**UNITED STATES SECURITIES AND EXCHANGE COMMISSON**

**Washington D.C., 20549**

 

**FORM 10-Q**

 

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

 

**For the quarterly period ended September 30, 2008**

 

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

 

**For the transition period from                       to                      **

 

**Commission File Number  000-52096**

 

**SKAGIT STATE BANCORP, INC.**

(Exact Name of Registrant asSpecified in Its Charter)

 

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

 

**301 East Fairhaven Avenue**

**Burlington, Washington  98233**

(Address of PrincipalExecutive Offices) (Zip Code)

 

**(360) 755-0411**

(Registrant’s TelephoneNumber, Including Area Code)

 

Indicate by check mark whether the registrant: (1) has filed allreports required to be filed by Section 13 or 15(d) of the ExchangeAct of 1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days.

 

Yes x            No o

 

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

 

Large acceleratedfiler o Acceleratedfiler o Non-accelerated filer o SmallerReporting Company x

 

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

 

Yes o            No x

 

Indicate the number of shares outstanding of each of the issuer’sclasses of common stock, as of the latest practicable date:

 

The number of shares of the issuer’s Common Stock outstanding at November 14,2008 was 588,444.

 

 

 

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**SKAGIT STATE BANCORP, INC.**

**TABLE OF CONTENTS**

 
| **PART I.**  | **FINANCIAL INFORMATION** |                                                                                                                                                  |
|-------------------|---------------------------|-------------------------------------------------------------------------------------------------------------------------------------------------------|
|              |                      |                                                                                                                                                  |   |
|              | Item 1.                   | Financial  Statements                                                                                                                                 |   |
|              |                      |                                                                                                                                                  |   |
|              |                      | Consolidated  Balance Sheets as of September 30, 2008 and December 31, 2007                                                                 | 3 |
|              |                      |                                                                                                                                                  |   |
|              |                      | Consolidated  Statements of Income for the three and nine months ended September 30,  2008 and 2007                                              | 4 |
|              |                      |                                                                                                                                                  |   |
|              |                      | Consolidated  Statements of Changes in Stockholders’ Equity and Comprehensive Income for  the nine months ended September 30, 2008 and 2007 | 5 |
|              |                      |                                                                                                                                                  |   |
|              |                      | Consolidated  Statements of Cash Flows for the nine months ended September 30, 2008  and 2007                                                    | 6 |
|              |                      |                                                                                                                                                  |   |
|              |                      | Notes  to Consolidated Financial Statements                                                                                                           | 7-12 |
|              |                      |                                                                                                                                                  |   |
|              | Item 2.                   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                                           | 12-23 |
|              |                      |                                                                                                                                                  |   |
|              | Item 3.                   | Quantitative  and Qualitative Disclosures About Market Risk                                                                                           | 23 |
|              |                      |                                                                                                                                                  |   |
|              | Item 4T.                  | Controls  and Procedures                                                                                                                              | 23 |
|              |                      |                                                                                                                                                  |   |
| **PART II.** | **OTHER INFORMATION**     |                                                                                                                                                  |
|              |                      |                                                                                                                                                  |   |
|              | Item 1.                   | Legal  Proceedings                                                                                                                                    | 24 |
|              |                      |                                                                                                                                                  |   |
|              | Item 1 A.                 | Risk  Factors                                                                                                                                         | 24-26 |
|              |                      |                                                                                                                                                  |   |
|              | Item 2.                   | Unregistered  Sales of Equity Securities and Use of Proceeds                                                                                          | 26 |
|              |                      |                                                                                                                                                  |   |
|              | Item 3.                   | Defaults  Upon Senior Securities                                                                                                                      | 26 |
|              |                      |                                                                                                                                                  |   |
|              | Item 4.                   | Submission  of Matters to a Vote of Security Holders                                                                                                  | 26 |
|              |                      |                                                                                                                                                  |   |
|              | Item 5.                   | Other  Information                                                                                                                                    | 26 |
|              |                      |                                                                                                                                                  |   |
|              | Item 6.                   | Exhibits                                                                                                                                              | 26 |
|              |                      |                                                                                                                                                  |   |
|              |                      | Signatures                                                                                                                                            | 27-30 |

 

2

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**Item 1.    Financial Statements**

 

**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

**CONSOLIDATED BALANCE SHEETS(Unaudited)**

 
| **(dollars in thousands except share data)**                                                                                                | ** ** | **September 30, 2008** | ** ** | **December 31, 2007** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                                                                                                                           | ** ** | ** **                       | ** ** | ** **                      | ** ** |
| **ASSETS**                                                                                                                                                           | ** ** |
| ** **                                                                                                                                                           | ** ** | ** **                       | ** ** | ** **                      | ** ** |
| **ASSETS**                                                                                                                                                           | ** ** | ** **                       | ** ** | ** **                      | ** ** |
| Cash and due  from banks                                                                                                                                             |       | $                                | 15,797     |                            | $          | 16,641 |   |
| Federal funds  sold                                                                                                                                                  |       | —                           |       | 41,195                          |       |
| Investment  securities                                                                                                                                               |       |                             |       |                            |       |
| Available-for-sale,  at fair value                                                                                                                                   |       | 108,209                          |       | 126,953                         |       |
| Held-to-maturity,  at amortized cost                                                                                                                                 |       | 36,181                           |       | 39,926                          |       |
| Loans                                                                                                                                                                |       | 393,358                          |       | 355,198                         |       |
| Allowance for  loan losses                                                                                                                                           |       | (4,373                           | )          | (4,535                          | )          |
| Net loans                                                                                                                                                            |       | 388,985                          |       | 350,663                         |       |
| Bank premises  and equipment, net                                                                                                                                    |       | 11,652                           |       | 12,095                          |       |
| Other real  estate owned                                                                                                                                             |       | 5,616                            |       | —                          |       |
| Accrued interest  receivable                                                                                                                                         |       | 3,112                            |       | 3,464                           |       |
| Other assets                                                                                                                                                         |       | 2,085                            |       | 1,726                           |       |
| **TOTAL  ASSETS**                                                                                                                                                    |       | $                                | 571,637    |                            | $          | 592,663 |   |
| ** **                                                                                                                                                           | ** ** | ** **                       | ** ** | ** **                      | ** ** |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                       | ** ** |
| ** **                                                                                                                                                           | ** ** | ** **                       | ** ** | ** **                      | ** ** |
| **LIABILITIES**                                                                                                                                                      |       |                             |       |                            |       |
| Deposits                                                                                                                                                             |       |                             |       |                            |       |
| Interest-bearing                                                                                                                                                     |       | $                                | 393,456    |                            | $          | 422,463 |   |
| Non-interest-bearing                                                                                                                                                 |       | 73,449                           |       | 77,957                          |       |
| Total deposits                                                                                                                                                       |       | 466,905                          |       | 500,420                         |       |
| Other borrowings                                                                                                                                                     |       | 42,852                           |       | 15,851                          |       |
| Other  liabilities                                                                                                                                                   |       | 1,770                            |       | 3,709                           |       |
| Total  liabilities                                                                                                                                                   |       | 511,527                          |       | 519,980                         |       |
|                                                                                                                                                                 |       |                             |       |                            |       |
| **STOCKHOLDERS’  EQUITY**                                                                                                                                       |       |                             |       |                            |       |
| Common stock no  par value, 5,000,000 shares authorized, 586,075 and 670,997 shares issued and  outstanding at September 30, 2008 and December 31, 2007 respectively |       | 11,989                           |       | 13,564                          |       |
| Accumulated  other comprehensive income, net of tax                                                                                                                  |       | 347                              |       | 694                             |       |
| Retained  earnings                                                                                                                                                   |       | 47,774                           |       | 58,425                          |       |
| Total  stockholders’ equity                                                                                                                                     |       | 60,110                           |       | 72,683                          |       |
| **TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                 |       | $                                | 571,637    |                            | $          | 592,663 |   |

 

*See accompanying notes to theseconsolidated financial statements*

 

3

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**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

**CONSOLIDATEDSTATEMENTS OF INCOME (Unaudited)**

 
| ** **                                                            | ** ** | **Three months ended Sept. 30,** | ** ** | **Nine months ended Sept. 30,** | ** ** |
|-----------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| **(dollars in thousands except share data)** | ** ** | **2008**                                             | ** ** | **2007**                                            | ** ** | **2008** | ** ** | **2007** | ** ** |
| ** **                                                            |       |                                                 |       |                                                |       |   |   |   |   |
| **INTEREST  INCOME**                                                  |       |                                                 |       |                                                |       |   |   |   |   |
| Interest and  fees on loans                                           |       | $                                                    | 6,516      |                                                | $          | 7,050 |   | $ | 19,187 |   | $ | 21,126 |   |
| Investment  securities                                                |       |                                                 |       |                                                |       |   |   |   |   |
| Taxable                                                               |       | 1,225                                                |       | 1,421                                               |       | 4,094 |   | 4,027 |   |
| Exempt from  federal income tax                                       |       | 290                                                  |       | 281                                                 |       | 924 |   | 757 |   |
| Federal funds  sold                                                   |       | 12                                                   |       | 431                                                 |       | 285 |   | 1,393 |   |
| Total interest  income                                                |       | 8,043                                                |       | 9,183                                               |       | 24,490 |   | 27,303 |   |
| **INTEREST  EXPENSE**                                                 |       |                                                 |       |                                                |       |   |   |   |   |
| Deposits                                                              |       | 2,213                                                |       | 3,327                                               |       | 7,636 |   | 9,296 |   |
| Other borrowed  funds                                                 |       | 131                                                  |       | 168                                                 |       | 384 |   | 453 |   |
| Total interest  expense                                               |       | 2,344                                                |       | 3,495                                               |       | 8,020 |   | 9,749 |   |
| **NET  INTEREST INCOME**                                              |       | 5,699                                                |       | 5,688                                               |       | 16,470 |   | 17,554 |   |
| Provision (benefit)  for loan losses                                  |       | 760                                                  |       | —                                              |       | 760 |   | (150 | ) |
| **NET  INTEREST INCOME AFTER PROVISION (BENEFIT) FOR LOAN LOSSES**    |       | 4,939                                                |       | 5,688                                               |       | 15,710 |   | 17,704 |   |
| **NON-INTEREST  INCOME**                                              |       |                                                 |       |                                                |       |   |   |   |   |
| Service charges  on deposits                                          |       | 797                                                  |       | 765                                                 |       | 2,322 |   | 1,943 |   |
| Other                                                                 |       | 166                                                  |       | 343                                                 |       | 546 |   | 773 |   |
| Gain on sale of  assets                                               |       | 327                                                  |       | 9                                                   |       | 455 |   | 15 |   |
| Total non-interest  income                                            |       | 1,290                                                |       | 1,117                                               |       | 3,323 |   | 2,731 |   |
| **NON-INTEREST  EXPENSE**                                             |       |                                                 |       |                                                |       |   |   |   |   |
| Salaries                                                              |       | 2,058                                                |       | 1,950                                               |       | 5,938 |   | 5,628 |   |
| Payroll taxes  and employee benefits                                  |       | 445                                                  |       | 443                                                 |       | 1,400 |   | 1,369 |   |
| Writedown of  other real estate owned                                 |       | 1,369                                                |       | —                                              |       | 1,369 |   | — |   |
| Bank premises  and equipment                                          |       | 253                                                  |       | 322                                                 |       | 782 |   | 971 |   |
| Occupancy                                                             |       | 187                                                  |       | 153                                                 |       | 573 |   | 508 |   |
| State business  taxes                                                 |       | 111                                                  |       | 146                                                 |       | 337 |   | 376 |   |
| Advertising                                                           |       | 229                                                  |       | 261                                                 |       | 598 |   | 678 |   |
| Other                                                                 |       | 1,016                                                |       | 891                                                 |       | 2,870 |   | 2,628 |   |
| Total non-interest  expense                                           |       | 5,668                                                |       | 4,166                                               |       | 13,867 |   | 12,158 |   |
| **INCOME  BEFORE PROVISION FOR INCOME TAX**                           |       | 561                                                  |       | 2,639                                               |       | 5,166 |   | 8,277 |   |
| **PROVISION  FOR INCOME TAX**                                         |       |                                                 |       |                                                |       |   |   |   |   |
| Provision for  income tax                                             |       | (83                                                  | )          | 698                                                 |       | 918 |   | 2,033 |   |
| Deferred income  tax (benefit)                                        |       | —                                               |       | (78                                                 | )          | (7 | ) | (78 | ) |
| Total provision  for income tax                                       |       | (83                                                  | )          | 620                                                 |       | 911 |   | 1,955 |   |
| **NET  INCOME**                                                       |       | $                                                    | 644        |                                                | $          | 2,019 |   | $ | 4,255 |   | $ | 6,322 |   |
| **BASIC  EARNINGS PER SHARE**                                         |       | $                                                    | 1.10       |                                                | $          | 3.00 |   | $ | 6.94 |   | $ | 9.40 |   |
| **DILUTED  EARNINGS PER SHARE**                                       |       | $                                                    | 1.09       |                                                | $          | 3.00 |   | $ | 6.89 |   | $ | 9.38 |   |
| **DIVIDENDS  DECLARED PER SHARE**                                     |       | $                                                    | 0.00       |                                                | $          | 0.00 |   | $ | 2.25 |   | $ | 2.25 |   |

 

*Seeaccompanying notes to these consolidated financial statements*

 

4

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**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

**CONSOLIDATEDSTATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY AND COMPREHENSIVE INCOME(Unaudited)**

** **

Nine months ended September 30, 2008 and 2007

 
| ** **                                                                                            | ** ** | ** **            | ** ** | ** **        | ** ** | **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, 2007                                                                           |       | 673,532               |       | $                 | 13,935     |                   | $          | (269                   | )          | $                 | 52,878     |       | $          | 66,544 |   |   |   |
| Comprehensive  income                                                                                 |       |                  |       |              |       |                   |       |                   |       |              |       |       |       |
| Net income                                                                                            |       | —                |       | —            |       | —                 |       | 6,322                  |       | 6,322             |       | $          | 6,322      |   |
| Other  comprehensive income:                                                                          |       |                  |       |              |       |                   |       |                   |       |              |       |       |       |
| Unrealized losses  on available-for-sale securities, net of taxes of $93                              |       | —                |       | —            |       | 180                    |       | —                 |       | 180               |       | 180        |       |
| Total other  comprehensive loss                                                                       |       |                  |       |              |       |                   |       |                   |       |              |       | 180        |       |
| Comprehensive  income                                                                                 |       |                  |       |              |       |                   |       |                   |       |              |       | $          | 6,502      |   |
| Cash dividend  declared, $2.25 per share                                                              |       | —                |       | —            |       | —                 |       | (1,517                 | )          | (1,517            | )          |       |       |
| Common stock  redemption                                                                              |       | (2,870                | )          | (510              | )          | —                 |       | —                 |       | (510              | )          |       |       |
| Stock  compensation expense                                                                           |       | 100                   |       | 101               |       | —                 |       | —                 |       | 101               |       |       |       |
| **BALANCE,**September 30,  2007                                                                       |       | 670,762               |       | $                 | 13,526     |                   | $          | (89                    | )          | $                 | 57,683     |       | $          | 71,120 |   |   |   |
|                                                                                                  |       |                  |       |              |       |                   |       |                   |       |              |       |       |       |
| **BALANCE,**January 1, 2008                                                                           |       | 670,997               |       | $                 | 13,564     |                   | $          | 694                    |       | $                 | 58,425     |       | $          | 72,683 |   |   |   |
| Comprehensive  income                                                                                 |       |                  |       |              |       |                   |       |                   |       |              |       |       |       |
| Net income                                                                                            |       | —                |       | —            |       | —                 |       | 4,255                  |       | 4,255             |       | $          | 4,255      |   |
| Other  comprehensive income:                                                                          |       |                  |       |              |       |                   |       |                   |       |              |       |       |       |
| Unrealized losses  on available-for-sale securities, net of tax benefit of $178                       |       | —                |       | —            |       | (347                   | )          | —                 |       | (347              | )          | (347       | )          |
| Total other  comprehensive loss                                                                       |       |                  |       |              |       |                   |       |                   |       |              |       | (347       | )          |
| Comprehensive  income                                                                                 |       |                  |       |              |       |                   |       |                   |       |              |       | $          | 3,908      |   |
| Cash dividend declared,  $2.25 per share                                                              |       | —                |       | —            |       |                   |       | (1,323                 | )          | (1,323            | )          |       |       |
| Common stock  redemption                                                                              |       | (85,022               | )          | (1,721            | )          | —                 |       | (13,583                | )          | (15,304           | )          |       |       |
| Stock  compensation expense                                                                           |       | 100                   |       | 146               |       | —                 |       | —                 |       | 146               |       |       |       |
| **BALANCE,**September 30,  2008                                                                       |       | 586,075               |       | $                 | 11,989     |                   | $          | 347                    |       | $                 | 47,774     |       | $          | 60,110 |   |   |   |

 

*Seeaccompanying notes to these consolidated financial statements*

 

5

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**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(Unaudited**)

** **
| **(dollars in thousands)**                                                                         | ** ** | ** ** | ** ** | ** ** | ** ** |
|--------------------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| **Nine months ended September 30,**                                                      | ** ** | **2008**   | ** ** | **2007**   | ** ** |
| **CASH  FLOWS FROM OPERATING ACTIVITIES**                                                                    |       |       |       |       |       |
| Net income                                                                                                   |       | $          | 4,255      |       | $          | 6,322 |   |
| *Adjustments  to reconcile net income to net cash flows from operating activities:*                          |       |       |       |       |       |
| Provision  (benefit) for loan losses                                                                         |       | 760        |       | (150       | )          |
| Writedown on  other real estate owned                                                                        |       | 1,369      |       | —     |       |
| Depreciation                                                                                                 |       | 663        |       | 654        |       |
| Loss (gain) on  sale of premises and equipment                                                               |       | (232       | )          | 81         |       |
| Gain on sale of  other real estate owned                                                                     |       | —     |       | (6         | )          |
| Gain on sale of  loans                                                                                       |       | (223       | )          | (9         | )          |
| Amortization of  investment security premiums and discounts, net                                             |       | (178       | )          | (146       | )          |
| Provision for  deferred income taxes                                                                         |       | (7         | )          | (78        | )          |
| Stock  compensation for employee services                                                                    |       | 146        |       | 101        |       |
| *Changes  in operating assets and liabilities:*                                                              |       |       |       |       |       |
| Originations of  loans held for sale                                                                         |       | (15,892    | )          | (555       | )          |
| Proceeds for  sales of loans held for sale                                                                   |       | 16,115     |       | 564        |       |
| Decrease  (increase) in interest receivable                                                                  |       | 352        |       | (354       | )          |
| Increase in  other assets                                                                                    |       | (173       | )          | (1,400     | )          |
| Increase  (decrease) in other liabilities                                                                    |       | (1,939     | )          | 428        |       |
| Net cash flows  from operating activities                                                                    |       | 5,016      |       | 5,452      |       |
| **CASH  FLOWS FROM INVESTING ACTIVITIES**                                                                    |       |       |       |       |       |
| Proceeds from  maturities, calls, and principal paydowns of investment securities –  available-for-sale |       | 38,841     |       | 31,789     |       |
| Purchases of  investment securities – available-for-sale                                                |       | (20,445    | )          | (36,437    | )          |
| Proceeds from  maturities, calls, and principal paydowns of investment securities –  held-to-maturity   |       | 5,872      |       | 3,172      |       |
| Purchases of  investment securities – held-to-maturity                                                  |       | (2,127     | )          | (6,805     | )          |
| Net decrease  (increase) in federal funds sold                                                               |       | 41,195     |       | (17,930    | )          |
| Net increase in  loans                                                                                       |       | (46,028    | )          | (22,756    | )          |
| Purchase of  premises and equipment                                                                          |       | (289       | )          | (602       | )          |
| Capitalized  expenditures for improvements to other real estate owned                                        |       | (39        | )          | —     |       |
| Proceeds from  sale of premises and equipment                                                                |       | 301        |       | —     |       |
| Proceeds from  sale of other real estate owned                                                               |       | —     |       | 6          |       |
| Net cash flows  from investing activities                                                                    |       | 17,281     |       | (49,563    | )          |
| **CASH  FLOWS FROM FINANCING ACTIVITIES**                                                                    |       |       |       |       |       |
| Net decrease in  demand deposits, money market, NOW and savings accounts                                     |       | (1,242     | )          | (6,229     | )          |
| Net increase  (decrease) in time deposits                                                                    |       | (32,273    | )          | 42,810     |       |
| Amount paid for  redemption of common stock                                                                  |       | (15,304    | )          | (510       | )          |
| Net increase  (decrease) in federal funds purchased and securities sold under agreements to  repurchase      |       | 27,001     |       | 2,628      |       |
| Cash dividends  paid                                                                                         |       | (1,323     | )          | (1,517     | )          |
| Net cash flows  from financing activities                                                                    |       | (23,141    | )          | 37,182     |       |
| **NET  CHANGE IN CASH AND DUE FROM BANKS**                                                                   |       | (844       | )          | (6,929     | )          |
| **CASH  AND DUE FROM BANKS,**beginning of period                                                             |       | 16,641     |       | 21,535     |       |
| **CASH  AND DUE FROM BANKS,**end of period                                                                   |       | $          | 15,797     |       | $          | 14,606 |   |
| **SUPPLEMENTAL  DISCLOSURES OF CASH FLOW INFORMATION**                                                       | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash paid during  the period for income taxes                                                                |       | $          | 1,417      |       | $          | 2,387 |   |
| Cash paid during  the period for interest                                                                    |       | 8,293      |       | 9,595      |       |
| **NONCASH  FINANCING AND INVESTING TRANSACTIONS**                                                            |       |       |       |       |       |
| Property taken  in settlement of loans                                                                       |       | 6,946      |       | —     |       |

 

*See accompanying notes to theseconsolidated financial statements*

 

6

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**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

**Note 1:   BASIS OF PRESENTATION**

 

The accompanyingconsolidated financial statements include the accounts of Skagit State Bancorp, Inc.and its subsidiary Skagit State Bank, (collectively, “Company” or “Bancorp).All significant inter-company accounts and transactions have been eliminated.The consolidated financial statements have been prepared in conformity withaccounting principles generally accepted in the United States of America forinterim financial information and with instructions to Form 10-Q.Accordingly they do not include all of the information and footnotes requiredby accounting principles generally accepted in the United States of America forcomplete financial statements. In the opinion of management, all adjustments(consisting of normal recurring accruals) considered necessary for a fairpresentation have been included. Operating results for the nine months ended September 30,2008 are not necessarily indicative of the results anticipated for the yearending December 31, 2008. For additional information, refer to the auditedfinancial statements and footnotes for the most recent annual period ended December 31,2007 contained in the Annual Report on Form 10-K.

 

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

 

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

 

Bancorp’s financialstatements are based upon the selection and application of significantaccounting policies which by their nature are inherently subject to estimationtechniques, valuation assumptions and other subjective assessments. Inparticular, management has identified several accounting policies that due tojudgments, estimates and assumptions inherent in those policies are importantto an understanding of Bancorp’s financial statements.  These policies relate to the determination ofthe allowance for loan losses, the valuation of real estate owned, deferredincome taxes, stock based compensation and impairment of investments. Thesepolicies and the judgments, estimates and assumptions are described in theAnnual Report on Form 10-K for the year ended December 31, 2007.

 

**Note 3:   RECLASSIFICATIONS**

 

Certain reclassificationshave been made to the 2007 financial statements to conform to the 2008presentation. Such classifications have no affect on net income.

 

**Note 4:   EARNINGSPER SHARE**

 

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

 

(dollars in thousands exceptshare and per share amounts)

 
| ** **                                                                      | ** ** | **Three months ended Sept. 30,** | ** ** | **Nine months ended Sept. 30,** | ** ** |
|---------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                      | ** ** | **2008**                                             | ** ** | **2007**                                            | ** ** | **2008** | ** ** | **2007** | ** ** |
| Numerator:                                                                      |       |                                                 |       |                                                |       |   |   |   |   |
| Net income                                                                      |       | $                                                    | 644        |                                                | $          | 2,019 |   | $ | 4,255 |   | $ | 6,322 |   |
| Denominator:                                                                    |       |                                                 |       |                                                |       |   |   |   |   |
| Denominator for  basic earnings per share - Weighted average shares outstanding |       | 586,038                                              |       | 671,085                                             |       | 612,682 |   | 672,298 |   |
| Effect of  dilutive securities:                                                 |       |                                                 |       |                                                |       |   |   |   |   |
| Stock options  and unvested restricted stock grants                             |       | 5,112                                                |       | 1,333                                               |       | 4,902 |   | 1,434 |   |
| Denominator for  diluted earning per share Weighted average shares outstanding  |       | 591,150                                              |       | 672,418                                             |       | 617,584 |   | 673,732 |   |
| Basic earnings  per share                                                       |       | $                                                    | 1.10       |                                                | $          | 3.00 |   | $ | 6.94 |   | $ | 9.40 |   |
| Diluted earnings  per share                                                     |       | $                                                    | 1.09       |                                                | $          | 3.00 |   | $ | 6.89 |   | $ | 9.38 |   |

 

7

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**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

**Note 5:   SUBSEQUENTEVENTS**

 

On July 11, 2008,Bancorp announced the pending sale and closure of its Boulevard branch locatedat 1575 Burlington Boulevard in Burlington, Washington. On October 31, 2008,the branch was closed.

 

**Note 6:   ALLOWANCE FOR LOAN LOSSES**

 

The allowance for loan losses is maintained at a level deemed adequateto provide for estimated future losses and represents management’s bestestimate of the probable credit losses inherent in the Bancorp’sportfolio.  Bancorp has a systematicmethodology for evaluating the adequacy of the allowance for loan losses andthe allowance is evaluated on a quarterly basis. The allowance consists ofspecific, general and unallocated components. The allowance is based upon Bancorp’s periodic evaluation of thepertinent factors underlying the quality of the loan portfolio, includingchanges in size and composition of the loan portfolio, levels and trends inlosses and delinquencies, actual loan loss experience, current economicconditions, specific industry conditions, loan concentrations, detailedanalysis of individual loans for which full collectability may not be assuredand the determination of the existence and the realizable value of the collateralsecuring the loans. The general allowance is then calculated, by applying aloss percentage factor to the different loan types and the different riskgradings.  In addition, as part of theprocess, 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 inherent in the underlyingassumptions used in the methodologies for estimated specific and general lossesin the loan portfolio.

 

Additions to the allowance, in the form of provisions, are reflected incurrent operating results, while charge-offs to the allowance are made when aloss is determined to have occurred.  Theultimate recovery of loans is susceptible to future market factors beyondBancorp’s control. These factors may result in losses or recoveries differingsignificantly from those provided in Bancorp’s financial statements. Bancorp’speriodic evaluation of the allowance for loan losses is inherently subjectiveas it requires estimates that are susceptible to significant revision as moreinformation becomes available. In addition, regulatory agencies, as an integralpart of their examination process, periodically review the estimated losses onloans.  Such agencies may require Bancorpto recognize additional provisions or adjustments to its allowance for loanlosses based on their judgment using information available to them at the timeof their examination.

 

**Note 7:   STOCK-BASEDCOMPENSATION**

 

Bancorp has one share-based payment plan, which is shareholderapproved, and permits the grant of share-based awards to its employees anddirectors up to 100,000 shares.  The planaddresses stock options, restricted stock awards and other stock basedcompensation awards.  This plan isprimarily designed to recognize, motivate, reward and retain eligible employeesand to better align the interest of Bancorp’s employees with those of itsshareholders.  In addition to thisshare-based payment plan, Bancorp has outstanding restricted stock awardsgranted pursuant to an employment agreement with an executive officer. Totalequity compensation expense was $146,000 and $101,000 for the nine months endedSeptember 30, 2008 and September 30, 2007, respectively.

 

All options granted during 2008 were Incentive Stock Options. In orderto qualify as Incentive Stock Options, options granted must meet certain IRScriteria which includes special criteria for employees with 10% or greaterownership in the Company.  Optionsgranted during 2008 are at a price equal to the market value of the stock onthe dates that the options were granted, have a term of 10 years from the grantdate and vest over a five year period. Bancorp measures the fair value of each stock option at the date of thegrant, using the Black Scholes option valuation model.  The application of this valuation modelinvolves assumptions that are judgmental and sensitive in the determination ofcompensation expense.

 

8

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**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

 

The following assumptions were used in arriving at the fair value ofoptions granted for the nine months ended September 30, 2008:

 
| ** **                               | ** ** | **Employee options** | ** ** |
|------------------------------------------|------------|---------------------------|------------|
| Expected price  volatility               |       | 16.14                     | %          |
| Risk-free  interest rate                 |       | 3.37                      | %          |
| Dividend yield  on underlying stock      |       | 2.38                      | %          |
| Weighted-average  expected life in years |       | 7.00                      |       |

 

Historical informationwas the primary basis for the selection of the expected volatility and expecteddividend yield.  As Bancorp does not havea history of stock options, an average or mid-point based on the vesting termand the expiration term was used in determining the weighted average expectedlife on options granted to employees. The risk-free interest rate was selected based upon U.S. Treasury issueswith a term equal to the expected life of the option being valued at the timeof grant.  SFAS 123(R) requires therecognition of equity-based compensation for the number of awards that areexpected to vest.  Estimated forfeitureswill be evaluated in subsequent periods and may change based on new facts andcircumstances. The following table summarizes the activity related to optionsoutstanding during the nine months ended September 30, 2008.

 

(dollars in thousandsexcept share and per share amounts)

 
| ** **                         | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise/Grant  Price** | ** ** | **Weighted  Average  Remaining  Contractual Terms  (in years)** | ** ** | **Aggregate  Intrinsic Value** | ** ** |
|------------------------------------|------------|------------|------------|----------------------------------------------|------------|---------------------------------------------------------------------------|------------|-------------------------------------|------------|
| Outstanding at  January 1, 2008    |       | 13,275     |       | $                                            | 163.43     |                                                                      | 8.16       |                                | $          | 300 |   |
| Granted                            |       | 5,056      |       | $                                            | 189.00     |                                                                      | 10.00      |                                | —     |   |
| Exercised                          |       | —     |       | —                                       |       | —                                                                    |       | —                              |       |
| Forfeited                          |       | —     |       | —                                       |       | —                                                                    |       | —                              |       |
| Outstanding at  September 30, 2008 |       | 18,331     |       | $                                            | 170.48     |                                                                      | 7.94       |                                | $          | 541 |   |
| Exercisable at  September 30, 2008 |       | 2,635      |       | $                                            | 163.44     |                                                                      | 7.39       |                                | $          | 96 |   |

 

The unrecognized share-based compensation cost relating to stock optionexpense at September 30, 2008 is approximately $468,000, which will berecognized over the remaining vesting schedule through 2013. The weightedaverage grant date fair value of options granted during 2008 was $31.84 pershare.

 

The aggregate intrinsic value in the table above and followingrepresents the total pretax intrinsic value (amount by which the fair value ofthe underlying stock exceeds the exercise price of an option or award, timesthe number of shares).  The followingtable summarizes the activity relating to restricted stock awards outstandingfor the nine months ended September 30, 2008.

 

(dollars in thousands except share and per share amounts)

 
| ** **                         | ** ** | **Shares** | ** ** | **Weighted Average  Remaining  Contractual Terms (in  years)** | ** ** | **Weighted  Average Grant-  Date Fair Value** | ** **   |
|------------------------------------|------------|------------|------------|-------------------------------------------------------------------------------|------------|--------------------------------------------------------------|--------------|
| Outstanding at  January 1, 2008    |       | 1,040      |       | 3.68                                                                          |       | $                                                            |  — |   |
| Granted                            |       | 1,429      |       | 5.00                                                                          |       | 270                                                          |         |
| Vested                             |       | 100        |       | —                                                                        |       | —                                                       |         |
| Forfeited                          |       | —     |       | —                                                                        |       | —                                                       |         |
| Outstanding at September  30, 2008 |       | 2,369      |       | 3.80                                                                          |       | $                                                            |  — |   |
| Exercisable at  September 30, 2008 |       | —     |       | —                                                                        |       | —                                                       |         |

 

9

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**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

 

Recipients of restricted stock awards do not pay any cash considerationto Bancorp for the shares and receive all dividends with respect to all suchshares, whether or not shares have vested. The awards vest over a five year period. Bancorp measures the fair value of each stock award at the date of thegrant and recognizes compensation based on the amount, if any, the market priceof Bancorp’s common stock exceeds the exercise price.  The unrecognized share-based compensationcost relating to restricted stock awards expense at September 30, 2008 is$254,000, which will be recognized over the remaining vesting schedule through2013. The weighted average grant date fair value of restricted stock awardsgranted during 2008 was $189.00 per share.

 

For additionalinformation on the stock-based equity compensation plan, refer to Bancorp’saudited financial statements and footnotes for the most recent annual periodended December 31, 2007 contained in the Annual Report on Form 10-K.

 

**Note 8:   INCOMETAXES**

 

Bancorp files a consolidated federal income tax return.  Bancorp accounts for income taxes using theliability method and deferred taxes are reflected at currently enacted incometax rates applicable to the period in which the deferred tax assets or liabilitiesare expected to be realized or settled. Deferred taxes result from temporary differences in the recognition ofcertain income and expense amounts between Bancorp’s financial statements andits tax returns.As changes in tax laws or rates are enacted, deferred tax assets andliabilities are adjusted through the provision for income taxes.

 

Bancorp adopted FIN 48, “Accountingfor Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109”on January 1, 2007. FIN 48 seeks to reduce the diversity in practiceassociated with certain aspects of measurement and recognition in accountingfor income taxes. FIN 48 provides guidance on de-recognition, classification,interest and penalties and accounting in interim periods and requires expandeddisclosure with respect to uncertainty in income taxes.  Our accounting policy with respect tointerest and penalties arising from income tax settlements is to recognize themas non-interest expense.

 

**Note 9:   FINANCIALINSTRUMENTS**

 

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

 

The following is a summary of the off-balance-sheet financialinstruments or contracts outstanding as of September 30, 2008: (dollars inthousands)

 
| Unfunded  commitments to extend credit  |   | $      | 72,400 |   |
|-----------------------------------------|--------|--------|--------|--------|
| Credit card  arrangements               |   | 10,920 |   |
| Commitments to  fund municipal warrants |   | 6,586  |   |
| Standby letters  of credit              |   | 3,889  |   |

 

**Note 10:  FAIR VALUE**

 

SFAS No. 157, “FairValue Measures” defines fair value, establishes a framework for measuring fairvalue and expands disclosures about fair value measurements. SFAS No. 157establishes a hierarchy that prioritizes the use of fair value inputs used inthe valuation methodologies into the following three levels:

 

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

 

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

 

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

 

10

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**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

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

 

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

 

Impaired Loans – Impairedloans are reported at the fair value of the underlying collateral if repaymentis expected from the collateral. Collateral values are estimated using Level 3 inputs based ondiscounting criteria.

 

The table below showsassets measured at fair value on a recurring basis as of September 30,2008.

 

(dollars in thousands)

 
| ** **                     | ** ** | ** ** | ** ** | **Quoted Prices  in Active  Markets for  Identical Assets** | ** ** | **Significant  Other  Observable  Inputs** | ** ** | **Significant  Unobservable  Inputs** | ** ** |
|--------------------------------|------------|------------|------------|---------------------------------------------------------------------------------|------------|--------------------------------------------|------------|---------------------------------------|------------|
| **Description**                | ** ** | **Total**  | ** ** | **(Level 1)**                                                              | ** ** | **(Level 2)**                         | ** ** | **(Level 3)**                    | ** ** |
| Available-for-sale  securities |       | $          | 108,209    |                                                                            | $          | —                                     |       | $                                     | 108,209    |   | $ | — |   |
| Total                          |       | $          | 108,209    |                                                                            | $          | —                                     |       | $                                     | 108,209    |   | $ | — |   |

 

The table below showsassets measured at fair value on a non-recurring basis as of September 30,2008.

 

(dollars in thousands)

 
| ** **      | ** ** | ** ** | ** ** | **Quoted Prices  in Active  Markets for  Identical Assets** | ** ** | **Significant  Other  Observable  Inputs** | ** ** | **Significant  Unobservable  Inputs** | ** ** |
|-----------------|------------|------------|------------|---------------------------------------------------------------------------------|------------|--------------------------------------------|------------|---------------------------------------|------------|
| **Description** | ** ** | **Total**  | ** ** | **(Level 1)**                                                              | ** ** | **(Level 2)**                         | ** ** | **(Level 3)**                    | ** ** |
| Impaired loans  |       | $          | 5,830      |                                                                            | $          | —                                     |       | $                                     | —     |   | $ | 5,830 |   |
| Total           |       | $          | 5,830      |                                                                            | $          | —                                     |       | $                                     | —     |   | $ | 5,830 |   |

 

In accordance with FASBStatement No. 114, “Accounting for Creditors for Impairment of a Loan”,impaired loans, with carrying amounts of $5.8 million had specific reserveallocations totaling $360,000, which were included in the allowance for loanlosses.

 

**Note 11:  NEW ACCOUNTING PRONOUNCEMENTS**

 

In March 2008, theFASB issued SFAS No. 161, “Disclosures About Derivative Instruments andHedging Activities, an Amendment of SFAS No. 133”. SFAS 161 amends SFAS133, “Accounting for Derivative Instruments and Hedging Activities”, to amendand expand the disclosure requirements of SFAS 133 to provide greatertransparency about how and why an entity uses derivative instruments; howderivative instruments and related hedged items are accounted for under SFAS133 and its related interpretations; how derivative instruments and relatedhedge items affect an entity’s financial position, results of operations andcash flows. This statement is effective for Bancorp on January 1, 2009 andis not expected to have a material impact on its consolidated financialstatements.

 

11

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**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

In May 2008, theFASB issued SFAS No. 162, “TheHierarchy of Generally Accepted Accounting Principles”.  SFAS No. 162identifies the sources of accounting principles and the framework for selectingthe principles to be used in the preparation of financial statements ofnongovernmental entities that are presented in conformity with generallyaccepted accounting principles (GAAP) in the United States (the GAAPhierarchy). Statement No. 162 is effective 60 days following the SEC’sapproval of the Public Company Accounting Oversight Board amendments to AU Section 411,The Meaning of Present Fairly in Conformity With Generally Accepted AccountingPrinciples. Bancorp does not expect this statement to have a material impact onits consolidated financial statements.

 

On January 1, 2008,Bancorp adopted SFAS No. 157; “Fair Value Measures” defines fair value,establishes a framework for measuring fair value and expands disclosures aboutfair value measurements. In February 2008, the FASB issued FASB StaffPosition FAS 157-2 which defers the effective date of SFAS No. 157 until January 1,2009 for nonfinancial asset and liabilities except for those items recognizedor disclosed at fair value on an annual or more frequent recurring basis. Theadoption of this statement did not have a material effect on Bancorp’sconsolidated financial statements.

 

**Item 2.    MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ANDRESULTS OF OPERATIONS**

 

*The following discussion shouldbe read in conjunction with the consolidated financial statements and notesthereto presented elsewhere in this report. For additional information, refer to the financial statements andfootnotes for the year ended December 31, 2007 in the Annual Report on Form 10-K.*

 

**FORWARD LOOKING STATEMENTS**

** **

Inaddition to historical information, this report contains certain “forwardlooking statements” within the meaning of the Private Securities LitigationReform Act of 1995 (PSLRA).  Thisstatement is included for the express purpose of availing Bancorp of theprotections of the safe harbor provision of the PSLRA.  The forward-looking statements contained inthis report are subject to factors, risk, and uncertainties that may causeactual results to differ materially from those projected.  Important factors that might cause such amaterial difference include, but are not limited to, those discussed in thissection of the report.  In addition, thefollowing items are among the factors that could cause actual results to differmaterially from the forward looking statements in this report: general economicconditions, including the continued softening of the real estate market;business conditions in the banking industry; increase in insurance premiums;the regulatory environment; new legislation; vendor quality and efficiency;employee retention factors; rapidly changing technology and evolving bankingindustry standards; competitive factors, including increased competition withcommunity, regional, and national financial institutions; fluctuating interestrate environments; and similar matters. Readers are cautioned not to place undue reliance on theseforward-looking statements, which reflect management’s analysis only as of thedate of the statement.  Bancorpundertakes no obligation to publicly review or update these forward-lookingstatements to reflect events or circumstances that arise after the date of thisreport.  Readers should carefully reviewany risk factors described in this and other documents we file from time totime with the Securities and Exchange Commission.

 

**OVERVIEW**

 

Skagit State Bancorp, Inc.is a bank holding company with one wholly owned subsidiary - Skagit State Bank(collectively, “Company” or “Bancorp”). On June 30, 2006, at thecompletion of a corporate reorganization, Skagit State Bank became awholly-owned subsidiary of Skagit State Bancorp, Inc. Skagit State Bankbegan operations in 1958 and is headquartered in Burlington (Skagit County),Washington.  The Bank provides a fullrange of banking services and products to both businesses and individualsthrough 13 full service banking offices located in Skagit, Snohomish and Whatcomcounties.

 

Net income was $644,000and $2.0 million for the quarters ended September 30, 2008 and 2007 withdiluted earnings per share at $1.09 and $3.00, respectively. Net income was$4.3 million and $6.3 million for the nine months ended September 30, 2008and 2007 with diluted earnings per share at $6.89 and $9.38, respectively.  The decreases in net income were primarily aresult of a writedown on other real estate owned of $1.4 million and aprovision for loan losses as discussed below and a decrease in net interestincome which was partially offset by 

 

12

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increases in non-interestincome. For purposes of comparability, the nine months ended September 30,2007 were favorably impacted by a $495,000 interest recovery on one loanrelationship and a $150,000 benefit for loan losses.

 

Annualized return onaverage assets was 0.45 percent and 0.99 percent for the quarter and ninemonths ending September 30, 2008 compared to 1.43 percent and 1.53 percentduring the same time periods in 2007. Annualized return on average equity was 4.33 percent and 8.87 percentfor the quarter and nine months ending September 30, 2008 compared to11.58 percent and 12.26 percent, respectively, for the same time periods in2007.

 

Total assets decreased to$571.6 million at September 30, 2008 compared to $592.7 million at December 31,2007.  The decrease was primarily due toa $15.3 million repurchase of company stock and a $33.5 million decrease indeposits. Net loans increased by $38.3 million or 10.9 percent to $389.0million at September 30, 2008, compared to $350.7 million at December 31,2007.

 

**RESULTS OF OPERATIONS**

 

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

 

**NET INTEREST INCOME  **Net interest income isBancorp’s principal source of revenue and is comprised of interest income onearning 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$5.7 million and $16.5 million for the quarter and nine months ended September 30,2008 compared to $5.7 million and $17.6 million for the like periods in2007.  The decrease for the nine monthsended September 30, 2008 was primarily due to interest-earning assetsre-pricing more rapidly at lower interest rates than interest-bearingliabilities and a $495,000 interest recovery on one loan relationship during2007.

 

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.  TheFederal Reserve decreased rates 100 basis points in 2007 and in 2008 hasdecreased rates an additional 225 basis points through September 30, 2008.Bancorp’s prime rate generally moves in conjunction with the federal fundsrate.  For the quarter and nine monthsended September 30, 2008, the net interest margin was 4.29 percent and4.08 percent from 4.24 percent and 4.55 percent compared to the like periods in2007, respectively. The decrease for the nine months ended September 30,2008 was primarily a result of the more rapid decrease in the yield on interest-earningassets than cost of funds as our assets tend to reprice more quickly than ourdeposits.  Also, contributing to thedecline in net interest margin for the quarter and nine months in 2008 was$495,000 interest recovery from one loan relationship during 2007.  This recovery contributed 19 basis points tothe net interest margin for the nine months ended September 30, 2007.

 

*Interest-earning assets*

 

The largest component ofinterest income is interest earned on loans. Total interest income earned from loans was $6.5 million and $19.2million for the quarter and nine months ended September 30, 2008 comparedto $7.1 million and $21.1 million for the like periods in 2007.  For the current quarter, this decrease wasprimarily a result of the current declining interest rate environment whichdecreased the yield earned on loans from 8.21 percent to 6.82 percent.  Partially offsetting the decrease in yieldwas an increase in the average balance of loans by $39.5 million compared tothe same time period in 2007.  For thenine months ended September 30, 2008 compared to the like period in 2007,the yield earned on loans decreased from 8.54 percent to 7.00 percent.  Partially offsetting the decrease in yieldwas an increase a $35.5 million increase in the average balance of loans. Inaddition, for the nine months ended September 30, 2007, Bancorp recorded a$495,000 interest recovery on one loan relationship.

 

Interest earned oninvestments and federal funds sold decreased $606,000 and $874,000 for thequarter and nine months ended September 30, 2008 compared to the likeperiods in 2007. Interest earned on investments decreased by $187,000 for thequarter ended, and increased $234,000 for the nine months ended September 30,2008, compared to the like periods in 2007. Within the investment total, interest on federal funds decreased$419,000 and 

 

13

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$1.1 million for thequarter and nine months ended September 30, 2008 compared to the likeperiods in 2007. This was the result of a 35 basis point and 221 basis pointdecrease in yield and a $34.9 million and $23.6 million decrease in the averagebalance for the quarter and nine months ended September 30, 2008 and 2007,respectively.

 

*Interest- bearing liabilities*

 

Interest expensedecreased to $2.3 million and $8.0 million from $3.5 million and $9.7 millionfor the quarter and nine months ended September 30, 2008 and 2007,respectively. These decreases were a result of a 112 basis point and a 74 basispoint decrease in the cost of funds for the quarter and nine months ended September 30,2008 compared to 2007. Partially offsetting the decreases in the cost of fundswas an increase in the average balance of interest bearing liabilities to$431.9 million and to $436.2 million for the quarter and nine months ended September 30,2008. The majority of our deposits are short term and re-price within a 12month period.

 

The following tablespresent information regarding average balances of assets and liabilities aswell as the total amounts of interest income from average interest-earningassets and interest expense on average interest-bearing liabilities, resultingyield and cost ratios, interest rate spread and net interest margin. Tax exemptsecurities, included in investment securities below are stated at theircontractual interest rate. Loan fees of $243,000 and $787,000 for the quarterand nine months ended September 30, 2008, and $240,000 and $773,000 forthe quarter and nine months ended September 30, 2007, respectively, areincluded in interest earned on loans. Non-accruing loans have been included inthe computation of average loans.

** **

**CondensedAverage Balance Sheets**

(dollars in thousandsexcept share data)

 
| ** **                                         | ** ** | **2008**             | ** ** | **2007**     | ** ** |
|----------------------------------------------------|------------|----------------------|------------|--------------|------------|
| **Three months ended September**    | ** ** | **Average  Balance** | ** ** | **Interest** | ** ** | **Yield  /Cost** | ** ** | **Average  Balance** | ** ** | **Interest** | ** ** | **Yield  /Cost** | ** ** |
| **Assets**                                         |       |                 |       |         |       |   |   |   |   |   |   |   |   |
| Federal funds  sold                                |       | $                    | 1,085      |         | $          | 12 |   | 4.40 | % | $ | 36,015 |   | $ | 431 |   | 4.75 | % |
| Taxable  investment securities                     |       | 99,282               |       | 1,225        |       | 4.91 |   | 109,825 |   | 1,421 |   | 5.13 |   |
| Tax exempt securities                              |       | 48,490               |       | 290          |       | 2.38 |   | 45,429 |   | 281 |   | 2.45 |   |
| Loans                                              |       | 380,087              |       | 6,516        |       | 6.82 |   | 340,631 |   | 7,050 |   | 8.21 |   |
| Total  interest-earning assets                     |       | 528,944              |       | 8,043        |       | 6.05 | % | 531,900 |   | 9,183 |   | 6.85 | % |
| Non-interest  earning assets                       |       | 37,384               |       |         |       |   |   | 34,826 |   |   |   |   |   |
| Total assets                                       |       | $                    | 566,328    |         |       |   |   |   | $ | 566,726 |   |   |   |   |   |
|                                               |       |                 |       |         |       |   |   |   |   |   |   |   |   |
| **Liabilities  and Stockholders’ Equity**     |       |                 |       |         |       |   |   |   |   |   |   |   |   |
| Interest-bearing  demand                           |       | $                    | 87,414     |         | $          | 120 |   | 0.55 | % | $ | 88,008 |   | $ | 283 |   | 1.28 | % |
| Savings and  money market                          |       | 149,802              |       | 523          |       | 1.39 |   | 139,951 |   | 762 |   | 2.16 |   |
| Certificates of  deposit                           |       | 170,368              |       | 1,570        |       | 3.67 |   | 178,724 |   | 2,282 |   | 5.07 |   |
| Total  interest-bearing deposits                   |       | 407,584              |       | 2,213        |       | 2.16 |   | 406,683 |   | 3,327 |   | 3.25 |   |
| Federal Funds  purchased and repurchase agreements |       | 24,324               |       | 131          |       | 2.14 |   | 16,400 |   | 168 |   | 4.06 |   |
| Total  interest-bearing deposits & liabilities |       | 431,908              |       | 2,344        |       | 2.16 | % | 423,083 |   | 3,495 |   | 3.28 | % |
| Non  interest-bearing demand deposits              |       | 72,464               |       |         |       |   |   | 70,428 |   |   |   |   |   |
| Other  non-interest-bearing liabilities            |       | 2,482                |       |         |       |   |   | 3,457 |   |   |   |   |   |
| Total  liabilities                                 |       | 506,854              |       |         |       |   |   | 496,968 |   |   |   |   |   |
| Stockholders’  equity                         |       | 59,474               |       |         |       |   |   | 69,758 |   |   |   |   |   |
| Total  liabilities and stockholders equity         |       | $                    | 566,328    |         |       |   |   |   | $ | 566,726 |   |   |   |   |   |
| Net interest  income                               |       |                 |       | $            | 5,699      |   |   |   |   |   | $ | 5,688 |   |   |   |
| Interest rate  spread                              |       |                 |       |         |       | 3.89 | % |   |   |   |   | 3.57 | % |
| Net interest  margin                               |       |                 |       |         |       | 4.29 | % |   |   |   |   | 4.24 | % |

 

14

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**CondensedAverage Balance Sheets**

(dollars in thousandsexcept share data)

 
| ** **                                         | ** ** | **2008**             | ** ** | **2007**     | ** ** |
|----------------------------------------------------|------------|----------------------|------------|--------------|------------|
| **Nine months ended September**     | ** ** | **Average  Balance** | ** ** | **Interest** | ** ** | **Yield  /Cost** | ** ** | **Average  Balance** | ** ** | **Interest** | ** ** | **Yield  /Cost** | ** ** |
| **Assets**                                         |       |                 |       |         |       |   |   |   |   |   |   |   |   |
| Federal funds  sold                                |       | $                    | 13,476     |         | $          | 285 |   | 2.82 | % | $ | 37,048 |   | $ | 1,393 |   | 5.03 | % |
| Taxable  investment securities                     |       | 110,224              |       | 4,094        |       | 4.96 |   | 105,661 |   | 4,027 |   | 5.10 |   |
| Tax exempt  securities                             |       | 49,775               |       | 924          |       | 2.48 |   | 42,628 |   | 757 |   | 2.37 |   |
| Loans                                              |       | 366,155              |       | 19,187       |       | 7.00 |   | 330,693 |   | 21,126 |   | 8.54 |   |
| Total  interest-earning assets                     |       | 539,630              |       | 24,490       |       | 6.06 | % | 516,030 |   | 27,303 |   | 7.07 | % |
| Non-interest  earning assets                       |       | 36,168               |       |         |       |   |   | 34,875 |   |   |   |   |   |
| Total assets                                       |       | $                    | 575,798    |         |       |   |   |   | $ | 550,905 |   |   |   |   |   |
|                                               |       |                 |       |         |       |   |   |   |   |   |   |   |   |
| **Liabilities  and Stockholders’ Equity**     |       |                 |       |         |       |   |   |   |   |   |   |   |   |
| Interest-bearing  demand                           |       | $                    | 89,157     |         | $          | 373 |   | 0.56 | % | $ | 85,187 |   | $ | 823 |   | 1.29 | % |
| Savings and  money market                          |       | 147,282              |       | 1,561        |       | 1.42 |   | 140,530 |   | 2,295 |   | 2.18 |   |
| Certificates of  deposit                           |       | 179,971              |       | 5,702        |       | 4.23 |   | 166,109 |   | 6,178 |   | 4.97 |   |
| Total  interest-bearing deposits                   |       | 416,410              |       | 7,636        |       | 2.46 |   | 391,826 |   | 9,296 |   | 3.17 |   |
| Federal Funds  purchased and repurchase agreements |       | 19,769               |       | 384          |       | 2.59 |   | 15,214 |   | 453 |   | 3.98 |   |
| Total  interest-bearing deposits & liabilities |       | 436,179              |       | 8,020        |       | 2.46 | % | 407,040 |   | 9,749 |   | 3.20 | % |
| Non  interest-bearing demand deposits              |       | 72,775               |       |         |       |   |   | 71,589 |   |   |   |   |   |
| Other  non-interest-bearing liabilities            |       | 2,888                |       |         |       |   |   | 3,506 |   |   |   |   |   |
| Total  liabilities                                 |       | 511,842              |       |         |       |   |   | 482,135 |   |   |   |   |   |
| Stockholders’  equity                         |       | 63,956               |       |         |       |   |   | 68,770 |   |   |   |   |   |
| Total  liabilities and stockholders equity         |       | $                    | 575,798    |         |       |   |   |   | $ | 550,905 |   |   |   |   |   |
| Net interest  income                               |       |                 |       | $            | 16,470     |   |   |   |   |   | $ | 17,554 |   |   |   |
| Interest rate  spread                              |       |                 |       |         |       | 3.61 | % |   |   |   |   | 3.87 | % |
| Net interest  margin                               |       |                 |       |         |       | 4.08 | % |   |   |   |   | 4.55 | % |

 

15

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

 

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

(dollars inthousands except per share

 
| ** **                                             | ** ** | **Three months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|--------------------------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                             | ** ** | **2008 vs. 2007**                              | ** ** | **2008 vs. 2007**                             | ** ** |
| ** **                                             | ** ** | **Increase (Decrease) Due to**            | ** ** | **Increase (Decrease) Due to**           | ** ** |
| ** **                                             | ** ** | **Rate**                                                 | ** ** | **Volume**                                              | ** ** | **Total** | ** ** | **Rate** | ** ** | **Volume** | ** ** | **Total** | ** ** |
| **Interest-Earning  Assets**                           | ** ** | ** **                                               | ** ** | ** **                                              | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Federal funds  sold                                    |       | $                                                        | (29        | )                                                       | $          | (390 | ) | $ | (419 | ) | $ | (452 | ) | $ | (656 | ) | $ | (1,108 | ) |
| Investment  securities                                 |       | (105                                                     | )          | (82                                                     | )          | (187 | ) | (116 | ) | 350 |   | 234 |   |
| Loans                                                  |       | (4,166                                                   | )          | 3,632                                                   |       | (534 | ) | (5,016 | ) | 3,077 |   | (1,939 | ) |
| Total net change  in income on Interest-earning assets |       | (4,300                                                   | )          | 3,160                                                   |       | (1,140 | ) | (5,584 | ) | 2,771 |   | (2,813 | ) |
| **Interest-Bearing  Liabilities**                      |       |                                                     |       |                                                    |       |   |   |   |   |   |   |   |   |
| Deposits                                               |       | (1,409                                                   | )          | 295                                                     |       | (1,114 | ) | (2,728 | ) | 1,068 |   | (1,660 | ) |
| Federal funds  purchased and repurchase agreements     |       | (337                                                     | )          | 300                                                     |       | (37 | ) | (232 | ) | 163 |   | (69 | ) |
| Interest-bearing  liabilities                          |       | (1,746                                                   | )          | 595                                                     |       | (1,151 | ) | (2,960 | ) | 1,231 |   | (1,729 | ) |
| Net change in  net interest income                     |       | $                                                        | (2,554     | )                                                       | $          | 2,565 |   | $ | 11 |   | $ | (2,624 | ) | $ | 1,540 |   | $ | (1,084 | ) |

 

**NON-INTEREST INCOME**Non-interestincome, which consists primarily of fees and service charges on deposits andother income, was $1.3 million and $3.3 million for the quarter and nine monthsended September 30, 2008 compared to $1.1 million and $2.7 million for thequarter and nine months ended September 30, 2007. In July 2007,Bancorp began offering a new overdraft protection product to its checkingaccount customers and due primarily to this new product overdraft andnon-sufficient fund fees increased $6,000 and $303,000 for the quarter and ninemonths ended September 30, 2008 compared to like periods in 2007.  During May 2007, Bancorp expanded itshome loan department and as a result brokered loan fees, processing fees andgains on the sale of loans increased $3,000 and $65,000 for the quarter andnine months ended September 30, 2008 compared to the like periods in 2007.In addition to the gain on sale of loans, for the current quarter and ninemonths ended September 30, 2008, Bancorp recognized an additional $232,000gain on sale of assets.

 

**NON-INTEREST EXPENSE**Non-interestexpense was $5.7 million and $13.9 million for the quarter and nine monthsended September 30, 2008 compared to $4.2 million and $12.2 million in thelike periods in 2007.  These increaseswere primarily attributable to $1.4 million provision for other real estateowned losses. See discussion below in Asset Quality for further details.   In addition, salary expense increased 5.5percent for the quarter and nine months ended September 30, 2008 comparedto the like periods in 2007.

 

The efficiency ratio iscomputed by dividing total operating expenses by non-interest income and netinterest 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 and nine months ended September 30,2008 was 91.0 percent and 72.9 percent compared to 61.2 percent and 59.5percent for the same time periods in 2007. The increase from 2007 was primarilydue to increases in the provision for loan losses and the provision for OREOlosses.  Those provisions contributed 29.5percent and 9.7 percent to the efficiency ratio for the quarter and nine monthsended September 30, 2008.

 

**INCOME TAX EXPENSE **Income tax expense for thequarter and nine months ended September 30, 2008 was a benefit of $83,000and an expense of $911,000 compared to $620,000 expense and $2.0 millionexpense for the quarter and nine months ended September 30, 2007,respectively. Bancorp’s effective tax rates were 17.6 percent and 23.6 percentfor the nine months ended September 30, 2008 and 2007, respectively. Theeffective tax rate is lower than the federal statutory rate due to tax creditsfrom tax-exempt bonds and tax-exempt interest from 

 

16

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municipal bonds andloans.  As of September 30, 2008,Bancorp had $48.4 million in tax-exempt securities compared to $47.7 million asof September 30, 2007.

 

**REVIEW OF FINANCIAL CONDITION**

** **

Total assets decreased to$571.6 million at September 30, 2008 compared to $592.7 million at December 31,2007.  This decrease was primarily due toa $15.3 million repurchase of Skagit State Bancorp stock during 2008 and a$33.5 million decrease in deposits. Total loans increased $38.3 million duringthe same time period.

 

**INVESTMENTSECURITIES AND FEDERAL FUNDS SOLD     **Totalinvestment securities decreased to $144.4 million at September 30, 2008compared to $166.9 million at December 31, 2007. Security purchases were$22.6 million in the first nine months of 2008, which was partially offset bymaturities, calls and principal pay-downs of $44.7 million.  Bancorp had no federal funds sold as of September 30,2008 compared to $41.2 million at December 31, 2007.  This decreased primarily as a result of there-purchase of Bancorp stock, a decline in deposit levels, and the growth in totalloans.

 

The fair values for investment securities are based on quoted marketprices, where available. If quoted market values are not available, fair valuesare based on quoted market prices of comparable instruments. The fair values offixed rate warrants and qualified zone academy bonds, included in state andpolitical subdivisions investment securities, are estimated using discountedcash flow analysis using interest rates currently being offered for warrants ofsimilar terms or the current qualified zone academy bond interest rates.

 

Certain investmentsecurities included in the table below currently have fair values less thanamortized cost and, therefore, contain unrealized losses.  Bancorp has the ability to hold available-forsale investments for a period of time management believes to be sufficient fora market price recovery. Bancorp has evaluated these securities and believesthat the decline in value is temporary, with no permanent sector or issuercredit concerns or impairments.

 

Securitiesclassified as available-for-sale are reported at estimated fair value, withunrealized gains and losses (net of income taxes) reported in accumulated othercomprehensive income, as a separate component of stockholders’ equity.   The following table presents the recordedamounts and fair value of the portfolio of investment securities as of thedates indicated.

 

**Investment Securities Composition**

**September30, 2008** (dollarsin thousands)

** **
| ** **                        | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses (less  than 12  months)** | ** ** | **Gross  Unrealized  Losses (12  months or  more)** | ** ** | **Aggregate  Fair Value** | ** ** |
|-----------------------------------|------------|---------------------|------------|------------------------------|------------|------------------------------------------------------------|------------|---------------------------------------------------------------|------------|--------------------------------|------------|
| **AFS Securities**           | ** ** | ** **          | ** ** | ** **                   | ** ** | ** **                                                 | ** ** | ** **                                                    | ** ** | ** **                     | ** ** |
| US Government  Agencies           |       | $                   | 33,674     |                         | $          | 448                                                        |       | $                                                             | 105        |                           | $          | — |   | $ | 34,017 |   |
| Mortgage-backed-securities        |       | 61,790              |       | 582                          |       | 418                                                        |       | —                                                        |       | 61,954                         |       |
| State and Political  subdivisions |       | 12,220              |       | 116                          |       | 98                                                         |       | —                                                        |       | 12,238                         |       |
|                              |       | 107,684             |       | 1,146                        |       | 621                                                        |       | —                                                        |       | 108,209                        |       |
|                              |       |                |       |                         |       |                                                       |       |                                                          |       |                           |       |
| **HTM  Securities**               |       |                |       |                         |       |                                                       |       |                                                          |       |                           |       |
| State and  political subdivisions |       | 36,181              |       | 21                           |       | 123                                                        |       | 281                                                           |       | 35,798                         |       |
|                              |       | 36,181              |       | 21                           |       | 123                                                        |       | 281                                                           |       | 35,798                         |       |
|                              |       |                |       |                         |       |                                                       |       |                                                          |       |                           |       |
| Total                             |       | $                   | 143,865    |                         | $          | 1,167                                                      |       | $                                                             | 744        |                           | $          | 281 |   | $ | 144,007 |   |

 

17

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**December31, 2007**(dollarsin thousands)

 
| ** **                        | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses (less  than 12  months)** | ** ** | **Gross  Unrealized  Losses (12  months or  more)** | ** ** | **Aggregate  Fair Value** | ** ** |
|-----------------------------------|------------|---------------------|------------|------------------------------|------------|-------------------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------|------------|
| **AFS  Securities**               | ** ** | ** **          | ** ** | ** **                   | ** ** | ** **                                            | ** ** | ** **                                          | ** ** | ** **                | ** ** |
| US Government  Agencies           |       | $                   | 60,153     |                         | $          | 303                                                   |       | $                                                   | 12         |                      | $          | 24 |   | $ | 60,420 |   |
| Mortgage-backed-securities        |       | 54,719              |       | 666                          |       | —                                                |       | —                                              |       | 55,385                    |       |
| State and  Political subdivisions |       | 11,030              |       | 126                          |       | 7                                                     |       | 1                                                   |       | 11,148                    |       |
|                              |       | 125,902             |       | 1,095                        |       | 19                                                    |       | 25                                                  |       | 126,953                   |       |
|                              |       |                |       |                         |       |                                                  |       |                                                |       |                      |       |
| **HTM  Securities**               |       |                |       |                         |       |                                                  |       |                                                |       |                      |       |
| State and  political subdivisions |       | 39,926              |       | 261                          |       | —                                                |       | 40                                                  |       | 40,147                    |       |
|                              |       | 39,926              |       | 261                          |       | —                                                |       | 40                                                  |       | 40,147                    |       |
|                              |       |                |       |                         |       |                                                  |       |                                                |       |                      |       |
| Total                             |       | $                   | 165,828    |                         | $          | 1,356                                                 |       | $                                                   | 19         |                      | $          | 65 |   | $ | 167,100 |   |

** **

**LOANS **Netloans increased 10.9 percent to $389.0 million at September 30, 2008compared to $350.7 million at December 31, 2007.  Net loans represented 68.0 percent of totalassets at September 30, 2008.

 

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

 

*Real Estate Loans:*Real estate loans comprise the largest category of loans and our real estateportfolio consists of commercial and residential loans which are secured byproperty such as office buildings, retail buildings, owner occupied commercialbusiness properties, farm land, timber land, residential land developmentproperties and residential properties. The primary repayment source of these specific loan types are from thecash flows generated by the occupant business, occupant farm operation, or thesale of properties. While Bancorp has significant balances secured by realestate, Bancorp believes that its lending policies and concentration policiesare sufficient to minimize risks. However, economic conditions may affect a borrower’s ability to meet thestated repayment terms. Bancorp is committed to providing competitivecommercial real estate lending within our primary market areas.

 

*Commercial Loans*:Commercial loans, secured and unsecured, are made primarily to small andmedium-sized businesses including farms operating within Skagit, Snohomish andWhatcom Counties.  These loans areavailable for general operating purposes, acquisition of fixed assets,purchases of equipment and machinery, financing of inventory and accountsreceivable, and other business purposes. Bancorp originates Small Business Administration (SBA) loans, including504 and 7A loans.

 

*Consumer Loans:*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.

 

18

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

 

**Loan Composition**

** **
| ** **                                       | ** ** | **September 30, 2008** | ** ** | **December 31, 2007** | ** ** |
|--------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| **(dollars in thousands)**             | ** ** | **Amount**                       | ** ** | **%**                           | ** ** | **Amount** | ** ** | **%** | ** ** |
| Real estate –  residential & commercial |       | $                                | 254,232    |                            | 64.4       | % | $ | 229,680 |   | 64.4 | % |
| Real estate  construction                        |       | 18,285                           |       | 4.6                             | %          | 21,468 |   | 6.0 | % |
| Commercial,  industrial & agricultural       |       | 81,107                           |       | 20.6                            | %          | 70,040 |   | 19.6 | % |
| Consumer                                         |       | 41,041                           |       | 10.4                            | %          | 35,411 |   | 10.0 | % |
| Total loans                                      |       | 394,665                          |       | 100                             | %          | 356,599 |   | 100 | % |
| Less:                                            |       |                             |       |                            |       |   |   |   |   |
| Allowance for  loan losses                       |       | (4,373                           | )          |                            |       | (4,535 | ) |   |   |
| Deferred loan  fees                              |       | (1,307                           | )          |                            |       | (1,401 | ) |   |   |
| Net loans                                        |       | $                                | 388,985    |                            |       |   | $ | 350,663 |   |   |   |

 

*Concentrations*

* *

As shown in the tableabove, a concentration of loans in commercial and residential real estateexisted as of September 30, 2008.  At September 30, 2008,Bancorp’s real estate portfolio included $164.9 million in non-farmnon-residential real estate loans of which $93.9 million is owner occupied,$62.8 million in raw land, land development and construction loans and $47.9million in one-to-four family residential loans.  Although managementbelieves that loans within the real estate related concentration have no morethan the normal risk of collectability, a further decline in the performance ofthe economy, in general, or a further decline in real estate values in ourmarket areas, in particular, could have an adverse impact on collectability,increase the level of real estate non-performing loans or have other adverseeffects which alone or in aggregate could have a material adverse effect on ourbusiness, financial condition, results of operation and cash flows.

 

**PROVISION AND ALLOWANCE FOR LOANLOSSES**The allowance for loan losses was $4.4 million or 1.12percent of net loans as of September 30, 2008.  This compares to $4.5 million or 1.29 percentof net loans as of December 31, 2007.

 

For the quarter end andnine months ended September 30, 2008, Bancorp reported a $760,000provision for loan losses, compared to no provision and a $150,000 benefit forloan losses, for the like periods in 2007. The increase in provision expensesprimarily reflects the increase in net-charge offs, the growth of the Bancorp’sloan portfolio and our assessment of the impact on our market of the generaldeterioration of the national economy. The provision for loan losses is highlydependent upon Bancorp’s ability to manage asset quality and control the levelof net-charge-offs through prudent underwriting standards. See discussion under“Asset Quality” for details relating to non-accrual loans.

 

The allowance ismaintained at a level considered adequate by management to provide for loanlosses inherent in the portfolio. Management believes that the allowance is adequate and appropriate givenBancorp’s current analysis of the loan portfolio and the relative mix and riskof our loan portfolio. See discussion under “Loans” and “Concentrations” fordetails relating to real estate loan composition. Bancorp has a systematic methodologyfor evaluating the adequacy of the allowance for loan losses and the allowanceis evaluated on a quarterly basis and reviewed by the Board of Directors. Theallowance is based upon an assessment of levels and trends in losses anddelinquencies, actual loan loss experience, current economic conditions andother factors, including regulatory guidance and economic factors.

 

While Bancorp believesthat it uses the best information available to determine the allowance for loanlosses, unforeseen market conditions could result in adjustments to theallowance for loan losses, and net income could be significantly affected ifcircumstances differ substantially from the assumptions used in making thefinal determination.  The normal growthof the loan portfolio and a further decline in the performance of the economy,in general, or a further decline in real estate values in our market areas, inparticular, could have an adverse impact on collectability, increase the levelof real estate non-performing loans or have other adverse effects which aloneor in aggregate could have a material adverse effect on our business, financialcondition, results of operation and cash flows which may require additionalprovisions to our allowance for loan losses.

 

19

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Additionally, loans aresubject to examinations by regulators, who, based upon their judgment, mayrequire Bancorp to make additional provisions or adjustments to its allowancefor loan losses.

 

Loans deemed uncollectible,in whole or in part are charged against and reduce the allowance for loanlosses. Net charges-offs for the quarter and nine months ended September 30,2008 were $438,000 and $922,000 compared to $61,000 and $221,000 for the likeperiods in 2007. For the nine months ended September 30, 2008, grosscharge-offs included charge-offs of approximately $831,000 on two creditrelationships.

 

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

 

**Allowance for Loan Losses**

** **
| ** **                                                   | ** ** | **Three months ended,** | ** ** | **Nine months ended,** | ** ** |
|--------------------------------------------------------------|------------|-----------------------------------|------------|----------------------------------|------------|
| **(dollars in thousands)**                         | ** ** | **2008**                          | ** ** | **2007**                         | ** ** | **2008** | ** ** | **2007** | ** ** |
| Allowance as of  beginning of year                           |       | $                                 | 4,051      |                             | $          | 4,866 |   | $ | 4,535 |   | $ | 5,176 |   |
| Provision  (benefit) for loan losses                         |       | 760                               |       | —                           |       | 760 |   | (150 | ) |
| Charge-offs                                                  |       | (465                              | )          | (105                             | )          | (1,099 | ) | (436 | ) |
| Recoveries                                                   |       | 27                                |       | 44                               |       | 177 |   | 215 |   |
| Net charge-offs                                              |       | (438                              | )          | (61                              | )          | (922 | ) | (221 | ) |
| Balance at end  of period                                    |       | $                                 | 4,373      |                             | $          | 4,805 |   | $ | 4,373 |   | $ | 4,805 |   |
| Ratio of net  charge-offs to average loans during the period |       | (0.46                             | )%         | (0.07                            | )%         | (0.34 | )% | (0.09 | )% |
| Ratio of  allowance to net loans at end of period            |       | 1.12                              | %          | 1.40                             | %          | 1.12 | % | 1.40 | % |
| Ratio of  non-performing loans to allowance                  |       | 14.43                             | %          | 96.77                            | %          | 14.43 | % | 96.77 | % |

** **

**Activity**

** **

*Credit Risk Management*

* *

Bancorp monitors its loanportfolio for potential risk of loss according to an internal risk-gradingsystem and monitors its credit quality to identify potential problem creditsand any loss exposure in a timely manner. Bancorp has assessed and will continue to assess on an on-going basis,the impact of the economy on the credit risk in the loan portfolio. Theextension of credit to individuals and businesses is a significant portion ofBancorp’s principal business activity and requires ongoing portfolio and creditmanagement.  As such, Bancorp has establishedlending policies and procedures to manage and monitor risk. These lendingpolicies and procedures include guidelines for concentrations of credit, loanterms, loan-to-value ratios, collateral appraisals and loan approval limits.

 

***ASSETQUALITY*     **Non-performingassets consist of nonaccrual loans, accruing loans past due 90 days or more andother real estate owned. At September 30, 2008, non-performing assetsdecreased to $6.2 million or 1.09 percent of total assets compared to $7.7million or 1.30 percent as of December 31, 2007. This reduction resultedprimarily from the charge-off of approximately $1.4 million in other realestate owned.

 

*Non-accrualand impaired loans* - It is Bancorp’s policy to discontinuethe accrual of interest on all loans that are 90 days or more past due andplace them on non-accrual.  When a loanis placed on non-accrual status, any accrued but unpaid interest on that dateis removed from interest income. Non-accruing loans were $631,000 as of September 30,2008 compared to $7.7 million as of December 31, 2007 with $6.9 million ofthe December 2007 balance transferring into other real estate owned duringthe nine months ended September 30, 2008.

 

At September 30,2008, impaired loans decreased to $5.8 million compared to $7.7 million at December 31,2007.  As noted above, $6.9 million inimpaired loans were transferred to other real estate owned. One creditrelationship of $3.4 million, accounted for 58.2 percent of impaired loans asof September 30, 2008. As of September 30, 2008, a $322,000 specificallocation relating to four credit relationships was included in the allowancefor loan losses. All material loan restructurings have been included inimpaired loans.

 

*Otherreal estate owned*     During 2008,Bancorp foreclosed on four non-accrual credit relationships of $6.9 millionwhich were transferred into other real estate owned.  As a result, as of September 30, 2008,Bancorp held four foreclosed properties which represent four separate landdevelopment projects consisting of finished lots with a carrying balance of$5.6 million, compared to no properties owned at December 31, 2007.  Valuation of the property occurs when it isforeclosed upon and at least annually thereafter.  Based on current appraisals received duringthe quarter and the decrease in fair market values of these real estateproperties, Bancorp recorded a writedown on other real estate owned of $1.4million for the nine months ended September 30, 2008.

 

20

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It is Bancorp’s plan tocontinue its collection efforts and liquidation of collateral, as necessary, torecover as large a portion of the non-accrual assets or other real estate ownedas possible. The following table presents non-performing asset information relatedto loans accounted for on a non-accrual basis, accruing loans 90 days or morepast due and other real estate owned for the dates indicated.

 

**Non-Performing Assets**

** **
| **(dollars in thousands)**         | ** ** | **September 30, 2008** | ** ** | **December 31, 2007** | ** ** |
|----------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| Non-accrual  loans                           |       | $                                | 631        |                            | $          | 7,690 |   |
| Loans past due  90 days or more              |       | —                           |       | —                          |       |
| Total  non-performing loans                  |       | 631                              |       | 7,690                           |       |
| Other real  estate owned                     |       | 5,616                            |       | —                          |       |
| Total  non-performing assets                 |       | $                                | 6,247      |                            | $          | 7,690 |   |
| Total  non-performing loans to net loans     |       | 0.16                             | %          | 2.19                            | %          |
| Total non-performing  loans to total assets  |       | 0.11                             | %          | 1.30                            | %          |
| Total  non-performing assets to total assets |       | 1.09                             | %          | 1.30                            | %          |

** **

**DEPOSITS      **Bancorpoffers a full range of deposit services including checking accounts, savingsaccounts, money market accounts and various types of certificates ofdeposit.  The transaction accounts andcertificates of deposit are tailored to Bancorp’s primary market area at ratescompetitive with those offered in the area. Bancorp offers both interest andnon-interest bearing checking accounts.

 

Total deposits decreasedto $466.9 million at September 30, 2008 compared to $500.4 million at December 31,2007.  Within the total, time depositsdecreased $32.3 million while core deposits decreased $1.2 million. Timedeposits decreased to 34.1 percent of deposits at September 30, 2008compared to 38.2 percent of deposits at December 31, 2007.  During the quarter, Bancorp used federalfunds purchased to lower the Bancorp’s cost of funds replacing higher costingtime deposits.

 

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

 

**Deposit Composition**

** **
| ** **                           | ** ** | **September 30, 2008** | ** ** | **December 31, 2007** | ** ** |
|--------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| **(dollars in thousands)** | ** ** | **Amount**                       | ** ** | **% of Total**        | ** ** | **Amount** | ** ** | **% of Total** | ** ** |
| Non-interest  bearing demand         |       | $                                | 73,449     |                            | 15.7       | % | $ | 77,957 |   | 15.5 | % |
| Interest bearing  demand             |       | 88,943                           |       | 19.0                            | %          | 89,830 |   | 18.0 | % |
| Money market                         |       | 64,511                           |       | 13.8                            | %          | 67,857 |   | 13.6 | % |
| Savings                              |       | 80,963                           |       | 17.4                            | %          | 73,464 |   | 14.7 | % |
| Time                                 |       | 159,039                          |       | 34.1                            | %          | 191,312 |   | 38.2 | % |
| Total deposits                       |       | $                                | 466,905    |                            | 100.0      | % | $ | 500,420 |   | 100.0 | % |

 

**BORROWINGS      **Totalborrowings, including securities sold under agreements to repurchase andfederal funds purchased, increased to $42.9 million at September 30, 2008compared to $15.9 million as of December 31, 2007.  As noted above under deposits, during thequarter, Bancorp used federal funds purchased to lower the Bancorp’s cost offunds replacing higher costing time deposits. Federal Funds purchased increasedto $29.1 million as of September 30, 2008.

 

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

 

**CAPITAL RESOURCES**      Stockholders’equity decreased to $60.1 million at September 30, 2008 from $72.7 millionat December 31, 2007.  This decreasewas primarily due to a private stock repurchase of a large block of 85,022shares from one corporate stockholder for $15.3 million during the firstquarter of 2008. Book value per share at September 30, 2008 was $102.56compared to a book value of $108.32 at December 31, 2007.

 

Bancorp has only oneclass of stock. Bancorp’s stock is not actively traded or quoted and no brokercurrently makes a market in the stock. However, sales and transfers of thestock do occur.  Skagit State Bank actsas transfer agent for 

 

21

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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 of its common stock. The number of shares of stockthat will be repurchased and the price that will be paid is the result of manyfactors including market and economic conditions, the number of sharesavailable, Bancorp’s liquidity and capital needs and regulatory requirements.For the nine months ended September 30, 2008, Bancorp repurchased 85,022shares of stock at an average price of $180 per share.

 

On October 3, 2008,Congress approved and the President signed the Emergency Economic StabilizationAct of 2008 (the “Act”).  The TroubledAssets Relief Program (“TARP”) is the heart of the Act and provides theSecretary of the Treasury the authority to purchase troubled assets fromeligible financial institutions in an aggregate amount of up to $700billion.  Under the Act, the Treasurycreated the Capital Purchase Program (“CPP”) that enables the federalgovernment to purchase equity in participating financial institutions to helprestore credit markets.  Application toparticipate in the CPP must be submitted by November 14, 2008.  Bancorp is considering possible participationin the CPP.

 

Banking regulationsrequire bank holding companies and banks to maintain certain minimum capitallevels.  As the following table indicatesas of September 30, 2008 and December 31, 2007, Skagit State Bancorp, Inc.and Skagit State Bank both exceeded the well-capitalized requirements.

 
| ** **                           | ** ** | ** ** | ** ** | ** **                 | ** ** | **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 September  30, 2008            |       |       |       |                       |       |                       |       |   |   |   |   |   |   |
| Total Capital                        |       |       |       |                       |       |                       |       |   |   |   |   |   |   |
| (to  Risk-Weighted Assets)           |       |       |       |                       |       |                       |       |   |   |   |   |   |   |
| Skagit State  Bank                   |       | $          | 63,945     |                       | 13.75      | %                          | $          | 37,204 |   | > 8.00 | % | $ | 46,505 |   | > 10.00 | % |
| Skagit State  Bancorp, Inc.          |       | $          | 64,136     |                       | 13.79      | %                          | $          | 37,213 |   | > 8.00 | % | $ | 46,516 |   | > 10.00 | % |
| Tier I Capital                       |       |       |       |                       |       |                       |       |   |   |   |   |   |   |
| (to  Risk-Weighted Assets)           |       |       |       |                       |       |                       |       |   |   |   |   |   |   |
| Skagit State  Bank                   |       | $          | 59,572     |                       | 12.81      | %                          | $          | 18,602 |   | > 4.00 | % | $ | 27,903 |   | > 6.00 | % |
| Skagit State  Bancorp, Inc.          |       | $          | 59,763     |                       | 12.85      | %                          | $          | 18,606 |   | > 4.00 | % | $ | 27,910 |   | > 6.00 | % |
| Tier I Capital                       |       |       |       |                       |       |                       |       |   |   |   |   |   |   |
| (to Average  Assets)                 |       |       |       |                       |       |                       |       |   |   |   |   |   |   |
| Skagit State  Bank                   |       | $          | 59,572     |                       | 10.53      | %                          | $          | 22,620 |   | > 4.00 | % | $ | 28,275 |   | > 5.00 | % |
| Skagit State  Bancorp, Inc.          |       | $          | 59,763     |                       | 10.57      | %                          | $          | 22,620 |   | > 4.00 | % | $ | 28,275 |   | > 5.00 | % |
|                                 |       |       |       |                       |       |                       |       |   |   |   |   |   |   |
| As of December  31, 2007             |       |       |       |                       |       |                       |       |   |   |   |   |   |   |
| Total Capital                        |       |       |       |                       |       |                       |       |   |   |   |   |   |   |
| (to  Risk-Weighted Assets)           |       |       |       |                       |       |                       |       |   |   |   |   |   |   |
| Skagit State  Bank                   |       | $          | 76,354     |                       | 17.25      | %                          | $          | 35,407 |   | > 8.00 | % | $ | 44,259 |   | > 10.00 | % |
| Skagit State  Bancorp, Inc.          |       | $          | 76,524     |                       | 17.29      | %                          | $          | 35,412 |   | > 8.00 | % | $ | 44,265 |   | > 10.00 | % |
| Tier I Capital                       |       |       |       |                       |       |                       |       |   |   |   |   |   |   |
| (to  Risk-Weighted Assets)           |       |       |       |                       |       |                       |       |   |   |   |   |   |   |
| Skagit State  Bank                   |       | $          | 71,819     |                       | 16.23      | %                          | $          | 17,704 |   | > 4.00 | % | $ | 26,556 |   | > 6.00 | % |
| Skagit State  Bancorp, Inc.          |       | $          | 71,989     |                       | 16.26      | %                          | $          | 17,706 |   | > 4.00 | % | $ | 26,559 |   | > 6.00 | % |
| Tier I Capital                       |       |       |       |                       |       |                       |       |   |   |   |   |   |   |
| (to Average  Assets)                 |       |       |       |                       |       |                       |       |   |   |   |   |   |   |
| Skagit State  Bank                   |       | $          | 71,819     |                       | 12.39      | %                          | $          | 23,183 |   | > 4.00 | % | $ | 28,979 |   | > 5.00 | % |
| Skagit State  Bancorp, Inc.          |       | $          | 71,989     |                       | 12.42      | %                          | $          | 23,183 |   | > 4.00 | % | $ | 28,979 |   | > 5.00 | % |
|                                 |       |       |       |                       |       |                       |       |   |   |   |   |   |   |

 

22

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**LIQUIDITY**

 

The objective ofliquidity risk management is to ensure that the Bank has the continuing abilityto maintain cash flows that are adequate to fund operations including day today cash flow requirements of either its depositors wanting to withdraw fundsor to provide for customers credit needs. Bancorp has a formal liquidity policythat establishes liquidity guidelines and the maintenance of contingencyliquidity plans that provide for actions and timely responses to liquiditystress situations.

 

Liquidity is generatedfrom both internal and external sources. The majority of funding comes fromcustomer deposits within the Bank’s market area. In addition, funding needs aremet through loan repayments, investment securities repayments, earnings and otherborrowings through pre-approved credit lines. Liquidity may also be obtained bymaintaining assets that are can be converted to cash with little or no risk ofloss.  However, in this turbulent marketenvironment assets may be more difficult to convert to cash with or without aloss.

 

As part of the Bank’sliquidity management, the Bank utilizes federal funds purchased to supplementthe primary source of funds, which are deposits.  As a result, there could be fluctuations inthese borrowing balances depending on short-term liquidity and longer-termfinancing needs of the Bank.  As a meansof augmenting liquidity sources, during the quarter the Bank increased itsfederal funds lines with various correspondent banks and the Federal ReserveBank. As of September 30, 2008, Bancorp had approximately $33.0 million inapproved unsecured credit lines from various financial institutions and hadsecurities with a market value of $37.8 million pledged as collateral forborrowing at the Federal Reserve Discount Window.

 

Because the Bank’sprimary sources and uses of funds are deposits and loans, the relationshipbetween net loans and total deposits provides one measure of the Bank’sliquidity.  The Bank’s loan to depositratio increased to 83.3 percent at September 30, 2008 compared to 70.1percent at December 31, 2007, as a result of the decrease in deposits andthe increase in loans.

 

The recent turmoil in thecredit markets did not have a direct impact on Bancorp’s liquidity managementpractices. Access to our correspondent banks and the Federal Reserve remainedopen. Management believes that Bancorp’s liquidity position at September 30,2008 was adequate to fund ongoing operations.

 

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

 

**Item 3.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

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

 

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

 

Bancorp believes thatthere have not been any material changes about Bancorp’s market risk from theinformation that was provided in the Form 10-K for the year ended December 31,2007.

 

# **Item 4T. CONTROLSAND PROCEDURES**

# ** **

Evaluation of DisclosureControls and Procedures

 

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

 

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Changes in InternalControls

 

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

 

**PART II-****                                            OTHERINFORMATION**

 

**Item 1.****                                                           LegalProceedings**

 

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

 

**Item 1A.****                                                  RiskFactors**

 

Thereare certain risks inherent to Bancorp’s business.  The material risk and uncertainties thatmanagement believes affect Bancorp are described below.  Although we have risk management policies,procedures and verification procedures in place, additional risks anduncertainties that management is not aware of or focused on or that managementcurrently deems immaterial may also impair Bancorp’s business operations.  If any of the following risks actually occur,our financial condition and results of operations could be materially andadversely affected.

 

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

 

Bancorp’s profitabilityis dependent to a large extent upon net interest income. Earnings and cashflows are largely dependent upon our net interest income.  Net interest income is the difference (or “spread”)between the interest earned on loans, securities and other interest-earningassets and Bancorp’s cost of funds, primarily interest expense on deposits andborrowings. Interest rates are highly sensitive to many factors that are beyondour control including, but not limited to, general economic conditions,policies of various governmental and regulatory agencies. Changes in monetarypolicy, including changes in interest rates, impact the level of loans,deposits and investments, the credit profile of existing loans and the ratesreceived on loans and investment securities and the rates paid on deposits andborrowings. If the interest on deposits increase at a faster rate than theinterest received on loans and investment securities, Bancorp’s net interestincome, and therefore earnings could be adversely affected.  Earnings could also be adversely affected ifinterest received on loans and investments decrease faster than interest paidon deposits.   The Federal Reservedecreased rates 100 basis points in 2007 and 225 basis points through September 30,2008.

 

**Borrowersunwilling or unable to repay loans could adversely affect Bancorp’sprofitability**

 

Creditrisk, the possibility that borrowers will be unwilling or unable to repay theirobligations when due, could profoundly impact our earnings.  We maintain an allowance for loan losses forestimated future loan losses.  The levelof our allowance for loan losses is based on management’s judgments and variousassumptions about the loan portfolio.  Ifour assumptions are incorrect, the allowance for loan losses may not besufficient to cover losses, which could adversely affect our results of operations.

 

**Our allowancefor loan losses may not be adequate to cover actual loan losses, which couldadversely affect Bancorp’s earnings**

 

Bancorp maintains anallowance for loan losses in an amount that we believe is adequate to providefor losses inherent in the portfolio. While Bancorp strives to carefully monitor credit quality and toidentify loans that may become nonperforming or uncollectible, at any timethere are loans included in the portfolio that will result in losses, but thathave not been identified as nonperforming or potential problem loans.  We cannot be sure that we will be able toidentify deteriorating loans before they become nonperforming assets, or thatwe will be able to limit losses on those loans that are identified.  As a result, future additions to theallowance may be necessary. Additionally, future additions to the allowance may be required based onchanges in the loans comprising the portfolio and changes in the financialcondition of borrowers, such as may result from changes in economic conditions,or as a result of incorrect assumptions by management in determining theallowance.  Additionally, federal andstate banking regulators, as an integral part of their supervisory function,periodically review our allowance for loan losses.  These regulatory agencies may require us torecognize further loan charge-offs based upon their judgments, which may bedifferent from ours.  Any increase in theallowance for loan losses could have a negative effect on our financialcondition and results of operation.

 

24

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

 

Real estate loanscomprise the largest category of loans and represent 69.0 percent of totalloans.  Our real estate portfolioconsists of commercial and residential lending. These loans are secured by property such as office buildings, commercialbusiness properties, healthcare buildings, agricultural land, timber land andresidential properties.  Commercial andcommercial real estate loans generally are viewed as having more risk ofdefault than residential real estate loans or certain other types of loans orinvestments.  Typically, these types ofloans are larger than residential real estate loans and other loans.  Because the loan portfolio contains a numberof commercial real estate loans with relatively large balances, thedeterioration of one or a few of these loans may cause a significant increasein nonperforming loans.  An increase innonperforming loans could result in; a loss of earnings from these loans; anincrease in the provision for loan losses; or an increase in loan charge-offs,which could have an adverse impact on our results of operations and financialcondition.

 

**Therehas been an economic downturn in many parts of the country, particularly in thehousing and commercial real estate sectors. The Pacific Northwest economy typically lags the national economy;however, the effects of that slowdown have started to impact our marketarea.  Accordingly, a further economicdownturn in the market area we serve may cause us to have lower earnings andcould increase our credit risk associated with our loan portfolio. Theinability of borrowers to repay loans can erode our earnings. Substantially allof our loans are to businesses and individuals in Skagit, Snohomish or WhatcomCounties and any decline in the economy of this market area could impact usadversely.  As a lender, we are exposedto the risk that our customers will be unable to repay their loans inaccordance with their terms, and that any collateral securing the payment oftheir loans may not be sufficient to assure repayment.**

** **

**Tighteningof credit markets and liquidity risk**

 

**Atightening of the credit market and the inability to obtain adequate money tofund continued loan growth may negatively affect our asset growth and liquidityposition and, therefore, our earnings capability.  In addition to core deposit growth, maturityof investment securities and loan payments, the Company also relies onalternative funding sources through correspondent banking, and borrowing lineswith the Federal Reserve Bank to fund loans. In the event of a downturn in the economy, particularly in the housingmarket, these resources could be negatively affected, both as to price andavailability, which would limit and or raise the cost of the funds available tothe Company.**

** **

**Wecannot predict the effect of the recently enacted federal rescue plan.**

 

**Congressrecently enacted the Emergency Economic Stabilization Act of 2008, which isintended to stabilize the financial markets, including providing funding of upto $700 billion to purchase troubled assets and loans from financialinstitutions.  The legislation alsoincreases the amount of deposit account insurance coverage from $100,000 to$250,000 for interest-bearing deposit accounts and non-interest bearingtransaction accounts, the latter of which are fully insured until December 31,2009.  Most recently, the federalgovernment agreed to invest $125 billion in preferred stock of nine U.S.financial institutions, and to make available up to another $125 billion forinvestment in preferred stock of other U.S. financial institutions, on certainterms and conditions.  The full effect ofthis wide-ranging legislation on the national economy and financialinstitutions, particularly on mid-sized institutions like us, cannot bepredicted.**

** **

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

 

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

 

**We couldfind it difficult to attract and retain skilled employees**

 

Competitionfor skilled employees in some areas can be intense and we may not be able tohire or retain the key employees we want or need.  As our success, in large part, is due to ourability to attract and retain key employees, the loss of key employees or if weare unable to attract key employees, could adversely affect our business.

 

25

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**Competitionmay adversely affect our ability to attract and retain customers at currentlevels**

 

Thebanking and financial services industry is highly competitive.  Competition may limit our ability to attractand retain customers.  We facecompetition from other financial institutions as well as non-bank financial servicecompanies. If we are unable to attract and retain customers, we may be unableto continue loan and deposit growth which could adversely affect our businessand results of operations.

 

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

 

There is no active marketfor our outstanding shares, and it is unlikely that an established market forour shares will develop in the near future. We presently do not intend to seek listing of the shares on anysecurities exchange, or quotation on the NASDAQ interdealer quotation system.It is not known whether significant trading activity will take place forseveral years, if at all.  Accordingly,our shares should be considered as a long-term investment.

 

**Thereare restrictions on changes in control of Bancorp that could decrease ourshareholders’ chance to realize a premium on their shares. Provisions in ourArticles of Incorporation include a staggered Board of Directors, andnon-monetary factor provisions and an affirmative vote of two-thirds of shares(entitled to be counted) to approve an interested shareholder transaction, anyor all of which could have the effect of hindering, delaying or preventing atakeover bid.  These provisions mayinhibit takeover bids and could decrease the chance of shareholders realizing apremium over market price for their shares as a result of the takeover bid.**

** **

**The FDIChas increased insurance premiums to rebuild and maintain the federal depositinsurance fund.**

 

Due to recent events andthe state of the economy, the FDIC has increased federal deposit insurancepremiums beginning in the first quarter of 2009 to double what we have recentlypaid.  The increase of these premiumswill add to our cost of operations and could have a significant impact on theCompany.

 

**Item 2.****                                                           UnregisteredSales of Equity Securities and Use of Proceeds**

 

None

 

**Item 3.****                                                           DefaultsUpon Senior Securities**

 

None

 

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

 

None

 

**Item 5.****                                                           OtherInformation**

 

None

 

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

 

(a)                                  Exhibits.

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

 

26

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**SIGNATURES**

 

 

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

 

 
|   |                   | SKAGIT STATE BANCORP,  INC. |
|--------|------------------------|-----------------------------|
|   |                   | (Registrant)                |
|   |                   |                        |
|   |                   |                        |
| Dated: | November 14, 2008 |                        | /s/Cheryl R. Bishop |
|   |                   | Cheryl R. Bishop            |
|   |                   | Chief Executive Officer     |
|   |                   |                        |
|   |                   |                        |
| Dated: | November 14, 2008 |                        | /s/Carla F. Tucker |
|   |                   | Carla F. Tucker             |
|   |                   | Executive  Vice-President   |
|   |                   | Chief Financial Officer     |

 

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