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

**FORM 10-Q**

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

**Forthe quarterly period ended March 31, 2007**

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

**Forthe transition period from                                to                                **

**Commission File Number  000-52096**

**SKAGITSTATE BANCORP, INC.**(ExactName 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 ofPrincipal Executive Offices) (Zip Code)

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

Indicateby check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) ofthe Exchange Act 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.

Yes     x               No     o

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

Large accelerated filer  o             Acceleratedfiler  o             Non-acceleratedfiler  x

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act.

Yes     o               No     x

Indicatethe number of shares outstanding of each of the issuer’s classes of commonstock, as of the latest practicable date:

Thenumber of shares of the issuer’s Common Stock outstanding at May 10, 2007 was673,057.

 

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**SKAGITSTATE BANCORP, INC.****TABLE OF CONTENTS**
| **PART I.**  | **FINANCIAL INFORMATION** |                                                                                                                                         |   |
|--------------|---------------------------|----------------------------------------------------------------------------------------------------------------------------------------------|--------|
| ** **   | ** **                | ** **                                                                                                                                   |   |   |
|         | Item 1.                   | Financial Statements                                                                                                                         |   |   |
|         |                      |                                                                                                                                         |   |   |
|         |                      | Consolidated  Balance Sheet as of March 31, 2007 and December 31, 2006                                                                       |   |   |
|         |                      |                                                                                                                                         |   |   |
|         |                      | Consolidated  Statement of Income for the three months ended March 31, 2007 and 2006                                                         |   |   |
|         |                      |                                                                                                                                         |   |   |
|         |                      | Consolidated  Statement of Changes in Stockholders’ Equity and Comprehensive Income for the  three months ended March 31, 2007 and 2006 |   |   |
|         |                      |                                                                                                                                         |   |   |
|         |                      | Consolidated  Statement of Cash Flows for the three months ended March 31, 2007 and 2006                                                     |   |   |
|         |                      |                                                                                                                                         |   |   |
|         |                      | Notes to  Consolidated Financial Statements                                                                                                  |   |   |
|         |                      |                                                                                                                                         |   |   |
|         | Item 2.                   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                                  |   |   |
|         |                      |                                                                                                                                         |   |   |
|         | Item 3.                   | Quantitative  and Qualitative Disclosures About Market Risk                                                                                  |   |   |
|         |                      |                                                                                                                                         |   |   |
|         | Item 4.                   | Controls and  Procedures                                                                                                                     |   |   |
|         |                      |                                                                                                                                         |   |   |
| **PART II.** | **OTHER INFORMATION**     |                                                                                                                                         |   |
| ** **   | ** **                | ** **                                                                                                                                   |   |   |
|         | Item 1.                   | Legal Proceedings                                                                                                                            |   |   |
|         |                      |                                                                                                                                         |   |   |
|         | Item  1 A.                | Risk  Factors                                                                                                                                |   |   |
|         |                      |                                                                                                                                         |   |   |
|         | Item 2.                   | Unregistered  Sales of Equity Securities and Use of Proceeds                                                                                 |   |   |
|         |                      |                                                                                                                                         |   |   |
|         | Item 3.                   | Defaults Upon  Senior Securities                                                                                                             |   |   |
|         |                      |                                                                                                                                         |   |   |
|         | Item 4.                   | Submission of  Matters to a Vote of Security Holders                                                                                         |   |   |
|         |                      |                                                                                                                                         |   |   |
|         | Item 5.                   | Other Information                                                                                                                            |   |   |
|         |                      |                                                                                                                                         |   |   |
|         | Item  6.                  | Exhibits                                                                                                                                     |   |   |
|         |                      |                                                                                                                                         |   |   |
|         |                      | Signatures                                                                                                                                   |   |   |

 

2

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**Item 1.    Financial Statements**

**SKAGIT STATE BANCORP, INC. AND SUBSIDIARYCONSOLIDATED BALANCE SHEET (Unaudited)**
| **(dollars in thousands except share data)**                                                                                            | ** ** | **March 31, 2007** | ** ** | **December 31, 2006** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|---------------------------------|------------|
| **ASSETS**                                                                                                                                                       |       |                         |       |                            |       |
| **ASSETS**                                                                                                                                                       |       |                         |       |                            |       |
| Cash and due  from banks                                                                                                                                         |       | $                            | 18,162     |                            | $          | 21,535 |   |
| Federal funds  sold                                                                                                                                              |       | 62,400                       |       | 25,700                          |       |
| Investment  securities                                                                                                                                           |       |                         |       |                            |       |
| Available-for-sale,  at fair value                                                                                                                               |       | 100,489                      |       | 113,941                         |       |
| Held-to-maturity,  at amortized cost                                                                                                                             |       | 35,331                       |       | 35,034                          |       |
| Loans                                                                                                                                                            |       | 323,395                      |       | 325,744                         |       |
| Allowance for  loan losses                                                                                                                                       |       | (5,018                       | )          | (5,176                          | )          |
| Net loans                                                                                                                                                        |       | 318,377                      |       | 320,568                         |       |
| Bank premises  and equipment, net                                                                                                                                |       | 11,128                       |       | 11,289                          |       |
| Accrued interest  receivable                                                                                                                                     |       | 3,281                        |       | 3,414                           |       |
| Other assets                                                                                                                                                     |       | 1,904                        |       | 1,307                           |       |
| **TOTAL ASSETS**                                                                                                                                                 |       | $                            | 551,072    |                            | $          | 532,788 |   |
|                                                                                                                                                             |       |                         |       |                            |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                   |       |                         |       |                            |       |
| **LIABILITIES**                                                                                                                                                  |       |                         |       |                            |       |
| Deposits                                                                                                                                                         |       |                         |       |                            |       |
| Interest-bearing                                                                                                                                                 |       | $                            | 391,423    |                            | $          | 368,093 |   |
| Non-interest-bearing                                                                                                                                             |       | 72,843                       |       | 81,250                          |       |
| Total deposits                                                                                                                                                   |       | 464,266                      |       | 449,343                         |       |
| Securities sold  under agreements to repurchase                                                                                                                  |       | 13,830                       |       | 14,102                          |       |
| Other  liabilities                                                                                                                                               |       | 3,921                        |       | 2,799                           |       |
| Total  liabilities                                                                                                                                               |       | 482,017                      |       | 466,244                         |       |
|                                                                                                                                                             |       |                         |       |                            |       |
| **STOCKHOLDERS’ EQUITY**                                                                                                                                    |       |                         |       |                            |       |
| Common stock no  par value, 5,000,000 shares authorized, 673,057 and 673,532 shares issued and  outstanding at March 31, 2007 and December 31, 2006 respectively |       | 13,895                       |       | 13,935                          |       |
| Accumulated  other comprehensive loss, net of tax                                                                                                                |       | (117                         | )          | (269                            | )          |
| Retained  earnings                                                                                                                                               |       | 55,277                       |       | 52,878                          |       |
| Total  stockholders’ equity                                                                                                                                 |       | 69,055                       |       | 66,544                          |       |
| **TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                              |       | $                            | 551,072    |                            | $          | 532,788 |   |

 

*Seeaccompanying notes to these consolidated financial statements*

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**SKAGIT STATE BANCORP, INC. AND SUBSIDIARYCONSOLIDATED STATEMENT OF INCOME (Unaudited)**
| ** **                                                            | ** ** | **For the three months ended March 31,** | ** ** |
|-----------------------------------------------------------------------|------------|------------------------------------------------------------------------|------------|
| **(dollars in thousands except share data)** | ** ** | **2007**                                                               | ** ** | **2006** | ** ** |
|                                                                  |       |                                                                   |       |   |   |
| **INTEREST  INCOME**                                                  |       |                                                                   |       |   |   |
| Interest and fees on loans                                            |       | $                                                                      | 7,219      |   | $ | 6,134 |   |
| Investment securities                                                 |       |                                                                   |       |   |   |
| Taxable                                                               |       | 1,310                                                                  |       | 782 |   |
| Exempt from federal income tax                                        |       | 221                                                                    |       | 185 |   |
| Federal funds sold                                                    |       | 420                                                                    |       | 974 |   |
| Total interest income                                                 |       | 9,170                                                                  |       | 8,075 |   |
| **INTEREST  EXPENSE**                                                 |       |                                                                   |       |   |   |
| Deposits                                                              |       | 2,842                                                                  |       | 2,127 |   |
| Securities sold under agreements to repurchase                        |       | 132                                                                    |       | 103 |   |
| Total interest expense                                                |       | 2,974                                                                  |       | 2,230 |   |
| **NET  INTEREST INCOME**                                              |       | 6,196                                                                  |       | 5,845 |   |
| Provision (benefit) for loan losses                                   |       | (150                                                                   | )          | — |   |
| **NET  INTEREST INCOME AFTER PROVISION (BENEFIT) FOR LOAN LOSSES**    |       | 6,346                                                                  |       | 5,845 |   |
| **NON-INTEREST  INCOME**                                              |       |                                                                   |       |   |   |
| Service charges on deposits                                           |       | 548                                                                    |       | 511 |   |
| Other                                                                 |       | 211                                                                    |       | 169 |   |
| Gain on sale of assets                                                |       | 3                                                                      |       | 1 |   |
| Total non-interest income                                             |       | 762                                                                    |       | 681 |   |
| **NON-INTEREST  EXPENSES**                                            |       |                                                                   |       |   |   |
| Salaries                                                              |       | 1,788                                                                  |       | 1,654 |   |
| Payroll taxes and employee benefits                                   |       | 527                                                                    |       | 396 |   |
| Bank premises and equipment                                           |       | 318                                                                    |       | 293 |   |
| Occupancy                                                             |       | 190                                                                    |       | 176 |   |
| State business taxes                                                  |       | 111                                                                    |       | 112 |   |
| Advertising                                                           |       | 160                                                                    |       | 146 |   |
| Other                                                                 |       | 850                                                                    |       | 708 |   |
| Total non-interest expenses                                           |       | 3,944                                                                  |       | 3,485 |   |
| **INCOME  BEFORE PROVISION FOR INCOME TAX**                           |       | 3,164                                                                  |       | 3,041 |   |
| **PROVISION  FOR INCOME TAX**                                         |       |                                                                   |       |   |   |
| Provision for Income Tax                                              |       | 765                                                                    |       | 870 |   |
| **NET INCOME**                                                        |       | $                                                                      | 2,399      |   | $ | 2,171 |   |
| **BASIC  EARNINGS PER SHARE**                                         |       | $                                                                      | 3.56       |   | $ | 3.07 |   |
| **DILUTED EARNINGS PER SHARE**                                        |       | $                                                                      | 3.56       |   | $ | 3.07 |   |

 

*Seeaccompanying notes to these consolidated financial statements*

4

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**SKAGIT STATE BANCORP, INC. AND SUBSIDIARYCONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY (Unaudited)**

Three months ended March 31, 2007 and 2006
| ** **                                                                                            | ** ** | ** **            | ** ** | ** **        | ** ** | **Accum. Other**  | ** ** | ** **             | ** ** | **Total**         | ** ** | ** ** | ** ** |
|-------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|-------------------|------------|------------------------|------------|------------------------|------------|-------------------|------------|------------|------------|
| ** **                                                                                            | ** ** | **Common Stock** | ** ** | **Comprehensive** | ** ** | **Retained**           | ** ** | **Stockholders’** | ** ** | **Comprehensive** | ** ** |
| **(dollars in thousands except share and per share amounts)** | ** ** | **Shares**            | ** ** | **Amount**        | ** ** | **Income (Loss)** | ** ** | **Earnings**           | ** ** | **Equity**        | ** ** | **Income** | ** ** |
| **BALANCE,**January 1, 2006                                                                           |       | 707,237               |       | $                 | 14,604     |                   | $          | (370                   | )          | $                 | 51,139     |       | $          | 65,373 |   |   |   |
| Comprehensive  income                                                                                 |       |                  |       |              |       |                   |       |                   |       |              |       |       |       |
| Net income                                                                                            |       | —                |       | —            |       | —                 |       | 2,171                  |       | 2,171             |       | $          | 2,171      |   |
| Other comprehensive income:                                                                           |       |                  |       |              |       |                   |       |                   |       |              |       |       |       |
| Unrealized gains on available-for-sale securities,  net of taxes of $60                               |       | —                |       | —            |       | 117                    |       | —                 |       | 117               |       | 117        |       |
| Unrealized loss on available-for-sale securities, net  of tax benefit of $106                         |       | —                |       | —            |       | (206                   | )          | —                 |       | (206              | )          | (206       | )          |
| Total other comprehensive loss                                                                        |       |                  |       |              |       |                   |       |                   |       |              |       | (89        | )          |
| Comprehensive  income                                                                                 |       |                  |       |              |       |                   |       |                   |       |              |       | $          | 2,082      |   |
| Common stock  redemption                                                                              |       | (1,793                | )          | (18               | )          |                   |       | (228                   | )          | (246              | )          |       |       |
| **BALANCE,**March 31, 2006                                                                            |       | 705,444               |       | $                 | 14,586     |                   | $          | (459                   | )          | $                 | 53,082     |       | $          | 67,209 |   |   |   |
|                                                                                                  |       |                  |       |              |       |                   |       |                   |       |              |       |       |       |
| **BALANCE,**January 1, 2007                                                                           |       | 673,532               |       | $                 | 13,935     |                   | $          | (269                   | )          | $                 | 52,878     |       | $          | 66,544 |   |   |   |
| Comprehensive  income                                                                                 |       |                  |       |              |       |                   |       |                   |       |              |       |       |       |
| Net income                                                                                            |       | —                |       | —            |       | —                 |       | 2,399                  |       | 2,399             |       | $          | 2,399      |   |
| Other comprehensive income:                                                                           |       |                  |       |              |       |                   |       |                   |       |              |       |       |       |
| Unrealized gains on available-for-sale securities,  net of taxes of $165                              |       | —                |       | —            |       | 322                    |       | —                 |       | 322               |       | 322        |       |
| Unrealized loss on available-for-sale securities, net  of tax benefit of $87                          |       | —                |       | —            |       | (170                   | )          | —                 |       | (170              | )          | (170       | )          |
| Total other comprehensive loss                                                                        |       |                  |       |              |       |                   |       |                   |       |              |       | 152        |       |
| Comprehensive  income                                                                                 |       |                  |       |              |       |                   |       |                   |       |              |       | $          | 2,551      |   |
| Common stock  redemption                                                                              |       | (475                  | )          | (76               | )          | —                 |       | —                 |       | (76               | )          |       |       |
| Stock  compensation expense                                                                           |       |                  |       | 36                |       |                   |       |                   |       | 36                |       |       |       |
| **BALANCE,**March 31, 2007                                                                            |       | 673,057               |       | $                 | 13,895     |                   | $          | (117                   | )          | $                 | 55,277     |       | $          | 69,055 |   |   |   |

 

*See accompanying notes to theseconsolidated financial statements*

5

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**SKAGIT STATE BANCORP, INC. AND SUBSIDIARYSTATEMENT OF CASH FLOWS (Unaudited)**

(dollars inthousands)
| **Three months  ended March 31,**                                                   | ** ** | **2007** | ** ** | **2006** | ** ** |
|-------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| **CASH  FLOWS FROM OPERATING ACTIVITIES**                                           |       |     |       |     |       |
| Net income                                                                          |       | $        | 2,399      |     | $          | 2,171 |   |
| *Adjustments  to reconcile net income to net cash flows from operating activities*  |       |     |       |     |       |
| Provision (benefit) for loan losses                                                 |       | (150     | )          | —   |       |
| Depreciation                                                                        |       | 223      |       | 202      |       |
| Loss (gain) on sale of other real estate owned                                      |       | (3       | )          | —   |       |
| Amortization of investment security premiums and  discounts, net                    |       | (53      | )          | (8       | )          |
| Provision for deferred income taxes                                                 |       | —   |       | (130     | )          |
| Stock compensation for employee services                                            |       | 36       |       | —   |       |
| *Changes  in operating assets and liabilities*                                      |       |     |       |     |       |
| Decrease (increase) in interest receivable                                          |       | 133      |       | (326     | )          |
| Decrease (increase) in other assets                                                 |       | (675     | )          | (636     | )          |
| Increase (decrease) in other liabilities                                            |       | 1,122    |       | 939      |       |
| Net cash flows from operating activities                                            |       | 3,032    |       | 2,212    |       |
| **CASH  FLOWS FROM INVESTING ACTIVITIES**                                           |       |     |       |     |       |
| Proceeds from maturities of investment securities –  available-for-sale        |       | 15,634   |       | 6,000    |       |
| Purchases of investment securities –  available-for-sale                       |       | (1,899   | )          | (33,263  | )          |
| Proceeds from maturities of investment securities –  held-to-maturity          |       | 79       |       | 703      |       |
| Purchases of investment securities –  held-to-maturity                         |       | (376     | )          | (1,126   | )          |
| Net decrease (increase) in federal funds sold                                       |       | (36,700  | )          | 14,940   |       |
| Net decrease (increase) in loans                                                    |       | 2,341    |       | 2,328    |       |
| Purchase of premises and equipment                                                  |       | (62      | )          | (372     | )          |
| Proceeds from sale of other real estate owned                                       |       | 3        |       | —   |       |
| Net cash flows from investing activities                                            |       | (20,980  | )          | (10,790  | )          |
| **CASH  FLOWS FROM FINANCING ACTIVITIES**                                           |       |     |       |     |       |
| Net increase (decrease) in demand deposits, money  market, NOW and savings accounts |       | (2,661   | )          | 135      |       |
| Net increase (decrease) in time deposits                                            |       | 17,584   |       | 1,269    |       |
| Amount paid for redemption of common stock                                          |       | (76      | )          | (246     | )          |
| Net increase in securities sold under agreements to  repurchase                     |       | (272     | )          | 694      |       |
| Net cash flows from financing activities                                            |       | 14,575   |       | 1,852    |       |
| **NET  CHANGE IN CASH AND DUE FROM BANKS**                                          |       | (3,373   | )          | (6,726   | )          |
| **CASH  AND DUE FROM BANKS,** beginning of year                                     |       | 21,535   |       | 24,975   |       |
| **CASH  AND DUE FROM BANKS,** end of period                                         |       | $        | 18,162     |     | $          | 18,249 |   |
| **SUPPLEMENTAL  DISCLOSURES OF CASH FLOW INFORMATION**                              |       |     |       |     |       |
| Cash paid during the year for income taxes                                          |       | $        | 170        |     | $          | 125 |   |
| Cash paid during the year for interest                                              |       | 2,916    |       | 2,200    |       |
| **NONCASH  FINANCING AND INVESTING TRANSACTIONS**                                   |       |     |       |     |       |
| Property taken in settlement of loans                                               |       | —   |       | —   |       |
| Property sold  through seller financing                                             |       | —   |       | —   |       |

 

*See accompanying notes to theseconsolidated financial statements*

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**SKAGITSTATE BANCORP, INC. AND SUBSIDIARYNOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**Note 1:   BASIS OF PRESENTATION**

The accompanying consolidatedfinancial statements include the accounts of Skagit State Bancorp, Inc. and itssubsidiary Skagit State Bank, (collectively, “Company” or “Bancorp). Allsignificant inter-company accounts and transactions have been eliminated. Theconsolidated financial statements have been prepared in conformity withaccounting principles generally accepted in the United States of America forinterim financial information and with instructions to Form 10-Q. Accordinglythey do not include all of the information and footnotes required by accountingprinciples generally accepted in the United States of America for completefinancial statements. In the opinion of management, all adjustments (consistingof normal recurring accruals) considered necessary for a fair presentation havebeen included. Operating results for the three months ended March 31, 2007, arenot necessarily indicative of the results anticipated for the year endingDecember 31, 2007. For additional information, refer to the audited financialstatements and footnotes for the most recent annual period ended December 31,2006 contained in the Annual Report on Form 10-K.

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

**Note 2: CRITICAL ACCOUNTING POLICIESAND ESTIMATES**

In preparing the financial statements, management isrequired to make estimates and assumptions that affect the reported amounts ofrevenues and expenses for the periods presented, and assets and liabilities asof the date of the balance sheet. Material estimates that are particularlysusceptible to significant change in the near term relate to the determinationof the allowance for loan losses, the valuation of real estate acquired inconnection with foreclosures or in satisfaction of loans and deferred incometaxes. Uncertainties with respect to such estimates and assumptions areinherent in the preparation of Bancorp’s financial statements; accordingly, itis possible that actual results could differ from these estimates orassumptions, which could have a material effect on the reported amounts of theconsolidated financial position and results of operation. These policies are described in more detail inthe Annual Report on Form 10-K for the year ended December 31, 2006.

**Note 3:   RECLASSIFICATIONS**Certain reclassifications have been made tothe 2006 financial statements to conform to the 2007 presentation. Suchclassifications have no affect on net income.

**Note 4:   EARNINGSPER SHARE**Basic earnings per share amounts are computed based on the weighted averagenumber of shares outstanding. Diluted earnings per share is calculated bydividing net income by diluted weighted average shares outstanding, whichincludes common stock equivalents outstanding using the treasury stock method. 

(dollars in thousands except share and per shareamounts)
| **Three months ended March 31,**                             | ** ** | **2007** | ** ** | **2006** | ** ** |
|----------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| Numerator:                                                                       |       |     |       |     |       |
| Net income                                                                       |       | $        | 2,399      |     | $          | 2,171 |   |
| Denominator:                                                                     |       |     |       |     |       |
| Denominator for  basic earnings per share -  Weighted average shares outstanding |       | 673,221  |       | 706,381  |       |
| Effect of  dilutive securities:                                                  |       |     |       |     |       |
| Stock options and restricted stock grants                                        |       | 1,505    |       | 300      |       |
| Denominator for  diluted earning per share   Weighted average shares outstanding |       | 674,726  |       | 706,681  |       |
| Basic earnings  per share                                                        |       | $        | 3.56       |     | $          | 3.07 |   |
| Diluted earnings per  share                                                      |       | $        | 3.56       |     | $          | 3.07 |   |

 

7

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**Note 5:   ALLOWANCEFOR LOAN LOSSES**

The allowance for loan losses is maintained at a leveldeemed adequate to provide for estimated future losses. Bancorp has asystematic methodology for evaluating the adequacy of the allowance for loanlosses which is evaluated on a quarterly basis. The allowance consists ofspecific, general and unallocated components. The allowance is based upon Bancorp’s evaluation of the pertinentfactors underlying the quality of the loan portfolio, including changes in sizeand composition of the loan portfolio, levels and trends in losses anddelinquencies, actual loan loss experience, current economic conditions,specific industry conditions, loan concentrations, detailed analysis ofindividual loans for which full collectibility may not be assured and the determinationof the existence and the realizable value of the collateral securing the loans.The general allowance is then calculated, by applying a historical losspercentage factor to the different loan types and the different risk gradings.  In addition, as part of the process, aspecific allowance is determined based on Bancorp’s review of classified ornon-performing loans for specific weaknesses and evaluation of those loans forimpairment and loss exposure. 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. 

Additions to the allowance, in the form of provisions,are reflected in current operating results, while charge-offs to the allowanceare made when a loss is determined to have occurred.  The ultimate recovery of loans is susceptibleto future market factors beyond Bancorp’s control. These factors may result inlosses or recoveries differing significantly from those provided in Bancorp’sfinancial statements. Bancorp’s periodic evaluation of the allowance for loanlosses is inherently subjective as it requires estimates that are susceptibleto significant revision as more information becomes available. In addition,regulatory agencies, as an integral part of their examination process,periodically review the estimated losses on loans.  Such agencies may require Bancorp torecognize additional provisions or adjustments to its allowance for loan lossesbased on their judgment using information available to them at the time oftheir examination. 

**Note 6:   STOCKBASED COMPENSATION**

Bancorp has a stock-based equity compensationplan.  Under this plan, Bancorp isauthorized to grant options or restricted stock up to 100,000 shares.  No grants of options or restricted stock wereawarded for the quarter ended March 31, 2007. Foradditional information on the stock-based equity compensation plan, refer toBancorp’s audited financial statements and footnotes for the most recent annualperiod ended December 31, 2006 contained in the Annual Report on Form 10-K.

**Note 7:   FINANCIALINSTRUMENTS**

In the ordinary course of business, Bancorp hasentered into off-balance-sheet financial instruments consisting of commitmentsto extend credit, commitments under credit-card arrangements, commercialletters of credit, and standby letters of credit. Such financial instrumentsare recorded in the financial statements when they are funded or related feesare incurred or received.

The following is a summary of the off-balance-sheetfinancial instruments or contracts outstanding as of March 31, 2007 (dollars inthousands): 
| Unfunded commitments to  extend credit  |   | $      | 71,666 |   |
|-----------------------------------------|--------|--------|--------|--------|
| Credit card  arrangements               |   | 14,105 |   |
| Commitments to  fund municipal warrants |   | 1,448  |   |
| Standby letters of  credit              |   | 2,412  |   |

 

**Note 8:   NEWACCOUNTING PRONOUNCEMENTS**

In September 2006, the FASB issued SFAS No. 157, “FairValue Measures”. This statement defines fair value, establishes a framework formeasuring fair value in generally accepted accounting principles and expandsdisclosures about fair value measurements. SFAS No. 157 is effective for financial statements issued for fiscalyears beginning after November 15, 2007 and interim periods within those fiscalyears.  Bancorp does not anticipate theadoption of SFAS No. 157 will have a material impact on its consolidatedfinancial statements.

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In September 2006, theFASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pensionand Other Postretirement Plans”, an amendment of SFAS No. 87, 88, 106 and132(R).  This statement requires anemployer to recognize the over-funded or under-funded status of a definedbenefit postretirement plan as an asset or liability in its statement offinancial position and to recognize changes in that funded status in the yearin which the changes occur through comprehensive income.  This statement also requires an employer tomeasure the funded status of a plan as of the date of its year-end statement offinancial position. This Statement is effective for Bancorp as of January 1,2008.  Bancorp does not anticipate theadoption of SFAS No. 158 will have a material impact on its consolidatedfinancial statements.

In February 2007, theFASB issued SFAS No. 159, “The Fair Value Option for Financial Assets andFinancial Liabilities”, including an amendment of SFAS No. 115. This statementpermits companies to choose to measure selected financial instruments at fairvalue. Following the initial fair value measurement date, ongoing unrealizedgains and losses on items for which fair value reporting has been elected arereported in earnings.  SFAS No. 159 iseffective for financial statements issued for fiscal years beginning afterNovember 15, 2007. Early adoption of this statement is permitted only asallowed in paragraph 30 of the statement. Bancorp has not elected earlyadoption of this standard and does not anticipate the adoption of SFASNo. 159 on its effective date will have a material impact on itsconsolidated financial statements.

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

*The following discussion should beread 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, 2006 in the Annual Report on Form10-K.*

**FORWARD LOOKING STATEMENTS**

In addition to historicalinformation, this report contains certain “forward looking statements” withinthe meaning of the Private Securities Litigation Reform Act of 1995(PSLRA).  This statement is included forthe express purpose of availing Bancorp of the protections of the safe harborprovision of the PSLRA.  Theforward-looking statements contained in this report are subject to factors,risk, and uncertainties that may cause actual results to differ materially fromthose projected.  Important factors thatmight cause such a material difference include, but are not limited to, thosediscussed in this section of the report. In addition, the following items are among the factors that could causeactual results to differ materially from the forward looking statements in thisreport: general economic conditions, including the effects of recent worldevents; business conditions in the banking industry; the regulatoryenvironment; new legislation; vendor quality and efficiency; employee retentionfactors; rapidly changing technology and evolving banking industry standards;competitive factors, including increased competition with community, regional,and national financial institutions; fluctuating interest rate environments;and similar matters.  Readers arecautioned not to place undue reliance on these forward-looking statements,which reflect management’s analysis only as of the date of the statement.  Bancorp undertakes no obligation to publiclyreview or update these forward-looking statements to reflect events orcircumstances that arise after the date of this report.  Readers should carefully review any riskfactors described in this and other documents we file from time to time withthe Securities and Exchange Commission.

**OVERVIEW**

Skagit State Bank, awholly-owned subsidiary of Skagit State Bancorp, Inc., began operations in 1958and is headquartered in Burlington (Skagit County), Washington.  The Bank provides a full range of bankingservices and products to both businesses and individuals through 13 fullservice banking offices located in Skagit, Snohomish and Whatcom counties.

Net income was $2.4million and $2.2 million for the quarters ended March 31, 2007 and 2006. Theincrease from 2006 to 2007 was primarily due to a $495,000 interest recovery onone loan relationship.  Also,contributing was an increase in interest income resulting from growth in theaverage balance of interest-earning assets in 2007 which was partially offsetby an increase in interest expense.  Inaddition, for the quarter ended March 31, 2007, Bancorp reported a $150,000benefit for loan losses compared to no provision or benefit for loan losses in2006. This was primarily related to the improved credit quality in the loanportfolio and minimal net charge-offs in 2006 and 2007.

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Basic and dilutedearnings per share were $3.56 and $3.07 for the quarters ended March 31, 2007and 2006, respectively. Annualized return on average assets was 1.79 percentfor the quarter ending March 31, 2007 compared to 1.67 percent during the sametime period in 2006.  Annualized returnon average equity was 14.19 percent for the quarter ending March 31, 2007compared to 13.10 percent for the same time period in 2006.

Total assets increased to$551.1 million at March 31, 2007 compared to $532.8 million at December 31,2006.  The increase was primarily due toa $14.9 million increase in total deposits. Total loans decreased slightly by$2.4 million to $325.0 million compared to $327.4 million at December 31, 2006.

**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.   Bancorp generates non-interestincome primarily through service charges and fees.  Bancorp’s non-interest expenses consistprimarily of salaries and employee benefits expense, and occupancy expense.

**NET INTEREST INCOME  **Net interest income isBancorp’s principal source of revenue and is comprised of interest income onearnings assets (loans and investment securities) less interest expense oninterest-bearing liabilities (deposits and borrowings). Interest income andexpense are affected significantly by general economic conditions, particularlychanges in market interest rates, and by government policies and the actions ofregulatory authorities.

Net interest income was$6.2 million for the quarter ended March 31, 2007 compared to $5.8 million forthe like period in 2006.  This increasefrom 2006 to 2007 was primarily due to an increase in the balance of averageinterest-earning assets, an increase in yield on interest earnings assets from6.78 percent to 7.44 percent and a $495,000 interest recovery on one loanrelationship. These increases were partially offset by an increase in theaverage cost of interest-bearing liabilities from 2.39 percent to 3.08 percentfrom 2006 to 2007.

The net interest marginis net interest income expressed as a percent of average interest-earningassets. Net interest margin is influenced by the level and relative mix ofinterest-earning assets and interest-bearing liabilities as well as levels ofnon-interest bearing liabilities. Opportunities to increase Bancorp’s net interest margin are availablethrough replacing non-earning or low earning assets with higher earning assets;i.e., specifically, through the reduction in non-accruing loans and FederalFunds sold or increasing Bancorp’s loan to deposit ratio or reducing interestcosts. For the quarter ended March 31, 2007, the net interest margin increasedto 5.03% from 4.91% for the like period in 2006.  This increase was primarily a result of a$495,000 loan interest recovery in 2007. This was partially offset by the more rapid increase in the cost offunds than the yield on interest-earning assets. Even with the interestrecovery, the yield on interest-earning assets increased only 66 basis pointscompared to a 69 basis point increase in the cost of funds.

The volume ororigination of fixed or variable rate loans, the interest rate sensitivity ofdeposits, the overall level of interest rates and general economic conditionscan have a significant effect on Bancorp’s performance in a changing interestrate environment. During 2007, due primarily to the current market interestrate environment and competition among financial institutions for qualityloans, the percentage of variable rate loans in the loan portfolio decreasedfrom 66 percent at December 31, 2005 to 44 percent as of December 31, 2006 andto 42 percent as of March 31, 2007. Starting in 2004 and continuing in 2005 and2006, as interest rates began to increase, time deposits became more attractiveto investors.  Time deposits increased to34.8 percent of deposits at March 31, 2007 compared to 32.1 percent of depositsat December 31, 2006 and 27.2 percent of deposits at December 31, 2005.

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The followingtables present information regarding average balances of assets andliabilities  as well as the total amountsof interest income from average interest-earning assets and interest expense onaverage interest- bearing liabilities, resulting yield and cost ratios,interest rate spread and net interest margin.

**Condensed Average Balance Sheets**

(dollars in thousandsexcept share data)
| ** **                                           | ** ** | **2007**    | ** ** | **2006**                           | ** ** |
|------------------------------------------------------|------------|-------------|------------|------------------------------------|------------|
| ** **                                           | ** ** | **Average** | ** ** | ** **                         | ** ** | ** ** | ** ** | **Average** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Three months ended March 31,** | ** ** | **Balance** | ** ** | **Interest Yield /Cost** | ** ** | **Balance** | ** ** | **Interest Yield /Cost** | ** ** |
| **Assets**                                           |       |        |       |                               |       |   |   |   |   |   |   |   |   |
| Federal funds  sold                                  |       | $           | 36,938     |                               | $          | 420 |   | 4.61 | % | $ | 83,079 |   | $ | 974 |   | 4.75 | % |
| Taxable  investment securities                       |       | 103,469     |       | 1,310                              |       | 5.13 |   | 77,744 |   | 782 |   | 4.08 |   |
| Tax exempt  securities                               |       | 39,297      |       | 221                                |       | 2.28 |   | 33,043 |   | 185 |   | 2.27 |   |
| Loans                                                |       | 320,115     |       | 7,219                              |       | 9.15 |   | 289,050 |   | 6,134 |   | 8.61 |   |
| Total  interest-earning assets                       |       | 499,819     |       | 9,170                              |       | 7.44 | % | 482,916 |   | 8,075 |   | 6.78 | % |
| Non-interest  earning assets                         |       | 35,344      |       |                               |       |   |   | 38,062 |   |   |   |   |   |
| Total assets                                         |       | $           | 535,163    |                               |       |   |   |   | $ | 520,978 |   |   |   |   |   |
|                                                 |       |        |       |                               |       |   |   |   |   |   |   |   |   |
| **Liabilities  and Stockholders’ Equity**       |       |        |       |                               |       |   |   |   |   |   |   |   |   |
| Interest-bearing  demand                             |       | $           | 82,966     |                               | $          | 268 |   | 1.31 | % | $ | 89,762 |   | $ | 287 |   | 1.30 | % |
| Savings and  money market                            |       | 140,505     |       | 745                                |       | 2.15 |   | 154,980 |   | 734 |   | 1.92 |   |
| Certificates of  deposit                             |       | 153,516     |       | 1,829                              |       | 4.83 |   | 121,492 |   | 1,106 |   | 3.69 |   |
| Total  interest-bearing deposits                     |       | 376,987     |       | 2,842                              |       | 3.06 |   | 366,234 |   | 2,127 |   | 2.36 |   |
| Securities sold  under agreement to repurchase       |       | 14,103      |       | 132                                |       | 3.80 |   | 12,453 |   | 103 |   | 3.35 |   |
| Total  interest-bearing deposits & liabilities   |       | 391,090     |       | 2,974                              |       | 3.08 | % | 378,687 |   | 2,230 |   | 2.39 | % |
| Non  interest-bearing demand deposits                |       | 73,110      |       |                               |       |   |   | 73,376 |   |   |   |   |   |
| Other  non-interest-bearing liabilities              |       | 3,323       |       |                               |       |   |   | 2,615 |   |   |   |   |   |
| Total  liabilities                                   |       | 467,523     |       |                               |       |   |   | 454,678 |   |   |   |   |   |
| Stockholders’  equity                           |       | 67,640      |       |                               |       |   |   | 66,300 |   |   |   |   |   |
| Total  liabilities and stockholders equity           |       | $           | 535,163    |                               |       |   |   |   | $ | 520,978 |   |   |   |   |   |
| Net interest  income                                 |       |        |       | $                                  | 6,196      |   |   |   |   |   | $ | 5,845 |   |   |   |
| Interest rate  spread                                |       |        |       |                               |       | 4.36 | % |   |   |   |   | 4.39 | % |
| Net interest margin                                  |       |        |       |                               |       | 5.03 | % |   |   |   |   | 4.91 | % |

 

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The followingtable sets forth information on changes in net interest income which areattributable to changes in interest rates and changes in volume for the periodsindicated.  Tax exempt securities,included in investment securities below are stated at their contractualinterest rate. Loan fees of $250,000 and $368,000 respectively are included ininterest earned on loans for the three months ended March 31, 2007 and 2006.  Non-accruing loans have been included in thecomputation of average loans. Changes attributable to the combined effect ofvolume and interest rates have been allocated proportionately.

**Analysis of Changes in Interest Income and ExpenseDue to Changes in Volume and Rate**

(dollars in thousandsexcept share data)
| ** **                                                                        | ** ** | **Increase (Decrease) Due to** | ** ** |
|-----------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|
| **Three months ended March 31, 2007 vs. 2006** | ** ** | **Volume**                                    | ** ** | **Rate** | ** ** | **Total** | ** ** |
| **Interest-Earning  Assets**                                                      |       |                                          |       |   |   |   |   |
| Federal funds  sold                                                               |       | $                                             | (525       | ) | $ | (29 | ) | $ | (554 | ) |
| Investment  securities                                                            |       | 331                                           |       | 233 |   | 564 |   |
| Loans                                                                             |       | 685                                           |       | 400 |   | 1,085 |   |
| Total net change  in income on interest earning assets                            |       | 491                                           |       | 604 |   | 1,095 |   |
| **Interest-Bearing  Liabilities**                                                 |       |                                          |       |   |   |   |   |
| Deposits                                                                          |       | (12                                           | )          | 727 |   | 715 |   |
| Securities sold  under agreements to repurchase                                   |       | 15                                            |       | 14 |   | 29 |   |
| Total net change  in expense on interest-bearing liabilities                      |       | 3                                             |       | 741 |   | 744 |   |
| Net change in net  interest income                                                |       | $                                             | 488        |   | $ | (137 | ) | $ | 351 |   |

 

**NON-INTERESTINCOME  **Non-interestincome, which consists primarily of fees and service charges on deposits andother income, was $762,000 for the quarter ended March 31, 2007 compared to$681,000 for the same period in 2006. The largest component of these increasesrelated to an increase in non-sufficient fund fees, ATM fees and brokered loanfees.

**NON-INTERESTEXPENSE  **Non-interestexpense was $3.9 million for the quarter ended March 31, 2007 and $3.5 millionfor the quarter ended March 31, 2006. These increases were primarily attributable to an 8.1 percent increasein salary expense to $1.8 million in 2007 compared to $1.7 million in 2006 andan increase in consulting fees of $168,000. The increase in salary expense from 2006 to 2007 was primarily due tothe overall growth in employment as Bancorp continued its efforts to increaseand enhance its Retail Banking and Consumer and Commercial Lending staff.

The efficiencyratio is computed by dividing total operating expenses by non-interest incomeand net interest income after 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 ended March 31, 2007 was 55.5percent and 53.4 percent compared to the same time period in 2006. Theseincreases from 2006 were primarily due to increases in non-interest expenses.

**INCOMETAX EXPENSE  **Incometax expense for the quarter ended March 31, 2007 was $765,000 compared to$870,000 for the quarter ended March 31, 2006. The Bank’s effective tax rateswere 24.2 percent and 28.6 percent for the three months ended March 31, 2007and 2006, respectively. The effective tax rate is lower than the federalstatutory rate due to tax credits and interest income from tax-exempt municipalbonds and loans.

**REVIEW OF FINANCIAL CONDITION**

Assets totaled $555.1 million atMarch 31, 2007, compared to $532.8 million at December 31, 2006.  The increase was primarily due to a $14.9million increase in deposits.

**INVESTMENT SECURITIES AND FEDERALFUNDS SOLD   **Total investment securitiesand federal funds increased $23.5 million to $198.2 million at March 31, 2007compared to $174.7 million at December 31, 2006. This increase was primarilydue to a $36.7 million increase in federal funds sold which was partiallyoffset by decrease in US Agency investments.

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

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

**Investment Securities Composition**
| **(dollars in thousands)** | ** ** | **March 31, 2007** | ** ** | **December 31, 2006** | ** ** |
|--------------------------------------|------------|------------------------------|------------|---------------------------------|------------|
| **Held-to-maturity**                 |       |                         |       |                            |       |
| U.S. government  agencies            |       | $                            | —     |                            | $          | — |   |
| State and  political subdivisions    |       | 35,331                       |       | 35,034                          |       |
| Total                                |       | $                            | 35,331     |                            | $          | 35,034 |   |
| **Available-for-sale**               |       |                         |       |                            |       |
| U.S. government  agencies            |       | $                            | 76,709     |                            | $          | 90,520 |   |
| Mortgage-backed-securities           |       | 19,241                       |       | 19,777                          |       |
| State and  political subdivisions    |       | 4,539                        |       | 3,644                           |       |
| Total                                |       | $                            | 100,489    |                            | $          | 113,941 |   |

 

**LOANS  **Netloans were $318.4 million at March 31, 2007 compared to $320.6 million atDecember 31, 2006.  This decrease wasprimarily due to a decrease in commercial loans which was partially offset byan increase of $7.3 million in real estate commercial and residential loans.

Bancorpconcentrates on five areas of lending: loans to individuals for businesspurposes, loans for small and medium-sized businesses, agricultural loans,loans to commercial enterprises for real estate transactions and consumerpurpose loans.  Bancorp’s primary lendingactivities includes commercial real estate loans, commercial loans whichincludes agriculture production loans and consumer purpose loans.

Mostof Bancorp’s business activity is with customers located within Skagit,Snohomish and Whatcom Counties. Bancorp originates commercial, real estate andconsumer loans. Generally, loans are secured by accounts receivable, inventory,deposit accounts, personal property or real estate. Rights to collateral varyand are legally documented to the extent practicable.

Real estate loanscomprise the largest category of loans with a total of $228.1 million or 70.2percent and $227.0 million or 69.3 percent as of March 31, 2007 and December31, 2006, respectively. Bancorp is committed to providing competitivecommercial real estate lending within our primary market areas.  Our real estate portfolio consists ofcommercial and residential loans.  Theseloans are secured by property such as office buildings, retail buildings, owneroccupied commercial business properties, farm land, timber land, residentialland development properties and residential properties. While Bancorp hassignificant balances secured by real estate, Bancorp believes that its lendingpolicies and concentration policies are sufficient to minimize risks.  Also, economic conditions may affect aborrower’s ability to meet the stated repayment terms. Fixed-rate and variablerate residential mortgage loans are offered through Bancorp’s home loandepartment. Bancorp places a majority of these loans through Countrywide Mortgageand Washington Mutual.

Commercial loanswere $67.0 million as of March 31, 2007 and $72.0 million as of December 31,2006.    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 SmallBusiness Administration (SBA) loans, including 504 and 7A loans.

Consumer loanswere $29.9 million at March 31, 2007 and $28.4 million at December 31, 2006.Bancorp makes secured and unsecured consumer loans including loans toindividuals, primarily customers of Bancorp, for various purposes, includinghome equity loans, purchases of automobiles, mobile homes, boats and otherrecreational vehicles, home improvement loans and loans for education andpersonal investments.

The Board ofDirectors has approved specific lending policies and procedures for Bancorp andmanagement is responsible for implementation of the policies.  The lending policies and procedures includeguidelines for 

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concentrations ofcredit, loan terms, loan-to-value ratios, collateral appraisals and interestrates.  The loan policies also vestvarying levels of loan authority in management, Bancorp’s loan officers and theBoard of Directors.

The following table presents the composition of loans for Bancorp as ofthe dates indicated.

**Loan Composition**
| ** **                                       | ** ** | **March 31, 2007** | ** ** | **December 31, 2006** | ** ** |
|--------------------------------------------------|------------|------------------------------|------------|---------------------------------|------------|
| **(dollars in thousands)**             | ** ** | **Amount**                   | ** ** | **%**                           | ** ** | **Amount** | ** ** | **%** | ** ** |
| Real estate –  residential & commercial |       | $                            | 202,270    |                            | 62.2       | % | $ | 194,989 |   | 59.5 | % |
| Real estate  construction                        |       | 25,861                       |       | 8.0                             | %          | 32,031 |   | 9.8 | % |
| Commercial, industrial  & agricultural       |       | 67,036                       |       | 20.6                            | %          | 72,033 |   | 22.0 | % |
| Consumer                                         |       | 29,850                       |       | 9.2                             | %          | 28,385 |   | 8.7 | % |
| Total loans                                      |       | 325,017                      |       | 100                             | %          | 327,438 |   | 100 | % |
| Less:                                            |       |                         |       |                            |       |   |   |   |   |
| Allowance for  loan losses                       |       | 5,018                        |       |                            |       | 5,176 |   |   |   |
| Deferred loan  fees                              |       | 1,622                        |       |                            |       | 1,694 |   |   |   |
| Net loans                                        |       | $                            | 318,377    |                            |       |   | $ | 320,568 |   |   |   |

 

**PROVISIONAND ALLOWANCE FOR LOAN LOSSES  **Theallowance for loan losses was $5.0 million as of March 31, 2007 and $5.2million as of December 31, 2006. When available information confirms thatspecific loans, or portions thereof, are uncollectible, those amounts arecharged off against the allowance for loan losses.  Net charges-offs for the three months endedMarch 31, 2007 were $8,000 compared to net recoveries of $176,000 for the threemonths ended March 31, 2006.

For the quarterended March 31, 2007, Bancorp reported a $150,000 benefit for loan lossescompared to no provision or benefit for loan losses in 2006. This was primarilyrelated to the improved credit quality in the loan portfolio and minimal netcharge-offs.  Total non-accrual loansincreased $3.1 million year over year, however total classified assets andtotal loan delinquency rates (excluding non-accruing loans) decreased year overyear. In the future, normal growth of the loan portfolio may require anincrease in the allowance for loan losses.

The allowance for loan losses is maintained at a level deemed adequateto provide for estimated future losses. Bancorp has a systematic methodologyfor evaluating the adequacy of the allowance for loan losses and the allowanceis evaluated on a quarterly basis. The allowance consists of specific, generaland unallocated components.  Theallowance is based upon Bancorp’s periodic evaluation of the pertinent factorsunderlying the quality of the loan portfolio, including changes in size andcomposition of the loan portfolio, levels and trends in losses anddelinquencies, actual loan loss experience, current economic conditions,specific industry conditions, loan concentrations, detailed analysis ofindividual loans for which full collectibility may not be assured and thedetermination of the existence and the realizable value of the collateralsecuring the loans. The general allowance is then calculated, by applying ahistorical loss percentage factor to the different loan types and the differentrisk gradings.  In addition, as part ofthe process, a specific allowance is determined based on Bancorp’s review ofclassified or non-performing loans for specific weaknesses and evaluation ofthose loans for impairment and loss exposure. The unallocated component of theallowance reflects the margin of imprecision in inherent in the underlyingassumptions used in the methodologies for estimated specific and general lossesin the loan portfolio.   See Note 5 ofNotes to the Consolidated Financial Statements for more information on theallowance for loan losses.

Bancorp currentlymonitors its loan portfolio for potential risk of loss according to an internalrisk-grading system. Management monitors Bancorp’s credit quality to identifypotential problem credits and any loss exposure in a timely manner.  Additionally, loans are subject toexaminations by regulators, who, based upon their judgment, may require Bancorpto make additional provisions or adjustments to its allowance for loanlosses.  Bancorp has assessed and willcontinue to assess on an on-going basis, the impact of the economy on thecredit risk in the loan portfolio. Currently, management is not aware of any unusually large loanconcentrations in industries negatively impacted by the current economy.

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

**Allowance for Loan Loss Activity**

(dollars in thousands)
| ** **                                                                | ** ** | ** ** | ** ** | ** ** | ** ** |
|---------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| **For the three months ended March 31,**    | ** ** | **2007**   | ** ** | **2006**   | ** ** |
| Allowance as of  beginning of year                                        |       | $          | 5,176      |       | $          | 5,178 |   |
| Provision  (benefit) for loan losses                                      |       | (150       | )          | —     |       |
| Charge-offs                                                               |       | (45        | )          | (214       | )          |
| Recoveries                                                                |       | 37         |       | 390        |       |
| Net  (charge-offs) recoveries                                             |       | (8         | )          | 176        |       |
| Balance at end  of period                                                 |       | $          | 5,018      |       | $          | 5,354 |   |
| Ratio of net  (charge-offs) recoveries to average loans during the period |       | (0.01      | )%         | 0.24       | %          |
| Ratio of  allowance to net loans at end of period                         |       | 1.58       | %          | 1.83       | %          |
| Ratio of non-performing  loans to allowance                               |       | 106.56     | %          | 41.76      | %          |

 

**NON-PERFORMINGASSETS  **Non-performingassets decreased to $5.3 million as of March 31, 2007 compared to $5.7 millionas of December 31, 2006. At March 31 2007, three relationships comprised $4.9million of the non-accrual balance. Generally, these loans are well collateralized though loss of principalon certain types of these loans will remain in question until the loans arepaid or collateral is liquidated.  AtMarch 31, 2007, Bancorp had a $1.4 million specific allocation of its allowancefor loan losses relating to three credit relationships. Bancorp willaggressively continue its collection efforts and liquidation of collateral, torecover as large a portion of the non-accrual assets as possible.

Non-performingassets consist of nonaccrual loans, which generally are loans placed on anonaccrual basis when the loan becomes past due 90 days or more, othernon-performing loans and other real estate owned by Bancorp.

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

**Non-Performing Assets**
| **(dollars in thousands)**         | ** ** | **March 31, 2007** | ** ** | **December 31, 2006** | ** ** |
|----------------------------------------------|------------|------------------------------|------------|---------------------------------|------------|
| Non-accrual  loans                           |       | $                            | 5,347      |                            | $          | 5,734 |   |
| Loans past due  90 days or more              |       | —                       |       | —                          |       |
| Total  non-performing loans                  |       | 5,347                        |       | 5,734                           |       |
| Other real estate  owned                     |       | —                       |       | —                          |       |
| Total  non-performing assets                 |       | $                            | 5,347      |                            | $          | 5,734 |   |
| Total  non-performing loans to net loans     |       | 1.68                         | %          | 1.79                            | %          |
| Total  non-performing loans to total assets  |       | 0.97                         | %          | 1.08                            | %          |
| Total non-performing  assets to total assets |       | 0.97                         | %          | 1.08                            | %          |

 

**DEPOSITS  **Bancorp offers a fullrange of deposit services including checking accounts, savings accounts, moneymarket accounts and various types of certificates of deposit.  Transaction accounts and certificates ofdeposit are tailored to Bancorp’s primary market area at rates competitive withthose offered in the area.  At March 31,2007 total deposits were $464.3 million compared to $449.3 million at December31, 2006.  Starting in 2004 andcontinuing in 2005 and 2006, as interest rates began to increase, time depositsbecame more attractive to investors. Time deposits increased to 34.8 percent ofdeposits at March 31, 2007 compared to 32.1 percent of deposits at December 31,2006 as outlined in the following table. Time deposits increased $17.6 million while core deposits decreased $2.7million.

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The followingtable presents the balance and percent of total deposits in the variouscategories of deposits offered by Bancorp as of the dates indicated.

**Deposit Composition**
| ** **                           | ** ** | **March 31, 2007** | ** ** | **December 31, 2006** | ** ** |
|--------------------------------------|------------|------------------------------|------------|---------------------------------|------------|
| **(dollars in thousands)** | ** ** | **Amount**                   | ** ** | **% of Total**        | ** ** | **Amount** | ** ** | **% of Total** | ** ** |
| Non-interest  bearing demand         |       | $                            | 72,843     |                            | 15.7       | % | $ | 81,250 |   | 18.1 | % |
| Interest bearing  demand             |       | 86,258                       |       | 18.6                            | %          | 83,602 |   | 18.6 | % |
| Money market                         |       | 62,968                       |       | 13.6                            | %          | 59,855 |   | 13.3 | % |
| Savings                              |       | 80,411                       |       | 17.3                            | %          | 80,434 |   | 17.9 | % |
| Time                                 |       | 161,786                      |       | 34.8                            | %          | 144,202 |   | 32.1 | % |
| Total deposits                       |       | $                            | 464,266    |                            |       |   | $ | 449,343 |   |   |   |

 

**SECURITIESSOLD UNDER AGREEMENTS TO REPURCHASE  **Asof March 31, 2007 and December 31, 2006, securities sold under agreements torepurchase were $13.8 million and $14.1 million, respectively. These borrowingsdecrease or increase primarily based on the availability of funds and currentcompetitive interest rates offered. These borrowings are collateralized by securities with an estimated fairvalue exceeding the face value of the borrowings.

**CAPITALRESOURCES  **Stockholders’equity increased to $69.1 million at March 31, 2007 from $66.5 million atDecember 31, 2006.  Book value per shareat March 31, 2007 was $102.60 compared to book value of $98.80 at December 31,2006.

Bancorp has only one class of stock, which is common stock.  Bancorp’s stock is not actively traded orquoted and no broker currently makes a market in the stock. However, sales andtransfers of the stock do occur.  SkagitState Bank acts as transfer agent for Bancorp stock.  To facilitate trading, the Bank maintains alist of persons interested (known to the Bank) in either purchasing or sellingBancorp stock.  Purchasers and sellersthen negotiate their own transactions with the Bank acting as transfer agentfor those transactions. From time to time, Bancorp repurchases shares ofits common stock. The number of shares ofstock that will be repurchased and the price that will be paid is the result ofmany factors including market and economic conditions, the number of sharesavailable, Bancorp’s liquidity and capital needs and regulatoryrequirements.  For the three months endedMarch 31, 2007, the Company repurchased 475 shares of stock for a price of $161per share.

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Bankingregulations require bank holding companies and banks to maintain certainminimum capital levels.  As the followingtable indicates as of March 31, 2007, Skagit State Bancorp, Inc. and SkagitState Bank both exceeded the well-capitalized requirements.   The following table sets forth theirrespective capital positions as of March 31, 2007:
| ** **                           | ** ** | ** ** | ** ** | ** **                 | ** ** | ** **                 | ** ** | ** **                 | ** ** | **To Be Well**   | ** ** |
|--------------------------------------|------------|------------|------------|----------------------------|------------|----------------------------|------------|----------------------------|------------|----------------------------|------------|
| ** **                           | ** ** | ** ** | ** ** | ** **                 | ** ** | ** **                 | ** ** | ** **                 | ** ** | **Capitalized Under** | ** ** |
| ** **                           | ** ** | ** ** | ** ** | ** **                 | ** ** | **For Capital**       | ** ** | **Prompt Corrective** | ** ** |
| ** **                           | ** ** | **Actual** | ** ** | **Adequacy Purposes** | ** ** | **Action Provisions** | ** ** |
| **(dollars in thousands)** | ** ** | **Amount** | ** ** | **Ratio**                  | ** ** | **Amount**                 | ** ** | **Ratio**                  | ** ** | **Amount**                 | ** ** | **Ratio** | ** ** |
| As of March 31,  2007                |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| Total Capital                        |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| (to Risk-Weighted Assets)            |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| Skagit State Bank                    |       | $          | 73,982     |                       | 18.78      | %                          | $     | 31,520                     | >  | 8.00                       | %          | $  | 39,400 | >  | 10.00 | % |
| Skagit State Bancorp, Inc.           |       | $          | 74,099     |                       | 18.81      | %                          | $     | 31,523                     | >  | 8.00                       | %          | $  | 39,403 | >  | 10.00 | % |
| Tier I Capital                       |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| (to Risk-Weighted Assets)            |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| Skagit State Bank                    |       | $          | 69,056     |                       | 17.53      | %                          | $     | 15,760                     | >  | 4.00                       | %          | $  | 23,640 | >  | 6.00 | % |
| Skagit State Bancorp, Inc.           |       | $          | 69,172     |                       | 17.55      | %                          | $     | 15,761                     | >  | 4.00                       | %          | $  | 23,642 | >  | 6.00 | % |
| Tier I Capital                       |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| (to Average Assets)                  |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| Skagit State Bank                    |       | $          | 69,056     |                       | 12.94      | %                          | $     | 21,342                     | >  | 4.00                       | %          | $  | 26,677 | >  | 5.00 | % |
| Skagit State Bancorp, Inc.           |       | $          | 69,172     |                       | 12.96      | %                          | $     | 21,342                     | >  | 4.00                       | %          | $  | 26,677 | >  | 5.00 | % |
|                                 |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| As of December  31, 2006             |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| Total Capital                        |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| (to Risk-Weighted Assets)            |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| Skagit State Bank                    |       | $          | 71,548     |                       | 17.96      | %                          | $     | 31,878                     | >  | 8.00                       | %          | $  | 39,847 | >  | 10.00 | % |
| Skagit State Bancorp, Inc.           |       | $          | 71,796     |                       | 18.02      | %                          | $     | 31,878                     | >  | 8.00                       | %          | $  | 39,847 | >  | 10.00 | % |
| Tier I Capital                       |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| (to Risk-Weighted Assets)            |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| Skagit State Bank                    |       | $          | 66,565     |                       | 16.71      | %                          | $     | 15,939                     | >  | 4.00                       | %          | $  | 23,908 | >  | 6.00 | % |
| Skagit State Bancorp, Inc.           |       | $          | 66,813     |                       | 16.77      | %                          | $     | 15,939                     | >  | 4.00                       | %          | $  | 23,908 | >  | 6.00 | % |
| Tier I Capital                       |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| (to Average Assets)                  |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| Skagit State Bank                    |       | $          | 65,565     |                       | 12.66      | %                          | $     | 21,031                     | >  | 4.00                       | %          | $  | 26,289 | >  | 5.00 | % |
| Skagit State  Bancorp, Inc.          |       | $          | 66,813     |                       | 12.71      | %                          | $     | 21,031                     | >  | 4.00                       | %          | $  | 26,289 | >  | 5.00 | % |

 

**LIQUIDITY**Liquidity management focuses on the need to meet both short-term fundingrequirements and long-term strategies and goals.  The objective of liquidity management is toensure Bancorp has adequate liquidity to accommodate fluctuations in depositlevels, fund operations, and provide for customer credit needs and to meetother obligations and commitments on a timely basis. Bancorp’s long term growthobjectives are to attract and retain business customer and consumerrelationships with a focus on transaction accounts and commercial and consumerlending.  Bancorp structures the balancesheet to meet those objectives. The majority of Bancorp’s funding comes fromcustomer deposits within its market area. 

Bancorphas generally been a net seller of federal funds.  At March 31, 2007 and December 31, 2006,Bancorp’s federal funds sold were $62.4 million and $25.7 million,respectively. Other sources of potential liquidity include loan repayments,investment securities repayments and borrowing through pre-approved creditlines. Liquidity is also obtained by maintaining assets that are readilyconvertible to cash through maturities and sales.  As of March 31, 2007 Bancorp had $35.0million in approved credit lines from various financial institutions. 

SkagitState Bancorp, Inc. is a separate legal entity from the Bank and must providefor its own liquidity.  Substantially allof Bancorp’s revenues are obtained from dividends declared and paid by theBank. Skagit State 

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Bank’sability to pay dividends is limited by its earnings, financial condition andcapital requirements, as well as regulatory restrictions. 

**Item 3.    QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

Theresults of operations for financial institutions are largely dependent upon thefinancial institution’s ability to manage market risks which includes interestrate risk.  Interest rate risk refers tothe exposure of earnings and capital arising from changes in interest rates. 

Bancorpmaintains an asset/liability management program which is the responsibility ofthe Asset/Liability Committee.  Theobjective of asset/liability management is to maximize long-term stockholderreturns and to manage, protect and stabilize Bancorp’s net interest income fromundue interest rate risk through various interest rate cycles within theconstraints of credit quality, interest rate risk policies, levels of capitaland adequate levels of liquidity.  Thecommittee meets to monitor the composition of the balance, to review projectedearnings trends, and to formulate strategies consistent with these objectivesfor liquidity, interest rate risk, and capital adequacy. 

Bancorpbelieves that there have not been any material changes about Bancorp’s marketrisk from the information that was provided in the Form 10-K for the year endedDecember 31, 2006. 

**Item 4.    CONTROLSAND PROCEDURES**

Evaluation of Disclosure Controls and ProceduresThe Company’s Chief Executive Officer andChief Financial Officer have reviewed and evaluated the effectiveness of ourdisclosure controls and procedures, required by Exchange Act Rules 13(a) -15(b), as of the end of the period covered by this quarterly report.  Based on that evaluation, the Chief ExecutiveOfficer and Chief Financial Officer have concluded that Bancorp’s currentdisclosure controls and procedures are effective and timely, providing themwith material information relating to Bancorp required to be disclosed in thereports we file or submit under the Exchange Act.

Changes in Internal ControlsThere have not been any significant changesin our internal controls or in other factors that could significantly affectthese controls subsequent to the date of their evaluation.  Bancorp did not identify nor implement anycorrective actions with regard to any significant deficiencies or materialweaknesses in its internal controls.

**PART II -         OTHER INFORMATION**

**Item 1.              Legal Proceedings**

Fromtime to time, Bancorp may be a plaintiff and/or defendant in certain claims andlegal actions arising in the ordinary course of commercial banking involvingreal estate lending transactions and other ordinary routine litigationincidental to the business of Bancorp. Bancorp is not a party to any pending legal proceedings that Bancorpbelieves would have a material adverse effect on the financial condition ofBancorp. 

**Item 1A.           Risk Factors**

Therehave been no material changes in Bancorp’s risk factors from those disclosed inthe 2006 Annual Report on Form 10-K.  Forinformation regarding risk factors, refer to the Company’s 2006 Annual Reporton Form 10-K. 

**Item 2.              Unregistered Sales of Equity Securities and Use ofProceeds**

None

**Item 3.              Defaults Upon Senior Securities**

None

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

None

**Item 5.              Other Information**

None

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**Item 6.              Exhibits**

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

 

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**SIGNATURES**

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.
|        |                | SKAGIT STATE BANCORP, INC.                                        |
|--------|---------------------|-------------------------------------------------------------------|
|   |                | (Registrant)                                                      |
|   |                |                                                              |
|   |                |                                                              |
| Dated: |   May 10, 2007 |                                                              | /s/ Cheryl R. Bishop |
|   |                | Cheryl R. Bishop   Chief Executive Officer                        |
|   |                |                                                              |
|   |                |                                                              |
| Dated: |   May 10, 2007 |                                                              | /s/ Carla F. Tucker |
|   |                | Carla F. Tucker   Senior Vice-President   Chief Financial Officer |

 

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