s ability to meet the stated repayment terms. Bancorp is committed toproviding competitive commercial real estate lending within our primary marketareas.

 

*Commercial Loans*: Commercial loans, secured andunsecured, are made primarily to small and medium-sized businesses includingfarms operating within Skagit, Snohomish and Whatcom Counties.  These loans are available for generaloperating purposes, acquisition of fixed assets, purchases of equipment andmachinery, financing of inventory and accounts receivable, and other businesspurposes.  Bancorp originates Small BusinessAdministration (SBA) loans, including 504 and 7A loans.

 

*Consumer Loans:* Bancorp makes secured and unsecured consumerloans including loans to individuals, primarily customers of Bancorp, forvarious purposes, including home equity loans, purchases of automobiles, mobilehomes, boats and other recreational vehicles, home improvement loans and loansfor education and personal investments.

 

The followingtable presents the composition of loans for Bancorp as of the dates indicated.

 

**Loan Composition**

 
| ** **                                            | ** ** | **September 30, 2009** | ** ** | **December 31, 2008** | ** ** |
|-------------------------------------------------------|------------|-----------------------------|------------|----------------------------|------------|
| **(dollars in thousands)**                            | ** ** | **Amount**                  | ** ** | **%**                      | ** ** | **Amount** | ** ** | **%** | ** ** |
| Real  estate – residential & commercial |       | $                           | 250,877    |                       | 65.4       | % | $ | 258,958 |   | 64.7 | % |
| Real  estate construction                             |       | 14,203                      |       | 3.7                        | %          | 17,470 |   | 4.4 | % |
| Commercial,  industrial & agricultural       |       | 62,785                      |       | 16.4                       | %          | 79,819 |   | 19.9 | % |
| Consumer                                              |       | 55,603                      |       | 14.5                       | %          | 44,224 |   | 11.0 | % |
| Total  loans                                          |       | 383,468                     |       | 100                        | %          | 400,471 |   | 100 | % |
| Less:                                                 |       |                        |       |                       |       |   |   |   |   |
| Allowance  for loan losses                            |       | 5,798                       |       |                       |       | 5,450 |   |   |   |
| Deferred  loan fees                                   |       | 1,067                       |       |                       |       | 1,246 |   |   |   |
| Net  loans                                            |       | $                           | 376,603    |                       |       |   | $ | 393,775 |   |   |   |

 

*Concentrations*

 

As shown in the tableabove, a concentration of loans in commercial and residential real estateexisted as of September 30, 2009.  At September 30, 2009,Bancorp’s real estate portfolio included $162.3 million in non-farmnon-residential real estate loans of which $97.4 million is owner occupied,$51.7 million in raw land, land development and construction loans and $57.7million in one-to-four family residential loans.  Further declines in theperformance of the economy, in general, or further declines in real estate valuesin our market areas, in particular, could have an adverse impact oncollectability, increase the level of non-performing loans or have otheradverse effects which alone or in aggregate could have a material adverseeffect on our business, financial condition, results of operation and cashflows.

 

**ALLOWANCE FOR LOAN LOSSES**             Theallowance for loan losses was $5.8 million or 1.54 percent of net loans as of September 30,2009 compared to $5.5 million or 1.38 percent of net loans as of December 31,2008. Additions to the allowance, in the form of provisions, are reflected incurrent operating results, while charge-offs to the allowance are made when aloss is determined to have occurred.

 

The allowance for loanlosses represents management’s best estimate and is maintained at a leveldeemed adequate to provide for estimated future losses and is evaluated on aregular basis and reviewed by the Board of Directors. Bancorp’s evaluation ofthe allowance for loan losses is inherently subjective as it requires estimatesthat are susceptible to significant revision as more information becomesavailable.  The allowance is based uponBancorp’s 

 

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evaluation of thepertinent factors underlying the quality and composition of the loan portfolio,levels and trends in losses and delinquencies, current economic conditions,specific industry conditions and estimated value of any underlying collateral.The allowance consists of specific, general and unallocated components.

 

·                  A specific allowance is calculated based on a reviewof classified or non-performing loans for specific weaknesses and evaluation ofthose loans for impairment and loss exposure.

 

·                  The general allowance is calculated by applying a losspercentage factor to the different loan types and the different risk gradings.The methodology is based on historical loss experience by type of loan withadjustments for current events and conditions. Bancorp’s process is designed to account for credit deterioration as itoccurs.  The adjustments are a result ofmanagement’s judgment about risks inherent in the portfolio and include suchfactors as  loan quality trends, levelsof and trends of non-accrual loans, past due loans, potential problem loans,criticized loan balances, net charge-offs and current economic and businessconditions, among other factors.

 

·                  The unallocated component of the allowance reflectsthe margin of imprecision inherent in the underlying assumptions used in themethodologies for estimated specific and general losses in the loan portfolio.The unallocated allowance provides for other credit losses inherent in the loanportfolio that may not have been contemplated in the general and specificcomponents of the allowance. The unallocated amount is reviewed periodicallybased on trends in credit losses, the results of credit reviews and overalleconomic trends.

 

While Bancorp believesthat it uses the best information available to determine the allowance for loanlosses, unforeseen market conditions could result in adjustments to theallowance for loan losses, and net income could be significantly affected ifcircumstances differ substantially from the assumptions used in making thefinal determination.  The growth of theloan portfolio and a further decline in the performance of the economy, ingeneral, or a further decline in real estate values in our market areas, inparticular, could have an adverse impact on collectability, increase the levelof non-performing loans or have other adverse effects which alone or inaggregate could have a material adverse effect on our business, financialcondition, results of operation and cash flows which may require additionalprovisions to our allowance for loan losses. The ultimate recovery of loans issusceptible to future market factors beyond Bancorp’s control. Additionally,loans are subject to examinations by regulators, who, based upon theirjudgment, may require Bancorp to make additional provisions or adjustments toits allowance for loan losses.

 

The following tablepresents Bancorp’s allocation of the allowance for loan losses by loan categoryas of the dates indicated.  (dollars inthousands)

 
| ** **                                      | ** ** | **September 30, 2009** | ** ** | **December 31, 2008** | ** ** | **September 30, 2008** | ** ** |
|-------------------------------------------------|------------|-----------------------------|------------|----------------------------|------------|-----------------------------|------------|
| Commercial,  industrial & agricultural |       | $                           | 1,286      |                       | $          | 1,682                       |       | $ | 904 |   |
| Real  estate-residential & commercial  |       | 3,209                       |       | 2,656                      |       | 2,342                       |       |
| Consumer                                        |       | 642                         |       | 395                        |       | 375                         |       |
| Unallocated                                     |       | 661                         |       | 717                        |       | 752                         |       |
| Total                                           |       | $                           | 5,798      |                       | $          | 5,450                       |       | $ | 4,373 |   |

 

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The following tablepresents the activity in the allowance for loan losses for the dates indicated.

 

**Allowance for Loan LossesActivity**

** **
| ** **                                                   | ** ** | **Three months ended,** | ** ** | **Nine months ended,** | ** ** |
|--------------------------------------------------------------|------------|-------------------------|------------|------------------------|------------|
| **(dollars in thousands)**                                   | ** ** | **2009**                | ** ** | **2008**               | ** ** | **2009** | ** ** | **2008** | ** ** |
| Allowance  as of beginning of period                         |       | $                       | 5,629      |                   | $          | 4,051 |   | $ | 5,450 |   | $ | 4,535 |   |
| Provision  for loan losses                                   |       | 1,320                   |       | 760                    |       | 2,220 |   | 760 |   |
| Charge-offs                                                  |       | (1,221                  | )          | (465                   | )          | (2,031 | ) | (1,099 | ) |
| Recoveries                                                   |       | 70                      |       | 27                     |       | 159 |   | 177 |   |
| Net  charge-offs                                             |       | (1,151                  | )          | (438                   | )          | (1,872 | ) | (922 | ) |
| Balance  at end of period                                    |       | $                       | 5,798      |                   | $          | 4,373 |   | $ | 5,798 |   | $ | 4,373 |   |
| Ratio  of net charge-offs to average loans during the period |       | (1.22                   | )%         | (0.46                  | )%         | (0.65 | )% | (0.34 | )% |
| Ratio  of allowance to net loans at end of period            |       | 1.54                    | %          | 1.12                   | %          | 1.54 | % | 1.12 | % |
| Ratio  of non-performing loans to allowance                  |       | 184.58                  | %          | 14.43                  | %          | 184.58 | % | 14.43 | % |

 

*Credit Risk Management*

 

The extension of creditto individuals and businesses is a significant portion of Bancorp’s principalbusiness activity and requires ongoing portfolio and credit management.  Bancorp has established lending policies andprocedures to manage and monitor risk. These lending policies and proceduresinclude guidelines for concentrations of credit, loan terms, loan-to-valueratios, collateral appraisals and loan approval limits. In addition, Bancorpmonitors its loan portfolio for potential risk of loss according to an internalrisk-grading system and monitors its credit quality to identify potentialproblem credits and any loss exposure in a timely manner.  Bancorp has assessed and will continue toassess on an on-going basis, the impact of the economy on the credit risk inthe loan portfolio.

 

***ASSETQUALITY*****    **Non-performing assets consist ofnonaccrual loans, accruing loans past due 90 days or more, restructured loansand other real estate owned. At September 30, 2009, non-performing assetsincreased to $17.2 million or 2.88 percent of total assets compared to $11.1 millionor 1.96 percent as of December 31, 2008.

 

*Non-accrualand other problem loans* - Bancorp’s policy is to discontinue the accrual of interest on allloans that are 90 days or more past due and place them on non-accrual.  When a loan is placed on non-accrual status,any accrued but unpaid interest on that date is removed from interest income.Non-accruing loans increased to $10.7 million as of September 30, 2009compared to $5.5 million as of December 31, 2008 with $1.4 million of the December balancetransferring into other real estate owned during 2009.  In addition, $5.8 million, representing 4loan credit relationships, were put on non-accrual status during 2009.   Raw land, construction, and land developmentloans are the primary components of non-performing loans representing $6.2million or 58% of non-performing loans as of September 30, 2009.

 

*Potential problem loans* —  Potential problem loans consist of loans that are currently performing,and not impaired, but for which management have identified as having a welldefined weakness or weaknesses. These weaknesses may jeopardize the liquidationof the loan and are characterized by the distinct possibility that Bancorp maysustain some loss if the deficiencies creating the weaknesses are not corrected.These loans are identified through our internal risk grading processes andmanagement monitors these loans closely and reviews their performance on aregular basis.  As of September 30, 2009, Bancorp had classified $11.7million as other potential problem loans.

 

*Other real estate owned* —  Other real estate owned increased to $6.5 million at September 30,2009 from $5.7 million at December 31, 2008.  During 2009, Bancorp foreclosed on twonon-accrual credit relationships of $1.4 million. In addition, Bancorptransferred the former Boulevard branch to other real estate owned.  As of September 30, 2009, Bancorp heldseven properties which represent four separate land development projectsconsisting of finished lots with a carrying balance of $4.9 million, twocommercial real estate property with a carrying balance of $1.5 million, and a$169,000 raw land property.  To preparecertain properties for sell, the Bank capitalized $136,000 in propertyimprovements during the nine months ended September 30, 2009.

 

Valuation of the propertyoccurs when it is foreclosed upon and at least annually thereafter. For thequarter ended September 30, 2009, based on updated appraisals received on3 land development projects, Bancorp recorded a write-down on other real estateowned of $541,000.  For the nine months,total write-downs were $914,000 for 4 land development projects. Bancorp plansto continue its collection efforts and liquidation of collateral, as necessary,to recover as large a portion of the non-accrual assets or other real estateowned as possible.

 

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The following tablepresents non-performing asset information related to loans accounted for on anon-accrual basis, accruing loans 90 days or more past due and other realestate owned for the dates indicated.

 

**Non-Performing Assets**

** **
| **(dollars in thousands)**                   | ** ** | **September 30, 2009** | ** ** | **December 31, 2008** | ** ** |
|----------------------------------------------|------------|-----------------------------|------------|----------------------------|------------|
| Non-accrual  loans                           |       | $                           | 10,697     |                       | $          | 5,456 |   |
| Loans  past due 90 days or more              |       | 5                           |       | —                     |       |
| Restructered  Loans                          |       | —                      |       | —                     |       |
| Total  non-performing loans                  |       | 10,702                      |       | 5,456                      |       |
| Other  real estate owned                     |       | 6,537                       |       | 5,667                      |       |
| Total  non-performing assets                 |       | $                           | 17,239     |                       | $          | 11,123 |   |
| Total  non-performing loans to net loans     |       | 2.84                        | %          | 1.39                       | %          |
| Total  non-performing loans to total assets  |       | 1.79                        | %          | 0.96                       | %          |
| Total  non-performing assets to total assets |       | 2.88                        | %          | 1.96                       | %          |

 

**DEPOSITS**                                  Bancorp offers a full range of depositservices including checking accounts, savings accounts, money market accountsand various types of certificates of deposit. The transaction accounts and certificates of deposit are tailored toBancorp’s primary market area at rates competitive with those offered in thearea. Bancorp offers both interest and non-interest bearing checking accounts.In December 2008, Bancorp initiated service through the Certificate ofDeposit Account Registry Service (CDARS), which allows us to assist customersin maximizing their FDIC insurance.

 

Total deposits increasedto $518.2 million at September 30, 2009 compared to $469.5 million at December 31,2008.  Within the total, core depositsincreased $18.3 million and time deposits increased $30.4 million.  Core deposits, which consist of non-interestand interest bearing demand accounts, money market accounts, and savingaccounts, represented 63.0% and 65.6% of total deposits at September 30,2009 and December 31, 2008, respectively.

 

The following tablepresents the balance and percent of total deposits in the various categories ofdeposits offered by Bancorp as of the dates indicated.

 

**Deposit Composition**

** **
| ** **                   | ** ** | **September 30, 2009** | ** ** | **December 31, 2008** | ** ** |
|------------------------------|------------|-----------------------------|------------|----------------------------|------------|
| **(dollars in thousands)**   | ** ** | **Amount**                  | ** ** | **% of Total**             | ** ** | **Amount** | ** ** | **% of Total** | ** ** |
| Non-interest  bearing demand |       | $                           | 64,004     |                       | 12.4       | % | $ | 75,116 |   | 16.0 | % |
| Interest  bearing demand     |       | 94,518                      |       | 18.2                       | %          | 87,091 |   | 18.5 | % |
| Money  market                |       | 83,114                      |       | 16.0                       | %          | 69,548 |   | 14.8 | % |
| Savings                      |       | 85,098                      |       | 16.4                       | %          | 76,646 |   | 16.3 | % |
| Time                         |       | 179,430                     |       | 34.6                       | %          | 157,127 |   | 33.5 | % |
| Brokered  time deposits      |       | 12,057                      |       | 2.4                        | %          | 4,010 |   | 0.9 | % |
| Total  deposits              |       | $                           | 518,221    |                       | 100.0      | % | $ | 469,538 |   | 100.0 | % |

** **

**OTHER BORROWINGS **Borrowings consist of federal funds purchased whichinclude discount window borrowings from the Federal Reserve Bank of SanFrancisco and securities sold under agreements to repurchase.  Total borrowings decreased to $15.8 millionat September 30, 2009 compared to $32.7 million as of December 31,2008.  Bancorp’s deposit growth duringthe 2009 year contributed to the $16.9 million reduction in Federal Fundspurchased to zero as of September 30, 2009.

 

Both securities soldunder repurchase and federal funds purchased are overnight funds or borrowingsthat typically mature within one year. Securities sold under agreement torepurchase decrease or increase primarily based on the availability of fundsand current competitive interest rates offered. Securities sold under agreement to repurchase are collateralized bysecurities with an estimated fair value exceeding the face value of theborrowings.

 

**CAPITAL RESOURCES**           Stockholders’ equity increased to $63.4 million at September 30,2009 from $61.8 million at December 31, 2008.  Book value per share at September 30,2009 was $108.05 compared to a book value of $105.41 at December 31, 2008.

 

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Bancorp has only oneclass of stock, which is common stock and at September 30, 2009, therewere 766 shareholders of record.  Bancorp’sstock is not actively traded or quoted and no broker currently makes a marketin the stock. However, sales and transfers of the stock do occur.  Skagit State Bank acts as transfer agent forBancorp stock.  To facilitate trading,the Bank maintains a list of persons interested (known to the Bank) in eitherpurchasing or selling Bancorp stock. Purchasers and sellers then negotiate their own transactions with theBank acting as transfer agent for those transactions. From time to time,Bancorp repurchases shares of its common stock. The number of shares of stockthat will be repurchased and the price that will be paid is the result of manyfactors including market and economic conditions, the number of sharesavailable, Bancorp’s liquidity and capital needs and regulatory requirements.For the three and nine months ended September 30, 2009, Bancorprepurchased no shares of stock.

 

On October 3,2008, Congress approved and the President signed the Emergency EconomicStabilization Act of 2008 (the “Act”). The Troubled Assets Relief Program (“TARP”) is the heart of the Act andprovides the Secretary of the Treasury the authority to purchase troubledassets from eligible financial institutions in an aggregate amount of up to$700 billion.  Under the Act, theTreasury created the Capital Purchase Program (“CPP”) that enables the federalgovernment to purchase equity in participating financial institutions to helprestore credit markets.  In November 2008,Bancorp applied to participate under this program.  In January 2009, Bancorp receivedpreliminary approval from the U.S. Department of Treasury for approximately $14million under the program.  After carefulconsideration by Executive Management and our Board of Directors, we determinednot to accept any of the TARP proceeds. In reaching this decision, the Board also considered the uncertaintiesand constraints (including dividend and stock repurchase restrictions)associated with the TARP.

 

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Banking regulationsrequire bank holding companies and banks to maintain certain minimum capital levels.  As the following table indicates as of September 30,2009 and December 31, 2008, Skagit State Bancorp, Inc. and SkagitState Bank both exceeded the well-capitalized requirements.

 
| ** **                                  | ** ** | **Actual** | ** ** | **For Capital  Adequacy Purposes** | ** ** | **To Be Well  Capitalized Under  Prompt Corrective  Action Provisions** | ** ** |
|---------------------------------------------|------------|------------|------------|------------------------------------|------------|-------------------------------------------------------------------------|------------|
| **(dollars in thousands)**                  | ** ** | **Amount** | ** ** | **Ratio**                          | ** ** | **Amount**                                                              | ** ** | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
| As  of September 30, 2009              |       |       |       |                               |       |                                                                    |       |   |   |   |   |   |   |
| Total  Capital  (to Risk-Weighted Assets)   |       |       |       |                               |       |                                                                    |       |   |   |   |   |   |   |
| Skagit  State Bank                          |       | $          | 66,162     |                               | 14.79      | %                                                                       | $          | 35,777 |   | > 8.00 | % | $ | 44,721 |   | >10.00 | % |
| Skagit  State Bancorp, Inc.            |       | $          | 66,330     |                               | 14.83      | %                                                                       | $          | 35,790 |   | > 8.00 | % | $ | 44,738 |   | >10.00 | % |
| Tier  I Capital   (to Risk-Weighted Assets) |       |       |       |                               |       |                                                                    |       |   |   |   |   |   |   |
| Skagit  State Bank                          |       | $          | 60,569     |                               | 13.54      | %                                                                       | $          | 17,888 |   | > 4.00 | % | $ | 26,833 |   | >   6.00 | % |
| Skagit  State Bancorp, Inc.            |       | $          | 60,735     |                               | 13.58      | %                                                                       | $          | 17,895 |   | > 4.00 | % | $ | 26,843 |   | >   6.00 | % |
| Tier  I Capital   (to Average Assets)       |       |       |       |                               |       |                                                                    |       |   |   |   |   |   |   |
| Skagit  State Bank                          |       | $          | 60,569     |                               | 10.30      | %                                                                       | $          | 23,524 |   | > 4.00 | % | $ | 29,404 |   | >   5.00 | % |
| Skagit  State Bancorp, Inc.            |       | $          | 60,735     |                               | 10.33      | %                                                                       | $          | 23,524 |   | > 4.00 | % | $ | 29,404 |   | >   5.00 | % |
|                                        |       |       |       |                               |       |                                                                    |       |   |   |   |   |   |   |
| As  of December 31, 2008               |       |       |       |                               |       |                                                                    |       |   |   |   |   |   |   |
| Total  Capital   (to Risk-Weighted Assets)  |       |       |       |                               |       |                                                                    |       |   |   |   |   |   |   |
| Skagit  State Bank                          |       | $          | 64,776     |                               | 14.04      | %                                                                       | $          | 36,901 |   | > 8.00 | % | $ | 46,127 |   | >10.00 | % |
| Skagit  State Bancorp, Inc.            |       | $          | 64,926     |                               | 14.07      | %                                                                       | $          | 36,913 |   | > 8.00 | % | $ | 46,141 |   | >10.00 | % |
| Tier  I Capital   (to Risk-Weighted Assets) |       |       |       |                               |       |                                                                    |       |   |   |   |   |   |   |
| Skagit  State Bank                          |       | $          | 59,326     |                               | 12.86      | %                                                                       | $          | 18,451 |   | > 4.00 | % | $ | 27,676 |   | >   6.00 | % |
| Skagit  State Bancorp, Inc.            |       | $          | 59,476     |                               | 12.89      | %                                                                       | $          | 18,456 |   | > 4.00 | % | $ | 27,684 |   | >   6.00 | % |
| Tier  I Capital   (to Average Assets)       |       |       |       |                               |       |                                                                    |       |   |   |   |   |   |   |
| Skagit  State Bank                          |       | $          | 59,326     |                               | 10.50      | %                                                                       | $          | 22,596 |   | > 4.00 | % | $ | 28,245 |   | >   5.00 | % |
| Skagit  State Bancorp, Inc.            |       | $          | 59,476     |                               | 10.53      | %                                                                       | $          | 22,596 |   | > 4.00 | % | $ | 28,245 |   | >   5.00 | % |

 

**LIQUIDITY**

 

The objective of liquidityrisk management is to ensure that Bancorp has the continuing ability tomaintain cash flows that are adequate to fund operations including day to daycash flow requirements of either its depositors wanting to withdraw funds or toprovide for customers credit needs. Bancorp has a formal liquidity policy thatestablishes liquidity guidelines and the maintenance of contingency liquidityplans that provide for actions and timely responses to liquidity stresssituations.

 

Liquidity is generatedfrom both internal and external sources. The majority of funding comes fromcustomer deposits within the Bank’s market area. In addition, funding needs aremet through loan repayments, investment securities repayments, earnings andother borrowings through pre-approved credit lines. Liquidity may also beobtained by maintaining assets that can be converted to cash with little or norisk of loss.  However, in this turbulentmarket environment, assets may be more difficult to convert to cash with orwithout a loss.

 

As part of the Bank’sliquidity management, the Bank utilizes federal funds purchased to supplementthe primary source of funds, which are deposits.  As a result, there could be fluctuations inthese borrowing balances depending on short-term liquidity and longer-termfinancing needs of the Bank.  As of September 30,2009, Bancorp had approximately $47.0 million in approved unsecured creditlines from various financial institutions and had securities with a marketvalue of $52.1 million pledged as collateral for borrowing at the FederalReserve Discount Window.

 

Because the Bank’sprimary sources and uses of funds are deposits and loans, the relationshipbetween net loans and total deposits provides one measure of the Bank’sliquidity.  The Bank’s loan to deposit ratiodecreased to 72.7 percent at September 30, 2009 compared to 83.9 percentat December 31, 2008, as a result of the increase in deposits and thedecrease in loans.

 

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The turmoil in the creditmarkets during the last few years did not have a direct impact on Bancorp’sliquidity management practices. Access to our correspondent banks and theFederal Reserve remained open. Management believes that Bancorp’s liquidityposition at September 30, 2009 was adequate to fund ongoing operations.

 

Skagit State Bancorp, Inc.is a separate legal entity from the Bank and must provide for its ownliquidity.  Substantially all of Bancorp’srevenues are obtained from dividends declared and paid by the Bank. SkagitState Bank’s ability to pay dividends is limited by its earnings, financialcondition and capital requirements, as well as regulatory restrictions.

 

**Item 3.****          ****QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISK**

 

The results of operationsfor financial institutions are largely dependent upon the financial institution’sability to manage market risks which includes interest rate risk.  Interest rate risk refers to the exposure ofearnings and capital arising from changes in interest rates.

 

Bancorp maintains anasset/liability management program which is the responsibility of theAsset/Liability Committee.  The objectiveof asset/liability management is to maximize long-term stockholder returns andto manage, protect and stabilize Bancorp’s net interest income from undueinterest rate risk through various interest rate cycles within the constraintsof credit quality, interest rate risk policies, levels of capital and adequatelevels of liquidity.  The committee meetsto monitor the composition of the balance, to review projected earnings trends,and to formulate strategies consistent with these objectives for liquidity,interest rate risk, and capital adequacy.

 

Bancorp believes thatthere have not been any material changes about Bancorp’s market risk from theinformation that was provided in the Form 10-K for the year ended December 31,2008.

 

# **Item 4T.  CONTROLSAND PROCEDURES**

# ** **

Evaluation of DisclosureControls and Procedures

 

Bancorp’s Chief ExecutiveOfficer and Chief Financial Officer have reviewed and evaluated theeffectiveness of our disclosure controls and procedures, required by ExchangeAct Rules 13(a) - 15(b), as of the end of the period covered by thisquarterly report.  Based on thatevaluation, the Chief Executive Officer and Chief Financial Officer haveconcluded that Bancorp’s current disclosure controls and procedures areeffective and timely, providing them with material information relating toBancorp required to be disclosed in the reports we file or submit under theExchange Act.

 

Changes in InternalControls

 

There have not been anysignificant changes in our internal controls or in other factors that couldsignificantly affect these controls subsequent to the date of theirevaluation.  Bancorp did not identify norimplement any corrective actions with regard to any significant deficiencies ormaterial weaknesses in its internal controls.

 

**PART II-  OTHER INFORMATION**

 

**Item 1.  Legal Proceedings**

 

From time to time,Bancorp may be a plaintiff and/or defendant in certain claims and legal actionsarising in the ordinary course of commercial banking involving real estatelending transactions and other ordinary routine litigation incidental to thebusiness of Bancorp.  Bancorp is not aparty to any pending legal proceedings that Bancorp believes would have amaterial adverse effect on the financial condition of Bancorp.

 

**Item 1A.  Risk Factors**

 

There are certain risksinherent to Bancorp’s business.  Thematerial risks and uncertainties that management believes affect Bancorp aredescribed below.  Although we have riskmanagement policies, procedures and verification procedures in place,additional risks and uncertainties that management is not aware of or focused onor that management currently deems immaterial may also impair Bancorp’sbusiness operations.  If any of thefollowing risks actually occur, our financial condition and results ofoperations could be materially and adversely affected.

 

**We cannot accurately predict theeffect of the national economic situation on Bancorp’s future results ofoperations.**

 

The national economy andthe financial services sector in particular are currently facing challenges ofa scope unprecedented in recent history. The Company cannot accurately predict the severity or duration of thecurrent economic downturn, which has adversely impacted the markets weserve.  Any further deterioration in theeconomies of the nation as a whole or in our markets would have an adverseeffect, which could be material, on our 

 

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business, financialcondition, results of operations and prospects. While it is impossible to predict how long these conditions may exist,the economic downturn could continue to present risks for some time for theindustry and our company.

 

**Bancorp’s concentration in realestate loans could adversely affect Bancorp’s earnings in an economic downturn.**

 

Real estate loanscomprise the largest category of loans and represent 69.1 percent of Bancorp’stotal loans.  Our real estate portfolioconsists of commercial and residential lending. These loans are secured by property such as office buildings, commercialbusiness properties, healthcare buildings, agricultural land, timber land andresidential properties.  Commercial andcommercial real estate loans generally are viewed as having more risk ofdefault than residential real estate loans or certain other types of loans orinvestments.  Typically, these types ofloans are larger than residential real estate loans and other loans.  Because the loan portfolio contains a numberof commercial real estate loans with relatively large balances, thedeterioration of one or a few of these loans may cause a significant increasein nonperforming loans.  An increase innonperforming loans could result in a loss of earnings from these loans, anincrease in the provision for loan losses or an increase in loan charge-offs,which could have an adverse impact on our results of operations and financialcondition.

 

There has been aneconomic downturn throughout the country, particularly in the housing andcommercial real estate sectors.  Whilethe Pacific Northwest economy typically lags the national economy, the effectsof the economic downturn are now significantly impacting our market area.  Further downturn in the market areas we servemay cause us to have lower earnings and could increase our credit riskassociated with our loan portfolio, as the collateral securing those loans maydecrease in value.  A continued downturnin the local economy could have a material adverse effect on both the abilityof borrowers to repay loans, as well as the value of the real property held ascollateral.  Substantially all of ourloans are to businesses and individuals in Skagit, Snohomish or WhatcomCounties and any decline in the economy of this market area could impact usadversely.  As a lender, we are exposedto the risk that our customers will be unable to repay their loans inaccordance with their terms, and that any collateral securing the payment oftheir loans may not be sufficient to assure repayment.

 

**Our allowance for loan losses maynot be adequate to cover actual loan losses, which could adversely affect ourearnings.**

 

Bancorp maintains anallowance for loan losses in an amount that we believe is adequate to providefor losses inherent in the portfolio.  While we strive to carefullymanage and monitor credit quality and to identify loans that may becomenonperforming, at any time there are loans included in the portfolio that willresult in losses, but that have not been identified as nonperforming orpotential problem loans.  By closely monitoring our credit quality,we attempt to identify deteriorating loans before they become nonperformingassets and adjust the loan loss reserve accordingly.  However,because future events are uncertain, and if the economy continues todeteriorate, there may be loans that deteriorate to a nonperforming status inan accelerated time frame.  As a result, future additions to theallowance may be necessary.  Because the loan portfolio contains anumber of loans with relatively large balances, the deterioration of one or afew of these loans may cause a significant increase in nonperforming loans,requiring an increase to the loan loss allowance.  As a result,future additions to the allowance at elevated levels may be required based onchanges in the mix of loans comprising the portfolio, changes in the financialcondition of borrowers, such as may result from changes in economic conditions,or as a result of incorrect assumptions by management in determining theallowance.  Additionally, banking regulators, as an integral part of theirsupervisory function, periodically review our loan portfolio and the adequacyof our allowance for loan losses.  These regulatory agencies mayrequire us to recognize further loan loss provisions or charge-offs based upontheir judgments, which may be different from ours.  Any increase inthe allowance for loan losses could have a negative effect on our financialcondition and results of operation.

 

**Acontinued tightening of the credit markets may make it difficult to obtainadequate funding for loan growth, which could adversely affect our earnings.**

 

A continued tightening ofthe credit market and the inability to obtain or retain adequate money to fundcontinued loan growth at an acceptable cost may negatively affect our assetgrowth and liquidity position and, therefore, our earningscapability.  In addition to core deposit growth, maturity ofinvestment securities and loan payments, Bancorp also relies on alternativefunding sources through correspondent banking, and borrowing lines with theFederal Reserve Bank to fund loans.  Inthe event the current economic downturn continues, particularly in the 

 

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housing market, theseresources could be negatively affected, both as to price and availability,which would limit and or raise the cost of the funds available to Bancorp.

 

**Fluctuatinginterest rates can adversely affect Bancorp’s profitability**

 

Bancorp’s profitabilityis dependent to a large extent upon net interest income. Earnings and cashflows are largely dependent upon our net interest income.  Net interest income is the difference (or “spread”)between the interest earned on loans, securities and other interest-earningassets and Bancorp’s cost of funds, primarily interest expense on deposits andborrowings. Interest rates are highly sensitive to many factors that are beyondour control including, but not limited to, general economic conditions, andpolicies of various governmental and regulatory agencies. Changes in monetarypolicy, including changes in interest rates, impact the level of loans,deposits and investments, the credit profile of existing loans and the ratesreceived on loans and investment securities and the rates paid on deposits andborrowings. If the interest paid on deposits increases at a faster rate thanthe interest received on loans and investment securities, Bancorp’s netinterest income, and therefore earnings could be adversely affected.  Earnings could also be adversely affected ifinterest received on loans and investments decrease faster than interest paidon deposits.

 

**Competitionin our market area may limit Bancorp’s future success**

 

Commercial banking is ahighly competitive business.  Bancorpcompetes with other commercial banks, savings and loan associations, creditunions and finance companies operating in our market area.  We are subject to substantial competition forloans and deposits from other financial institutions.  Some of our competitors are not subject tothe same degree of regulation and restriction as we are.  Some of our competitors have greaterfinancial resources than we do.  Wecompete for funds with other financial institutions that, in most cases, arelarger and able to provide a greater variety of services than we do and thusmay obtain deposits at lower rates of interest. If we are unable to effectively compete in our market area, our businessand results of operations could be adversely affected.

 

**We operatein a highly regulated environment and we cannot predict the effect of recentand pending federal legislation.**

 

Bancorpis subject to extensive regulation, supervision and examination by federal andstate banking authorities.  Any change inapplicable regulations or federal, state or local legislation could have asubstantial impact on Bancorp and its operations.  Additional legislation and regulations thatcould significantly affect Bancorp’s powers, authority and operations may beenacted or adopted in the future, which could have a material adverse effect onBancorp’s financial condition and results of operations.  Further, regulators have significantdiscretion and authority to prevent or remedy unsafe or unsound practices orviolations of laws or regulations by financial institutions and holdingcompanies in the performance of their supervisory and enforcement duties.  Recently these powers have been utilized morefrequently due to the serious national, regional and local economic conditionsBancorp is facing.  The exercise ofregulatory authority may have a negative impact on Bancorp’s financialcondition and results of operations.

 

On October 3, 2008,Congress enacted the Emergency Economic Stabilization Act of 2008 (“EESA”),which provides the United States Treasury Department (“Treasury”) with broadauthority to implement action intended to help restore stability and liquidityto the U.S. financial markets.  The EESAalso increased the amount of deposit account insurance coverage from $100,000to $250,000 effective until December 31, 2009, which was recently extendedto December 31, 2013 under the Helping Families Save Their Homes Act of2009.

 

In early 2009, theTreasury also announced the Financial Stability Plan which, among other things,provides a new capital program called the Capital Assistance Program, whichestablishes a public-private investment fund for the purchase of troubledassets, and expands the Term Asset-Backed Securities Loan Facility.  The full effect of this broad legislation onthe national economy and financial institutions, particularly on mid-sizedinstitutions like Bancorp, cannot now be predicted.  In addition, the American Recovery andReinvestment Act of 2009 (“ARRA”) was signed into law on February 17,2009, and includes, among other things, extensive new restrictions on thecompensation and governance arrangements of financial institutionsparticipating in the Treasury’s Troubled Asset Relief Program.  The SEC recently has proposed expanding someof the reforms in ARRA to apply to all public companies.  Other recent proposals include the Secretaryof the Treasury’s June 17, 2009 proposal to fundamentally change theregulation of financial institutions, markets and products, and the FederalReserve’s proposed guidance issued on October 22, 2009 regarding incentivecompensation practices at institutions it regulates, including the Company.

 

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In summary, numerousactions have been taken by the Federal Reserve, the U.S. Congress, theTreasury, the FDIC, the SEC and others to address the liquidity and creditcrisis.

 

Bancorp cannot predictthe actual effects of EESA, the ARRA, the proposed regulatory reform measuresand various governmental, regulatory, monetary and fiscal initiatives whichhave been and may be enacted on the financial markets, on Bancorp.  The terms and costs of these activities, or thefailure of these actions to help stabilize the financial markets, asset prices,market liquidity and a continuation or worsening of current financial marketand economic conditions could materially and adversely affect our business,financial condition, results of operations, and the trading price of our commonstock.

 

**Our ability to access markets forfunding and acquire and retain customers could be adversely affected by thedeterioration of other financial institutions or to the extent the financialservice industry’s reputation is damaged.**

 

Reputation risk is the risk toliquidity, earnings and capital arising from negative publicity regarding thefinancial services industry.  Thefinancial services industry continues to be featured in negative headlinesabout the global and national credit crisis and the resulting stabilizationlegislation enacted by the U.S. federal government.  These reports can be damaging to the industry’simage and potentially erode consumer confidence in insured financialinstitutions, such as our banking subsidiary. In addition, our ability to engage in routine funding and othertransactions could be adversely affected by the actions and financial conditionof other financial institutions. Financial services institutions are interrelatedas a result of trading, clearing, counterparty or other relationships. As aresult, defaults by, or even rumors or questions about, one or more financialservices institutions, or the financial services industry generally, could leadto market-wide liquidity problems, losses of depositor, creditor andcounterparty confidence and could lead to losses or defaults by us or by otherinstitutions. We could experience material changes in the level of deposits asa direct or indirect result of other banks’ difficulties or failure, which couldaffect the amount of capital we need.

 

**TheFDIC has increased insurance premiums to restore and maintain the federaldeposit insurance fund, which has increased our costs and could adverselyaffect our business.**

** **

The FDIC adopted a final rule revisingits risk-based assessment system, effective April 1, 2009.  The changes to the assessment system involveadjustments to the risk-based calculation of an institution’s unsecured debt,secured liabilities and brokered deposits. The potential increase in FDIC insurance premiums could have asignificant impact on Bancorp.

 

On May 22, 2009, theFDIC has imposed a special deposit insurance assessment of five basis points onall insured institutions.  This emergencyassessment was calculated based on the insured institution’s assets at June 30,2009, and collected on September 30, 2009. Based on our June 30, 2009 assets subject to the FDIC assessment,the special assessment was approximately $260,000.  This special assessment is in addition to theregular quarterly risk-based assessment.

 

The FDIC has recentlyproposed requiring insured institutions to prepay estimated quarterlyrisk-based assessments for the fourth quarter of 2009 and for 2010, 2011 and2012, and to increase the regular assessment rate by three basis pointseffective January 1, 2011, as a means of replenishing the depositinsurance fund.  The prepayment would becollected on December 30, 2009, and would be accounted for as a prepaidexpense amortized over the prepayment period. Although the FDIC could exempt institutions from the prepaymentrequirement when prepayment would impact the institution’s safety andsoundness, the FDIC has stated it expects few exemptions to be granted, andBancorp would not expect to apply for an exemption.  If the proposed rule becomes final, theprepayment of premiums could have an adverse impact on our liquidity.

 

The FDIC depositinsurance fund may suffer additional losses in the future due to bankfailures.  There can be no assurance thatthere will not be additional significant deposit insurance premium increases orspecial assessments in order to restore the insurance fund’s reserve ratio.

 

**There islittle trading activity in Bancorp’s stock**

 

There is no active marketfor our outstanding shares, and it is unlikely that an established market forour shares will develop in the near future. We presently do not intend to seek listing of the shares on anysecurities exchange.  It is not known whethersignificant trading activity will take place for several years, if at all.  Accordingly, our shares should be consideredas a long-term investment.

 

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**There are restrictions on changes in control ofBancorp that could decrease our shareholders’ chance to realize a premium ontheir shares.**

** **

Provisions in ourArticles of Incorporation include a staggered Board of Directors, andnon-monetary factor provisions and an affirmative vote of two-thirds of shares(entitled to be counted) to approve an interested shareholder transaction, anyor all of which could have the effect of hindering, delaying or preventing atakeover bid.

 

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

 

None

 

**Item 3.  Defaults Upon Senior Securities**

 

None

 

**Item 4.  Submission of Matters to a Voteof Security Holders**

 

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 therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

 

 
|   | SKAGIT STATE BANCORP,  INC. |
|--------|-----------------------------|
|   | (Registrant)                |
|   |                        |
|   |                        |
| Dated: | November 13, 2009      |   | /s/ Cheryl R. Bishop |
|   |                        |   | Cheryl R. Bishop |
|   |                        |   | Chief Executive Officer |
|   |                        |   |   |
|   |                        |   |   |
| Dated: | November 13, 2009      |   | /s/ Carla F. Tucker |
|   |                        |   | Carla F. Tucker |
|   |                        |   | Executive  Vice-President |
|   |                        |   | Chief Financial Officer |

 

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