** **

**UNITED STATESSECURITIES AND EXCHANGE COMMISSON**

**WashingtonD.C., 20549**

**FORM 10-Q**
| **x**      | **Quarterly Report Pursuant to Section 13 or 15(d)  of the Securities Exchange Act of 1934**                                                                                                                                                                                                                                                          |
|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** ** | ** **                                                                                                                                                                                                                                                                                                                                            |
| ** ** | **For the quarterly period ended September 30,  2006**                                                                                                                                                                                                                                                                                                |
| ** ** | ** **                                                                                                                                                                                                                                                                                                                                            |
| **o**      | **Transition Report Under Section 13 or 15(d) of  the Exchange Act**                                                                                                                                                                                                                                                                                  |
| ** ** | ** **                                                                                                                                                                                                                                                                                                                                            |
| ** ** | **For the transition period from                             to                          ** |

 

**CommissionFile Number  000-52096**

**SKAGIT STATE BANCORP, INC.**

(ExactName of Registrant as Specified in Its Charter)

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

 

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

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

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

Yes  x    No  o

Indicate by check mark whether the registrant is a large acceleratedfiler, an accelerate filer, or a non-accelerate.
|  | Large accelerated filer  o | Accelerated filer  o | Non-accelerated filer  x |
|--|--------------------------------------|--------------------------------|------------------------------------|

 

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

Yes  o    No  x

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

Thenumber of shares of the issuer’s Common Stock outstanding at November 10, 2006was 673,769.

 

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

 

2

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**Item 1.**                          FinancialStatements

**SKAGIT STATE BANCORP, INC. ANDSUBSIDIARY**

**CONSOLIDATEDBALANCE SHEET (Unaudited)**
| **(dollars in thousands except share data)**                                                                                                 | ** ** | **September 30, 2006** | ** ** | **December 31, 2005** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                                                                                                                            | ** ** | ** **                       | ** ** | ** **                      | ** ** |
| **ASSETS**                                                                                                                                                            | ** ** | ** **                       | ** ** | ** **                      | ** ** |
| ** **                                                                                                                                                            | ** ** | ** **                       | ** ** | ** **                      | ** ** |
| **ASSETS**                                                                                                                                                            | ** ** | ** **                       | ** ** | ** **                      | ** ** |
| Cash and due  from banks                                                                                                                                              |       | $                                | 20,567     |                            | $          | 24,975 |   |
| Federal funds  sold                                                                                                                                                   |       | 42,135                           |       | 88,090                          |       |
| Investment  securities                                                                                                                                                |       |                             |       |                            |       |
| Available-for-sale,  at fair value                                                                                                                                    |       | 96,251                           |       | 69,853                          |       |
| Held-to-maturity,  at amortized cost                                                                                                                                  |       | 33,578                           |       | 29,197                          |       |
| Loans                                                                                                                                                                 |       | 311,475                          |       | 300,614                         |       |
| Allowance for  loan losses                                                                                                                                            |       | (4,712                           | )          | (5,178                          | )          |
| Net loans                                                                                                                                                             |       | 306,763                          |       | 295,436                         |       |
| Bank premises  and equipment, net                                                                                                                                     |       | 10,986                           |       | 10,734                          |       |
| Accrued interest  receivable                                                                                                                                          |       | 3,176                            |       | 2,371                           |       |
| Other assets                                                                                                                                                          |       | 3,879                            |       | 1,223                           |       |
| **TOTAL ASSETS**                                                                                                                                                      |       | $                                | 517,335    |                            | $          | 521,879 |   |
|                                                                                                                                                                  |       |                             |       |                            |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                        | ** ** | ** **                       | ** ** | ** **                      | ** ** |
| ** **                                                                                                                                                            | ** ** | ** **                       | ** ** | ** **                      | ** ** |
| **LIABILITIES**                                                                                                                                                       | ** ** | ** **                       | ** ** | ** **                      | ** ** |
| Deposits                                                                                                                                                              |       |                             |       |                            |       |
| Interest-bearing                                                                                                                                                      |       | $                                | 360,052    |                            | $          | 366,193 |   |
| Non-interest-bearing                                                                                                                                                  |       | 75,713                           |       | 76,872                          |       |
| Total deposits                                                                                                                                                        |       | 435,765                          |       | 443,065                         |       |
| Securities sold  under agreements to repurchase                                                                                                                       |       | 13,501                           |       | 11,298                          |       |
| Other  liabilities                                                                                                                                                    |       | 2,771                            |       | 2,143                           |       |
| Total liabilities                                                                                                                                                     |       | 452,037                          |       | 456,506                         |       |
|                                                                                                                                                                  |       |                             |       |                            |       |
| **STOCKHOLDERS’ EQUITY**                                                                                                                                         | ** ** | ** **                       | ** ** | ** **                      | ** ** |
| Common stock, no  par value, 5,000,000 shares authorized 673,769 and 707,237 shares issued and  outstanding at September 30, 2006 and December 31, 2005, respectively |       | 13,955                           |       | 14,604                          |       |
| Retained earnings                                                                                                                                                     |       | 51,778                           |       | 51,139                          |       |
| Accumulated  other comprehensive loss, net of tax                                                                                                                     |       | (435                             | )          | (370                            | )          |
| Total  stockholders’ equity                                                                                                                                      |       | 65,298                           |       | 65,373                          |       |
| **TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                   |       | $                                | 517,335    |                            | $          | 521,879 |   |

 

*See accompanying notes to theseconsolidated financial statements*

3

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**SKAGIT STATEBANCORP, INC. AND SUBSIDIARY**

**CONSOLIDATEDSTATEMENT OF INCOME (Unaudited)**
| ** **                                                            | ** ** | **Three months ended Sept. 30,** | ** ** | **Nine months ended Sept. 30,** | ** ** |
|-----------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| **(dollars in thousands except share data)** | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                                  |       |                                                 |       |                                                |       |   |   |   |   |
| **INTEREST  INCOME**                                                  | ** ** | ** **                                           | ** ** | ** **                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest and fees on loans                                            |       | $                                                    | 6,534      |                                                | $          | 5,911 |   | $ | 18,774 |   | $ | 18,276 |   |
| Investment securities                                                 |       |                                                 |       |                                                |       |   |   |   |   |
| Taxable                                                               |       | 1,113                                                |       | 415                                                 |       | 2,972 |   | 880 |   |
| Exempt from federal income tax                                        |       | 210                                                  |       | 202                                                 |       | 586 |   | 598 |   |
| Federal funds sold                                                    |       | 587                                                  |       | 674                                                 |       | 2,205 |   | 1,359 |   |
| Total interest income                                                 |       | 8,444                                                |       | 7,202                                               |       | 24,537 |   | 21,113 |   |
| **INTEREST  EXPENSE**                                                 | ** ** | ** **                                           | ** ** | ** **                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Deposits                                                              |       | 2,448                                                |       | 1,617                                               |       | 6,855 |   | 4,237 |   |
| Securities sold under agreements to repurchase                        |       | 120                                                  |       | 37                                                  |       | 340 |   | 88 |   |
| Total interest expense                                                |       | 2,568                                                |       | 1,654                                               |       | 7,195 |   | 4,325 |   |
| **NET  INTEREST INCOME**                                              |       | 5,876                                                |       | 5,548                                               |       | 17,342 |   | 16,788 |   |
| Provision for loan losses                                             |       | —                                               |       | (400                                                | )          | — |   | (50 | ) |
| **NET  INTEREST INCOME AFTER**                                        | ** ** | ** **                                           | ** ** | ** **                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| **PROVISION  FOR LOAN LOSSES**                                        |       | 5,876                                                |       | 5,948                                               |       | 17,342 |   | 16,838 |   |
| **NON-INTEREST  INCOME**                                              | ** ** | ** **                                           | ** ** | ** **                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Service charges on deposits                                           |       | 555                                                  |       | 563                                                 |       | 1,622 |   | 1,630 |   |
| Other                                                                 |       | 262                                                  |       | 175                                                 |       | 658 |   | 529 |   |
| Total non-interest income                                             |       | 817                                                  |       | 738                                                 |       | 2,280 |   | 2,159 |   |
| **NON-INTEREST  EXPENSES**                                            | ** ** | ** **                                           | ** ** | ** **                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Salaries                                                              |       | 1,820                                                |       | 1,764                                               |       | 5,165 |   | 4,895 |   |
| Payroll taxes and employee benefits                                   |       | 415                                                  |       | 354                                                 |       | 1,211 |   | 1,034 |   |
| Bank premises and equipment                                           |       | 326                                                  |       | 275                                                 |       | 945 |   | 823 |   |
| Occupancy                                                             |       | 169                                                  |       | 164                                                 |       | 504 |   | 518 |   |
| State business taxes                                                  |       | 111                                                  |       | 107                                                 |       | 335 |   | 308 |   |
| Advertising                                                           |       | 195                                                  |       | 111                                                 |       | 521 |   | 376 |   |
| Other                                                                 |       | 755                                                  |       | 524                                                 |       | 2,166 |   | 2,263 |   |
| Total non-interest expenses                                           |       | 3,791                                                |       | 3,299                                               |       | 10,847 |   | 10,217 |   |
| **INCOME  BEFORE PROVISION**                                          | ** ** | ** **                                           | ** ** | ** **                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| **FOR  INCOME TAX**                                                   |       | 2,902                                                |       | 3,387                                               |       | 8,775 |   | 8,780 |   |
| **PROVISION  FOR INCOME TAX**                                         | ** ** | ** **                                           | ** ** | ** **                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Current                                                               |       | 760                                                  |       | 920                                                 |       | 2,316 |   | 2,243 |   |
| Deferred                                                              |       | —                                               |       | —                                              |       | 51 |   | 37 |   |
| Total provision for income tax                                        |       | 760                                                  |       | 920                                                 |       | 2,367 |   | 2,280 |   |
| **NET  INCOME**                                                       |       | $                                                    | 2,142      |                                                | $          | 2,467 |   | $ | 6,408 |   | $ | 6,500 |   |
| **BASIC AND DILUTED EARNINGS PER  SHARE**                             |       | $                                                    | 3.17       |                                                | $          | 3.49 |   | $ | 9.31 |   | $ | 9.19 |   |

 

*See accompanying notes to theseconsolidated financial statements*

4

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**SKAGIT STATE BANCORP, INC. ANDSUBSIDIARY**

**CONSOLIDATEDSTATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY (Unaudited)**
| ** **                                                                                            | ** ** | **Common Stock** | ** ** | **Retained** | ** ** | **Comprehensive** | ** ** | **Stockholders’** | ** ** | **Comprehensive** | ** ** |
|-------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|--------------|------------|-------------------|------------|------------------------|------------|-------------------|------------|
| **(dollars in thousands except share and per share amounts)** | ** ** | **Shares**            | ** ** | **Amount**   | ** ** | **Earnings**      | ** ** | **Income (Loss)** | ** ** | **Equity**        | ** ** | **Income** | ** ** |
| **BALANCE,**January 1, 2005                                                                           |       | 707,137               |       | $            | 14,591     |              | $          | 44,165                 |       | $                 | (23        | ) | $ | 58,733 |   |   |   |
| Comprehensive  income                                                                                 |       |                  |       |         |       |              |       |                   |       |              |       |   |   |
| Net income                                                                                            |       | —                |       | —       |       | 6,500             |       | —                 |       | 6,500             |       | $ | 6,500 |   |
| Other comprehensive income                                                                            |       |                  |       |         |       |              |       |                   |       |              |       |   |   |
| Unrealized gains on available-for-sale securities,  net of taxes of $57                               |       | —                |       | —       |       | —            |       | 110                    |       | 110               |       | 110 |   |
| Unrealized loss on available-for-sale securities,  net of tax benefit of $143                         |       | —                |       | —       |       | —            |       | (277                   | )          | (277              | )          | (277 |   |
| Total other comprehensive loss                                                                        |       |                  |       |         |       |              |       |                   |       |              |       | (167 | ) |
| Comprehensive  income                                                                                 |       |                  |       |         |       |              |       |                   |       |              |       | $ | 6,333 |   |
| Cash dividend  declared, $1.10 per share                                                              |       |                  |       |         |       | (778              | )          |                   |       | (778              | )          |   |   |
| Common stock  issued                                                                                  |       | 100                   |       | 13           |       | —            |       |                   |       | 13                |       |   |   |
| **BALANCE,**September 30, 2005                                                                        |       | 707,237               |       | $            | 14,604     |              | $          | 49,887                 |       | $                 | (190       | ) | $ | 64,301 |   |   |   |
|                                                                                                  |       |                  |       |         |       |              |       |                   |       |              |       |   |   |
| **BALANCE,**January 1, 2006                                                                           |       | 707,237               |       | $            | 14,604     |              | $          | 51,139                 |       | $                 | (370       | ) | $ | 65,373 |   |   |   |
| Comprehensive  income                                                                                 |       |                  |       |         |       |              |       |                   |       |              |       |   |   |
| Net income                                                                                            |       | —                |       | —       |       | 6,408             |       | —                 |       | 6,408             |       | $ | 6,408 |   |
| Other comprehensive income                                                                            |       |                  |       |         |       |              |       |                   |       |              |       |   |   |
| Unrealized gains on available-for-sale securities,  net of taxes of $306                              |       | —                |       | —       |       | —            |       | 594                    |       | 594               |       | 594 |   |
| Unrealized loss on available-for-sale securities,  net of tax benefit of $340                         |       | —                |       | —       |       | —            |       | (659                   | )          | (659              | )          | (659 |   |
| Total other comprehensive loss                                                                        |       |                  |       |         |       |              |       |                   |       |              |       | (65 | ) |
| Comprehensive  income                                                                                 |       |                  |       |         |       |              |       |                   |       |              |       | $ | 6,343 |   |
| Cash dividend  declared, $1.25 per share                                                              |       |                  |       |         |       | (849              | )          |                   |       | (849              | )          |   |   |
| Common stock  redemption                                                                              |       | (33,568               | )          | (664         | )          | (4,920            | )          |                   |       | (5,584            | )          |   |   |
| Common stock  issued                                                                                  |       | 100                   |       | 15           |       | —            |       |                   |       | 15                |       |   |   |
| **BALANCE,**September 30, 2006                                                                        |       | 673,769               |       | $            | 13,955     |              | $          | 51,778                 |       | $                 | (435       | ) | $ | 65,298 |   |   |   |

 

*Seeaccompanying notes to these consolidated financial statements*

5

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**SKAGIT STATE BANCORP, INC. ANDSUBSIDIARY**

**STATEMENT OF CASHFLOWS (Unaudited)**
| **(dollars in thousands)**                                               | ** ** | ** ** | ** ** | ** ** | ** ** |
|------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| **Nine months ended September 30,**                            | ** ** | **2006**   | ** ** | **2005**   | ** ** |
| **CASH  FLOWS FROM OPERATING ACTIVITIES**                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income                                                                         |       | $          | 6,408      |       | $          | 6,500 |   |
| *Adjustments  to reconcile net income to net cash flows from operating activities* | * *   | * *   | * *   | * *   | * *   |
| Provision for loan losses                                                          |       | —     |       | (50        | )          |
| Provision for other real estate owned losses                                       |       | —     |       | —     |       |
| Depreciation                                                                       |       | 629        |       | 583        |       |
| Gain on sale of assets                                                             |       | (22        | )          | (23        | )          |
| Gain on sale of other real estate owned                                            |       | —     |       | (188       | )          |
| Amortization of investment security premiums and  discounts, net                   |       | (42        | )          | (10        | )          |
| Provision for deferred income taxes                                                |       | 51         |       | 37         |       |
| Stock compensation for employee services                                           |       | 15         |       | 13         |       |
| *Changes  in operating assets and liabilities*                                     | * *   | * *   | * *   | * *   | * *   |
| Net increase in other assets                                                       |       | (3,479     | )          | (177       | )          |
| Net increase in other liabilities                                                  |       | 628        |       | 859        |       |
| Net cash flows from operating activities                                           |       | 4,188      |       | 7,544      |       |
| **CASH  FLOWS FROM INVESTING ACTIVITIES**                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Proceeds from maturities of investment securities—available-for-sale          |       | 18,500     |       | 6,000      |       |
| Purchases of investment securities—available-for-sale                         |       | (44,954    | )          | (33,287    | )          |
| Proceeds from maturities of investment securities—held-to-maturity            |       | 5,765      |       | 11,758     |       |
| Purchases of investment securities—held-to-maturity                           |       | (10,146    | )          | (14,641    | )          |
| Net decrease (increase) in federal funds sold                                      |       | 45,955     |       | (49,065    | )          |
| Net (increase) decrease in loans                                                   |       | (11,327    | )          | 52,863     |       |
| Purchase of premises and equipment                                                 |       | (881       | )          | (237       | )          |
| Proceeds from sale of assets                                                       |       | 22         |       | 23         |       |
| Proceeds from sale of other real estate owned                                      |       | —     |       | 1,608      |       |
| Net cash flows from investing activities                                           |       | 2,934      |       | (24,978    | )          |
| **CASH  FLOWS FROM FINANCING ACTIVITIES**                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net decrease in demand deposits, money market, NOW  and savings accounts           |       | (23,487    | )          | (2,569     | )          |
| Net increase in time deposits                                                      |       | 16,187     |       | 12,776     |       |
| Amount paid for redemption of common stock                                         |       | (5,584     | )          | —     |       |
| Net increase in securities sold under agreements to  repurchase                    |       | 2,203      |       | 484        |       |
| Cash dividends                                                                     |       | (849       | )          | (778       | )          |
| Net cash flows from financing activities                                           |       | (11,530    | )          | 9,913      |       |
| **NET  CHANGE IN CASH AND DUE FROM BANKS**                                         |       | (4,408     | )          | (7,521     | )          |
| **CASH  AND DUE FROM BANKS,**beginning of year                                     |       | 24,975     |       | 27,243     |       |
| **CASH  AND DUE FROM BANKS,**end of period                                         |       | $          | 20,567     |       | $          | 19,722 |   |
| **SUPPLEMENTAL  DISCLOSURES OF CASH FLOW INFORMATION**                             | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash paid during the year for income taxes                                         |       | $          | 2,478      |       | $          | 2,174 |   |
| Cash paid during the year for interest                                             |       | 7,120      |       | 4,292      |       |
| **NONCASH  FINANCING AND INVESTING TRANSACTIONS**                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Unrealized loss on available-for-sale securities                                   |       | 65         |       | 167        |       |
| Property taken  in settlement of loans                                             |       | —     |       | 224        |       |

 

*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**

On June 30, 2006, at the completion of the corporatereorganization, pursuant to the Plan and Agreement of Reorganization and Mergerdated January 17, 2006, Skagit State Bank became a wholly-owned subsidiaryof Skagit State Bancorp, Inc. In accordance with the plan, each outstanding whole share of Skagit State Bankcommon stock (675,930 shares) immediately before completion of thereorganization, was exchanged for one share of Skagit State Bancorp, Inc.common stock. As the successor holdingcompany and subsidiary Bank represent only a reorganization of corporatestructure, there was no effect from the reorganization upon previously issuedfinancial statements other than a recapitalization from $10 par value to no parvalue common stock.  As a result, thereorganization has been accounted for on a retrospective basis as if thecurrent structure had previously existed.

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

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

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

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

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

**Note 3:   RECLASSIFICATIONS**

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

**Note 4:   EARNINGSPER SHARE**

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

7

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| ** **                                                                                            | ** ** | **Three months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|-------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| **(dollars in thousands except share and per share amounts)** | ** ** | **2006**                                                 | ** ** | **2005**                                                | ** ** | **2006** | ** ** | **2005** | ** ** |
| Numerator:                                                                                            |       |                                                     |       |                                                    |       |   |   |   |   |
| Net income                                                                                            |       | $                                                        | 2,142      |                                                    | $          | 2,467 |   | $ | 6,408 |   | $ | 6,500 |   |
| Denominator:                                                                                          |       |                                                     |       |                                                    |       |   |   |   |   |
| Denominator for  basic and diluted earnings per share—Weighted average shares outstanding        |       | 675,372                                                  |       | 707,199                                                 |       | 688,339 |   | 707,158 |   |
| Basic and diluted  earnings per share                                                                 |       | $                                                        | 3.17       |                                                    | $          | 3.49 |   | $ | 9.31 |   | $ | 9.19 |   |

 

**Note 5:   ALLOWANCE FOR LOAN LOSSES**

The allowance forloan losses is maintained at a level deemed adequate to provide for estimatedfuture losses. The Bank has a systematic methodology for evaluating theadequacy of the allowance for loan losses and the allowance is evaluated on aquarterly basis. The allowance is based upon the Bank’s periodic evaluation ofthe pertinent 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 collectibility may not be assuredand the determination of the existence and the realizable value of thecollateral securing the loans. A portion of the allowance is then established,by applying a loss percentage factor to the different loan types and thedifferent risk gradings. In addition, as part of the process for determiningthe adequacy of the allowance for loan losses, the Bank reviews the loanportfolio for specific weaknesses and evaluates classified loans for impairmentand loss exposure.

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

**Note 6:   FINANCIALINSTRUMENTS**

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

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

8

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Standby letters of credit are conditional commitmentsissued by the Bank to guarantee the performance of a customer to a third party.Commercial and standby letters of credit were granted primarily to commercialborrowers. Those guarantees are primarily issued to support public and privateborrowing arrangements, including commercial paper, bond financing, and similartransactions. Except for certain long-term guarantees, the majority ofguarantees expire in one year. The credit risk involved in issuing letters ofcredit is essentially the same as that involved in extending loan facilities tocustomers. Collateral supporting those commitments, for which collateral isdeemed necessary, varies.

The following is a summary of the off-balance-sheet financialinstruments or contracts outstanding as of September 30, 2006: (dollars inthousands)
| Unfunded commitments to  extend credit  |   | $      | 70,742 |   |
|-----------------------------------------|--------|--------|--------|--------|
| Credit card  arrangements               |   | 13,881 |   |
| Commitments to  fund municipal warrants |   | 2,025  |   |
| Standby letters of  credit              |   | 3,591  |   |

 

**Note 7:   NEW ACCOUNTING PRONOUNCEMENTS**

On December 16,2004, FASB issued SFAS 123(R), “Share-Based Payment”, which is a revision ofFASB Statement No. 123, “Accounting for Stock-Based Compensation”. SFAS 123 (R)supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees” andamends FASB Statement No. 95, “Statement of Cash Flows”.  Generally, the approach in SFAS 123 (R) issimilar to the approach described in SFAS No. 123.  However, SFAS 123 (R) requires allshare-based payments to employees, including grants of employee stock options,to be recognized in the income statement based on their fair values.  A share-based payment plan was approved at the2005 Shareholder meeting, held on April 20, 2005.  At September 30, 2006, no options have beengranted under the share-based payment plan. The Bank does not currently anticipate the adoption of SFAS No. 123(R) will have a material impact on its financial statements.

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

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

In March 2006, theFASB issued SFAS No. 156, “Accounting for Servicing of Financial Assets”, whichrequires that servicing assets and liabilities be initially measured at fairvalue, if practicable.  SFAS No. 156 alsorequires an entity to choose one of two methods when subsequently measuring itsservicing assets and liabilities: the amortization method or the fair valuemethod. SFAS No. 156 Statement permits a one-time reclassification ofavailable-for-sale securities to the trading classification. This Statement iseffective for the Bank as of January 1, 2007. The Bank does not anticipate theadoption of SFAS No. 156 will have a material impact on its financialstatements.

In September 2006,the FASB issued SFAS No. 157, “Employers’ Accounting for Defined BenefitPension and Other Postretirement Plans”, an amendment of SFAS No. 87, 88, 106and 132(R).  This statement requires anemployer to recognize the over-funded or under-funded status of a definedbenefit postretirement plan as an asset or liability it its statement offinancial position and to recognize changes in that funded status in the yearin which the changes occur through comprehensive income.  This statement also requires an employer tomeasure the funded status of a plan as of the date of its year-end statement offinancial position. This Statement is effective for the Bank 

9

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as of January 1,2008.  The Bank does not anticipate theadoption of SFAS No. 157 will have a material impact on its financialstatements.

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

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

**FORWARD LOOKING STATEMENTS**

In addition tohistorical information, this report contains certain “forward lookingstatements” within the meaning of the Private Securities Litigation Reform Actof 1995 (PSLRA).  This statement isincluded for the express purpose of availing the Bank of the protections of thesafe harbor provision of the PSLRA.  Theforward-looking statements contained in this report are subject to factors,risk, and uncertainties that may cause actual results to differ materially fromthose projected.  Important factors thatmight cause such a material difference include, but are not limited to, thosediscussed in this section of the report. In addition, the following items are among the factors that could causeactual results to differ materially from the forward looking statements in thisreport: general economic conditions, including the effects of recent world events;business conditions in the banking industry; the regulatory environment; newlegislation; vendor quality and efficiency; employee retention factors; rapidlychanging technology and evolving banking industry standards; competitivefactors, including increased competition with community, regional, and nationalfinancial institutions; fluctuating interest rate environments; and similarmatters.  Readers are cautioned not toplace undue reliance on these forward-looking statements, which reflectmanagement’s analysis only as of the date of the statement.  The Bank undertakes no obligation to publiclyreview or update these forward-looking statements to reflect events orcircumstances that arise after the date of this report.  Readers should carefully review any riskfactors described in this and other documents we file from time to time withthe Securities and Exchange Commission.

**OVERVIEW**

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

SkagitState Bancorp, Inc. is a bank holding company with one wholly owned subsidiary- Skagit State Bank (collectively, “Company”or “Bank”). Skagit State Bank began operations in 1958 and isheadquartered in Burlington (Skagit County), Washington.  The Bank provides a full range of bankingservices and products to both businesses and individuals through 13 fullservice banking offices located in Skagit, Snohomish and Whatcom counties. TheBank’s objective is to expand its geographical market share in Whatcom andSnohomish Counties, while maintaining or increasing its market share in SkagitCounty. Additional expansion will be considered if probable customer demandexists and experienced managers and lending officers with a presence in thearea and existing relationships are available.

Net income was$2.1 million and $2.5 million for the quarters ended September 30, 2006 and2005. This decrease was primarily attributed to an increase in non-interestexpenses in 2006 and a reversal of $400,000 in the provision for loan losses in2005 which was partially offset by an increase in net interest income from 2005to 2006. Earnings per share were $3.17 and $3.49 for the quarters endedSeptember 30, 2006 and 2005, respectively. Net income was $6.4 million for thenine months ended September 30, 2006 compared to $6.5 million for the ninemonths ended September 30, 2005 with earnings per share at $9.31 and $9.19,respectively. The decrease in net income for the nine months ended September30, 2006 compared to the nine months ended September 30, 2005 was primarilyattributed to the increase in non-interest expenses which was partially offsetby an increase in net interest income.

Annualized returnon average assets was 1.68 percent and 1.65 percent for the quarter and ninemonths ending September 30, 2006 compared to 2.00 percent and 1.76 percentduring the same time periods in 2005. Annualized return on average equity was 13.34 percent and 13.19 percentfor the quarter and nine months ending September 30, 2006 compared to 15.67percent and 14.12 percent, respectively, for the same time periods in 2005.

10

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Total assetsdecreased to $517.3 million at September 30, 2006 compared to $521.9 million atDecember 31, 2005.  The decrease wasprimarily due to a decrease in total deposits.

**RESULTSOF OPERATIONS**

The Bank’s resultsof operations are dependent to a large degree on net interest income, operatingefficiency and the level of the provision for loan losses. The Bank’soperations are sensitive to interest rate changes and the resulting impact onnet interest income.   The Bank generatesnon-interest income primarily through service charges and fees.  The Bank’s non-interest expenses consistprimarily of salaries and employee benefits expense, and occupancy expense.

**NETINTEREST INCOME     **Net interest income is thedifference between interest earned on loans and investment securities and theBank’s cost of funds, primarily interest expense on deposits and borrowings.Several factors contribute to the changes in net interest income including theeffects of changes in average balances of interest-earning assets andinterest-bearing liabilities, changes in rates on interest-earning assets andrates paid on interest-bearing liabilities, the level of non-interest bearingdeposits and the level of non-accrual loans. The net interest margin is netinterest income expressed as a percent of average interest-earning assets.

Net interestincome was $5.9 million for the quarter ended September 30, 2006 compared to$5.5 million for the like period in 2005. This increase was primarily the result of an increase in the yield onfederal funds sold from 3.49 percent to 5.28 percent and an increase in loanyield from 7.78 percent to 8.59 percent. These increases were partially offset by an increase in the average costof interest-bearing liabilities from 1.83 percent to 2.75 percent for 2005 to2006.

Net interestincome for the nine months ended September 30, 2006 increased $554,000 to $17.3million compared to $16.8 million for 2005. This increase was primarily attributable to the favorable impact fromincreased market rates which were partially offset by $28.4 million decrease inthe average loan balance.  The yield onloans increased from 7.54 percent to 8.49 percent.  This increase was primarily due to therepricing of variable rate loans and higher rates on loan originations. Thebalance of average interest-bearing liabilities increased $17.4 million and theaverage cost of these interest-bearing liabilities increased from 1.62 percentto 2.57 percent.

The Bank’s netinterest margin was 4.91 percent and 4.85 percent for the quarter and ninemonths ended September 30, 2006 compared to 4.77 percent and 4.92 percent forthe same time periods a year ago.

During 2006, dueprimarily to the current market interest rate environment, competition amongfinancial institutions for quality loans and the payoff of certain variablerate adversely classified assets during 2005, the percentage of variable rateloans in the loan portfolio decreased from approximately 77 percent at December31, 2004 to approximately 66 percent as of December 31, 2005 and toapproximately 47 percent at September 30, 2006.

During the firstthree quarters of 2006, prime rate increased 100 basis points and for the year2005, prime rate increased 200 basis points. For the quarter and nine months ended September 30, 2006 and 2005, theincrease in market interest rates had a favorable impact on the Bank’s netinterest income.  The volume ororigination of fixed or variable rate loans, the interest rate sensitivity ofdeposits, the overall level of interest rates and general economic conditionscan have a significant effect on the Bank’s performance in a changing interestrate environment. If interest rates stabilize or otherwise change in thefuture, and/or if the level and relative mix of interest-earning assets andinterest-bearing liabilities change, the Bank may not see the same benefit asresulted from the increase in interest rates in the past.

11

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

**CondensedAverage Balance Sheets**
| ** **                                                            | ** ** | **2006**    | ** ** | ** **   | ** ** | **2005**       | ** ** | ** **  | ** ** |
|-----------------------------------------------------------------------|------------|-------------|------------|--------------|------------|----------------|------------|-------------|------------|
| **(dollars in thousands except share data)** | ** ** | **Average** | ** ** | ** **   | ** ** | ** **     | ** ** | **Average** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Three months ended September 30,**              | ** ** | **Balance** | ** ** | **Interest** | ** ** | **Yield/Cost** | ** ** | **Balance** | ** ** | **Interest** | ** ** | **Yield/Cost** | ** ** |
| **Assets**                                                            | ** ** | ** **  | ** ** | ** **   | ** ** | ** **     | ** ** | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Federal funds  sold                                                   |       | $           | 44,144     |         | $          | 587            |       | 5.28        | %          | $ | 76,639 |   | $ | 674 |   | 3.49 | % |
| Taxable  investment securities                                        |       | 91,951      |       | 1,113        |       | 4.80           |       | 49,418      |       | 415 |   | 3.33 |   |
| Tax exempt  securities                                                |       | 36,292      |       | 210          |       | 2.30           |       | 34,154      |       | 202 |   | 2.35 |   |
| Loans                                                                 |       | 301,944     |       | 6,534        |       | 8.59           |       | 301,341     |       | 5,911 |   | 7.78 |   |
| Total  interest-earning assets                                        |       | 474,331     |       | 8,444        |       | 7.06           | %          | 461,552     |       | 7,202 |   | 6.19 | % |
| Non-interest  earning assets                                          |       | 36,986      |       |         |       |           |       | 33,002      |       |   |   |   |   |
| Total assets                                                          |       | $           | 511,317    |         |       |           |       |        | $          | 494,554 |   |   |   |   |   |
|                                                                  |       |        |       |         |       |           |       |        |       |   |   |   |   |
| **Liabilities  and Stockholders’ Equity**                        | ** ** | ** **  | ** ** | ** **   | ** ** | ** **     | ** ** | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest-bearing  demand                                              |       | $           | 84,434     |         | $          | 274            |       | 1.29        | %          | $ | 96,838 |   | $ | 259 |   | 1.06 | % |
| Savings and  money market                                             |       | 141,196     |       | 741          |       | 2.08           |       | 152,375     |       | 567 |   | 1.48 |   |
| Certificates of  deposit                                              |       | 131,679     |       | 1,433        |       | 4.32           |       | 103,183     |       | 791 |   | 3.04 |   |
| Total  interest-bearing deposits                                      |       | 357,309     |       | 2,448        |       | 2.72           |       | 352,396     |       | 1,617 |   | 1.82 |   |
| Securities sold  under agreement to repurchase                        |       | 12,662      |       | 120          |       | 3.76           |       | 6,078       |       | 37 |   | 2.42 |   |
| Total  interest-bearing deposits & liabilities                    |       | 369,971     |       | 2,568        |       | 2.75           |       | 358,474     |       | 1,654 |   | 1.83 |   |
| Non  interest-bearing demand deposits                                 |       | 74,004      |       |         |       |           |       | 40,695      |       |   |   |   |   |
| Other  non-interest-bearing liabilities                               |       | 3,118       |       |         |       |           |       | 2,404       |       |   |   |   |   |
| Total  liabilities                                                    |       | 447,093     |       |         |       |           |       | 401,573     |       |   |   |   |   |
| Stockholders’  equity                                            |       | 64,224      |       |         |       |           |       | 62,981      |       |   |   |   |   |
| Total  liabilities and stockholders’ equity                      |       | $           | 511,317    |         |       |           |       |        | $          | 464,554 |   |   |   |   |   |
| Net interest  income                                                  |       |        |       | $            | 5,876      |           |       |        |       |   | $ | 5,548 |   |   |   |
| Interest rate  spread                                                 |       |        |       |         |       | 4.31           | %          |        |       |   |   | 4.36 | % |
| Net interest margin                                                   |       |        |       |         |       | 4.91           | %          |        |       |   |   | 4.77 | % |

 

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**CondensedAverage Balance Sheets**
| ** **                                                            | ** ** | **2006**    | ** ** | ** **   | ** ** | **2005**       | ** ** | ** **  | ** ** |
|-----------------------------------------------------------------------|------------|-------------|------------|--------------|------------|----------------|------------|-------------|------------|
| **(dollars in thousands except share data)** | ** ** | **Average** | ** ** | ** **   | ** ** | ** **     | ** ** | **Average** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Nine months ended September 30,**               | ** ** | **Balance** | ** ** | **Interest** | ** ** | **Yield/Cost** | ** ** | **Balance** | ** ** | **Interest** | ** ** | **Yield/Cost** | ** ** |
| **Assets**                                                            | ** ** | ** **  | ** ** | ** **   | ** ** | ** **     | ** ** | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Federal funds sold                                                    |       | $           | 61,674     |         | $          | 2,205          |       | 4.78        | %          | $ | 59,671 |   | $ | 1,359 |   | 3.04 | % |
| Taxable investment  securities                                        |       | 86,330      |       | 2,972        |       | 4.60           |       | 39,146      |       | 880 |   | 3.01 |   |
| Tax exempt securities                                                 |       | 34,736      |       | 586          |       | 2.26           |       | 33,331      |       | 598 |   | 2.40 |   |
| Loans                                                                 |       | 295,608     |       | 18,774       |       | 8.49           |       | 324,016     |       | 18,276 |   | 7.54 |   |
| Total interest-earning  assets                                        |       | 478,348     |       | 24,537       |       | 6.86           | %          | 456,164     |       | 21,113 |   | 6.19 | % |
| Non-interest earning  assets                                          |       | 37,926      |       |         |       |           |       | 35,585      |       |   |   |   |   |
| Total assets                                                          |       | $           | 516,274    |         |       |           |       |        | $          | 491,749 |   |   |   |   |   |
|                                                                  |       |        |       |         |       |           |       |        |       |   |   |   |   |
| **Liabilities and Stockholders’  Equity**                        | ** ** | ** **  | ** ** | ** **   | ** ** | ** **     | ** ** | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest-bearing demand                                               |       | $           | 87,653     |         | $          | 847            |       | 1.29        | %          | $ | 91,771 |   | $ | 666 |   | 0.97 | % |
| Savings and money  market                                             |       | 148,198     |       | 2,246        |       | 2.03           |       | 161,575     |       | 1,681 |   | 1.39 |   |
| Certificates of deposit                                               |       | 125,702     |       | 3,762        |       | 4.00           |       | 97,700      |       | 1,890 |   | 2.59 |   |
| Total interest-bearing  deposits                                      |       | 361,553     |       | 6,855        |       | 2.53           |       | 351,046     |       | 4,237 |   | 1.61 |   |
| Securities sold under  agreement to repurchase                        |       | 13,001      |       | 340          |       | 3.50           |       | 6,080       |       | 88 |   | 1.94 |   |
| Total interest-bearing  deposits & liabilities                    |       | 374,554     |       | 7,195        |       | 2.57           |       | 357,126     |       | 4,325 |   | 1.62 |   |
| Non interest-bearing  demand deposits                                 |       | 73,931      |       |         |       |           |       | 70,809      |       |   |   |   |   |
| Other  non-interest-bearing liabilities                               |       | 2,991       |       |         |       |           |       | 2,450       |       |   |   |   |   |
| Total liabilities                                                     |       | 451,476     |       |         |       |           |       | 430,385     |       |   |   |   |   |
| Stockholders’ equity                                             |       | 64,798      |       |         |       |           |       | 61,364      |       |   |   |   |   |
| Total liabilities and stockholders’  equity                      |       | $           | 516,274    |         |       |           |       |        | $          | 491,749 |   |   |   |   |   |
| Net interest income                                                   |       |        |       | $            | 17,342     |           |       |        |       |   | $ | 16,788 |   |   |   |
| Interest rate spread                                                  |       |        |       |         |       | 4.29           | %          |        |       |   |   | 4.57 | % |
| Net interest margin                                                   |       |        |       |         |       | 4.85           | %          |        |       |   |   | 4.92 | % |

 

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The followingtable sets forth information on changes in net interest income which areattributable to changes in interest rates and changes in volume for the periodsindicated.  Tax exempt securities,included in investment securities below are stated at their contractualinterest rate. Loan fees of $879,000 and $1.2 million respectively are includedin interest earned on loans for the nine months ended September 30, 2006 and2005.  Non-accruing loans have beenincluded in the computation of average loans. Changes attributable to thecombined effect of volume and interest rates have been allocated proportionately.

**Analysis of Changes in InterestIncome and Expense Due to Changes in Volume and Rate**
| ** **                                                                        | ** ** | **Three months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|-----------------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                        | ** ** | **2006 vs. 2005**                              | ** ** | **2006 vs. 2005**                             | ** ** |
| ** **                                                                        | ** ** | **Increase (Decrease) Due to**            | ** ** | **Increase (Decrease) Due to**           | ** ** |
| **(dollars in thousands except per share amounts)** | ** ** | **Rate**                                                 | ** ** | **Volume**                                              | ** ** | **Total** | ** ** | **Rate** | ** ** | **Volume** | ** ** | **Total** | ** ** |
| **Interest-Earning  Assets**                                                      | ** ** | ** **                                               | ** ** | ** **                                              | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
|                                                                              |       |                                                     |       |                                                    |       |   |   |   |   |   |   |   |   |
| Federal funds  sold                                                               |       | $                                                        | 1,193      |                                                    | $          | (1,280 | ) | ($87 | ) | $ | 799 |   | $ | 47 |   | $ | 846 |   |
| Investment  securities                                                            |       | 213                                                      |       | 493                                                     |       | 706 |   | 593 |   | 1,487 |   | 2,080 |   |
| Loans                                                                             |       | 611                                                      |       | 12                                                      |       | 623 |   | 2,820 |   | (2,322 | ) | 498 |   |
| Total net change  in income on Interest-earning assets                            |       | 2,017                                                    |       | (775                                                    | )          | 1,242 |   | 4,212 |   | (788 | ) | 3,424 |   |
| **Interest-Bearing  Liabilities**                                                 | ** ** | ** **                                               | ** ** | ** **                                              | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
|                                                                              |       |                                                     |       |                                                    |       |   |   |   |   |   |   |   |   |
| Deposits                                                                          |       | 989                                                      |       | (158                                                    | )          | 831 |   | 2,251 |   | 367 |   | 2,618 |   |
| Securities sold  under agreements to repurchase                                   |       | 28                                                       |       | 55                                                      |       | 83 |   | 105 |   | 147 |   | 252 |   |
| Total net change  in expense on Interest-bearing liabilities                      |       | 1,017                                                    |       | (103                                                    | )          | 914 |   | 2,356 |   | 514 |   | 2,870 |   |
| Net change in net  interest income                                                |       | $                                                        | 1,000      |                                                    | $          | (672 | ) | $ | 328 |   | $ | 1,856 |   | $ | (1,302 | ) | $ | 554 |   |
|                                                                                   |            |                                                          |            |                                                         |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**NON-INTERESTINCOME               **Non-interestincome, which consists primarily of fees and service charges on deposits andother income, was $817,000 and $2.3 million for the quarter and nine monthsended September 30, 2006 compared to $738,000 and $2.2 million for the sameperiods in 2005. The largest component of these increases related to anincrease in late charges collected on non-performing loans and an increase inATM fees.

**NON-INTERESTEXPENSE             **Non-interestexpense was $3.8 million for the quarter ended September 30, 2006 and $3.3million for the quarter ended September 30, 2005. For the nine months endedSeptember 30, 2006, non-interest expense increased 6.17 percent to $10.8million compared to $10.2 million for the same time period a year ago.  These increases were primarily attributable tohigher salaries, overall growth in employment and increased healthcare costs.

To measureoperating expenses, a computation called the “efficiency ratio” is computed bydividing total operating expenses by non-interest income plus net interestincome after provision for loan losses. An increase in the efficiency ratio indicates that more resources arebeing utilized to generate the same or greater volume of income. The efficiencyratio for the quarter and nine months ended September 30, 2006, respectively,was 56.6 percent and 55.3 percent compared to 49.3 percent and 53.8 percentduring the same time periods in 2005. These increases from 2005 were primarilydue to increases in non-interest expenses.

**INCOMETAX EXPENSE                 **Income tax expense for the quarterand nine months ended September 30, 2006 was $760,000 and $2.4 millioncompared to $920,000 and $2.3 million for the quarter and nine months endedSeptember 30, 2005. The Bank’s effective tax rates were 27.0 percent and 26.0percent for the nine months ended September 30, 2006 and 2005, respectively.The effective tax rate is lower than the federal statutory rate due to taxcredits from tax-exempt bonds and tax-exempt municipal bonds and loans.

14

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**REVIEW OFFINANCIAL CONDITION**

Assets totaled $517.3 million atSeptember 30, 2006, compared to $521.9 million at December 31, 2005.  The decrease was primarily due to a decreaseof $7.3 million in deposits.

**INVESTMENT SECURITIES AND FEDERALFUNDS SOLD  **                Total investment securities andfederal funds decreased $15.2 million to $172.0 million at September 30,2006 compared to $187.1 million at December 31, 2005. This decrease wasprimarily due to a $46.0 million decrease in federal funds sold which waspartially offset by increase in US Agency investments.

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

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

**Investment Securities Composition**
| **(dollars in thousands)**              | ** ** | **September 30, 2006** | ** ** | **December 31, 2005** | ** ** |
|---------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| **Held-to-maturity**                              | ** ** | ** **                       | ** ** | ** **                      | ** ** |
| State and  political subdivisions                 |       | $                                | 33,578     |                            | $          | 29,197 |   |
| Total                                             |       | $                                | 33,578     |                            | $          | 29,197 |   |
| **Available-for-sale**                            | ** ** | ** **                       | ** ** | ** **                      | ** ** |
| U.S. Treasury  and other U.S. government agencies |       | $                                | 92,287     |                            | $          | 66,322 |   |
| State and  political subdivisions                 |       | 3,964                            |       | 3,531                           |       |
| Total                                             |       | $                                | 96,251     |                            | $          | 69,853 |   |

 

**LOANS                **Net loans were$306.8 million at September 30, 2006 compared to $295.4 million at December 31,2005.  This increase was primarily due toa $6.2 million increase in consumer loans and a $3.3 million increase in realestate-residential & commercial loans.

Mostof the Bank’s business activity is with customers located within Skagit,Snohomish and Whatcom Counties. The Bank originates commercial, real estate andconsumer loans. Generally, loans are secured by accounts receivable, inventory,deposit accounts, personal property or real estate. Rights to collateral varyand are legally documented to the extent practicable. The Bank concentrates onfive areas of lending: loans to individuals, small and medium-sized businessloans, agricultural loans, loans to commercial enterprises for real estatetransactions and residential mortgage loans. The Bank’s primary lending activities includes commercial real estateloans, commercial loans which includes agriculture production loans,residential mortgage loans and consumer loans.

Loans secured byreal estate comprise the largest category of loans with a total of $221.4million or 70.7 percent and $217.9 million or 72.0 percent as of September 30,2006 and December 31, 2005, respectively. The Bank is committed to providingcompetitive commercial real estate lending within our primary marketareas.  Our real estate portfolioconsists of commercial and residential loans. These loans are secured by property such as office buildings, commercialbusiness properties, healthcare buildings, agricultural land, timber land andresidential properties. While the Bank has significant balances secured by realestate, the Bank does not have concentrations in any specific area of realestate and the Bank believes that its lending policies are sufficient tominimize risks.  Also, local economicconditions may affect a borrower’s ability to meet the stated repayment terms.Fixed-rate and variable rate residential mortgage loans are offered through theBank’s home loan department. The Bank places a majority of these loans throughCountrywide Mortgage and Washington Mutual.

Commercial loanswere $72.7 million as of September 30, 2006 and $70.9 million as of December31, 2005.    Commercial loans, securedand unsecured, are made primarily to small and medium-sized businessesoperating within Skagit, Snohomish and Whatcom Counties.  These loans are available for generaloperating purposes, acquisition of fixed assets, purchases of equipment andmachinery, financing of inventory and accounts receivable, and other businesspurposes.  The Bank originates SmallBusiness Administration (SBA) loans, including 504 and 7A loans.

Consumer loanswere $15.1 million at September 30, 2006 and $8.9 million at December 31, 2005.The development of the Bank’s home equity loan products was the primary factorfor the increase of $6.2 million in the consumer loan portfolio.  Home equity loans and similar productsincreased approximately $8.2 million from 

15

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December 31, 2005to September 30, 2006, and at September 30, 2006 represent 57.6 percent of theconsumer loan portfolio.  The Bank makessecured and unsecured consumer loans including loans to individuals, primarilycustomers of the Bank, for various purposes, including home equity loans,purchases of automobiles, mobile homes, boats and other recreational vehiclesand loans for education and personal investments.

The Board ofDirectors has approved specific lending policies and procedures for the Bankand is responsible for implementation of the policies.  The lending policies and procedures includeguidelines for loan terms, loan-to-value ratios, collateral appraisals andinterest rates.  The loan policies alsovest varying levels of loan authority in management, the Bank’s loan officersand the Board of Directors.  Managementof the Bank monitors lending activities through periodic loan committeemeetings, monthly reporting and periodic review of loans.

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

**Loan Composition**
| ** **                                     | ** ** | **September 30, 2006** | ** ** | **December 31, 2005** | ** ** |
|------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| **(dollars in thousands)**           | ** ** | **Amount**                       | ** ** | **%**                           | ** ** | **Amount** | ** ** | **%** | ** ** |
| Real estate—residential  & commercial |       | $                                | 197,556    |                            | 63.1       | % | $ | 194,273 |   | 64.2 | % |
| Real estate  construction                      |       | 23,873                           |       | 7.6                             | %          | 23,597 |   | 7.8 | % |
| Commercial,  industrial & agricultural     |       | 72,730                           |       | 23.2                            | %          | 70,923 |   | 23.4 | % |
| Consumer                                       |       | 15,097                           |       | 4.8                             | %          | 8,867 |   | 2.9 | % |
| Other loans                                    |       | 4,002                            |       | 1.3                             | %          | 4,857 |   | 1.7 | % |
| Total loans                                    |       | 313,258                          |       | 100                             | %          | 302,517 |   | 100 | % |
| Less:                                          |       |                             |       |                            |       |   |   |   |   |
| Allowance for  loan losses                     |       | 4,712                            |       |                            |       | 5,178 |   |   |   |
| Deferred loan  fees                            |       | 1,783                            |       |                            |       | 1,903 |   |   |   |
| Net loans                                      |       | $                                | 306,763    |                            |       |   | $ | 295,436 |   |   |   |

 

**PROVISIONAND ALLOWANCE FOR LOAN LOSSES**          Theallowance for loan losses was $4.7 million as of September 30, 2006 compared to$5.2 million at December 31, 2005. When available information confirms thatspecific loans, or portions thereof, are uncollectible, those amounts arecharged off against the allowance for loan losses.  Net charges-offs for the three months andnine months ended September 30, 2006 were $108,000 and $466,000 compared to$29,000 and $237,000 for the three and nine months ended September 30, 2005. Theincrease in net charge-offs from 2005 to 2006 was primarily due to a $600,000charge-off relating to one loan relationship.

The Bank had noprovision for loan losses for the quarter and nine months ended September 30,2006 compared to a $400,000 and $50,000 benefit for the quarter and nine monthsended September 30, 2005.  Totalnon-accrual loans increased $1.5 million year over year, however totalcriticized assets and total loan delinquency rates (excluding non-accruingloans) decreased year over year. In the future, normal growth of the loanportfolio may require an increase in the allowance for loan losses.

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

The Bank currentlymonitors its loan portfolio for potential risk of loss according to a loanrisk-grading system. Additionally, loans are subject to examinations byregulators, who, based upon their judgment, may require the Bank to makeadditional provisions or adjustments to its allowance for loan losses.  The Bank has assessed and will continue toassess on an on-going basis, the impact of the economy on the credit risk inthe loan portfolio.  Currently,management is not aware of any unusually large loan concentrations inindustries negatively impacted by the current 

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economy.Management continues to closely monitor the Bank’s credit quality and focuseson identifying potential problem credits and any loss exposure in a timelymanner.

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

**Allowance for Loan Loss Activity**
| ** **                                                                | ** ** | **Three months ended Sept. 30,** | ** ** | **Nine months ended Sept. 30,** | ** ** |
|---------------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| **(dollars in thousands)**                                      | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                                      |       |                                                 |       |                                                |       |   |   |   |   |
| Allowance as of  beginning of period                                      |       | $                                                    | 4,820      |                                                | $          | 5,972 |   | $ | 5,178 |   | $ | 5,830 |   |
| Provision for  loan losses                                                |       | —                                               |       | (400                                                | )          | — |   | (50 | ) |
| Charge-offs                                                               |       | (328                                                 | )          | (129                                                | )          | (1,251 | ) | (514 | ) |
| Recoveries                                                                |       | 220                                                  |       | 100                                                 |       | 785 |   | 277 |   |
| Net charge-offs                                                           |       | (108                                                 | )          | (29                                                 | )          | (466 | ) | (237 | ) |
| Balance at end  of period                                                 |       | $                                                    | 4,712      |                                                | $          | 5,543 |   | $ | 4,712 |   | $ | 5,543 |   |
|                                                                      |       |                                                 |       |                                                |       |   |   |   |   |
| Ratio of net  charge-offs (annualized) to average loans during the period |       | 0.14                                                 | %          | 0.04                                                | %          | 0.21 | % | 0.10 | % |
| Ratio of allowance to  net loans at end of period                         |       | 1.54                                                 | %          | 1.85                                                | %          | 1.54 | % | 1.85 | % |

 

**NON-PERFORMINGASSETS        **Non-performingassets increased to $6.5 million as of September 30, 2006 compared to $4.1million as of December 31, 2005. At September 30, 2006, four relationshipscomprised $5.8 million of the non-accrual balance.  Generally, these loans are wellcollateralized though loss of principal on certain types of these loans willremain in question until the loans are paid or collateral is liquidated.

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

**Non-Performing Assets**
| **(dollars in thousands)**                      | ** ** | **September 30, 2006** | ** ** | **December 31, 2005** | ** ** |
|-----------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| Non-accrual  loans                                        |       | $                                | 6,514      |                            | $          | 4,116 |   |
| Loans past due  90 days or more, still accruing           |       | —                           |       | —                          |       |
| Total  non-performing loans                               |       | 6,514                            |       | 4,116                           |       |
| Other real  estate owned                                  |       | —                           |       | —                          |       |
| Total  non-performing assets                              |       | $                                | 6,514      |                            | $          | 4,116 |   |
| Total  non-performing loans to net loans                  |       | 2.12                             | %          | 1.39                            | %          |
| Total non-performing  loans to total assets               |       | 1.26                             | %          | 0.79                            | %          |
| Total  non-performing assets to total assets              |       | 1.26                             | %          | 0.79                            | %          |
| Total non-performing  assets to allowance for loan losses |       | 138.24                           | %          | 79.49                           | %          |

 

**DEPOSITS          **The Bank offers afull range of deposit services including checking accounts, savings accounts,money market accounts and various types of certificates of deposit.  Transaction accounts and certificates ofdeposit are tailored to the Bank’s primary market area at rates competitivewith those offered in the area.  At September30, 2006, total deposits were $435.8 million compared to $443.1 million atDecember 31, 2005.  As outlined in thefollowing table, time deposits increased $16.2 million while interest-bearingdemand and savings decreased $19.8 million. The following table presents thebalance and percent of total deposits in the various categories of depositsoffered by the Bank as of the dates indicated.

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**Deposit Composition**
| ** **                           | ** ** | **September 30, 2006** | ** ** | **December 31, 2005** | ** ** |
|--------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| **(dollars in thousands)** | ** ** | **Amount**                       | ** ** | **% of Total**        | ** ** | **Amount** | ** ** | **% of Total** | ** ** |
| Non-interest  bearing demand         |       | $                                | 75,713     |                            | 17.4       | % | $ | 76,872 |   | 17.3 | % |
| Interest bearing  demand             |       | 84,159                           |       | 19.3                            | %          | 93,779 |   | 21.2 | % |
| Money market                         |       | 58,934                           |       | 13.5                            | %          | 61,454 |   | 13.9 | % |
| Savings                              |       | 80,113                           |       | 18.4                            | %          | 90,301 |   | 20.4 | % |
| Time                                 |       | 136,846                          |       | 31.4                            | %          | 120,659 |   | 27.2 | % |
| Total deposits                       |       | $                                | 435,765    |                            | 100.0      | % | $ | 443,065 |   | 100.0 | % |

 

**SECURITIESSOLD UNDER AGREEMENTS TO REPURCHASE           **Asof September 30, 2006 and December 31, 2005, securities sold under agreementsto repurchase were $13.5 million and $11.3 million, respectively. Theseborrowings decrease or increase primarily based on the availability of fundsand current competitive interest rates offered. These borrowings are collateralized by securities with an estimated fairvalue exceeding the face value of the borrowings.

**CAPITALRESOURCES   **                Stockholders’ equity decreasedto $65.3 million at September 30, 2006 from $65.4 million at December 31,2005.  This decrease was primarily due tostock repurchases of $5.6 million and payment of cash dividends of $849,000which was partially offset by net income of $6.4 million. Book value per shareat September 30, 2006 was $96.91 compared to book value of $92.43 at December31, 2005.

Skagit State Bancorp Inc.’s stock is not actively traded and no brokercurrently makes a market in the stock. To facilitate trading, Skagit State Bank acts as transfer agent forSkagit State Bancorp, Inc. and maintains a list of persons interested in eitherpurchasing or selling shares. From time to time, the holding company repurchasesshares of its common stock. The number ofshares of stock that will be repurchased and the price that will be paid is theresult of many factors including market and economic conditions, the number ofshares available, the Company’s liquidity and capital needs and regulatory requirements.For the nine months ended September 30, 2006, the Company repurchased 33,568shares of stock for $5.6 million with a range of prices from $135 to $171 pershare.

Bankingregulations require bank holding companies and banks to maintain certain minimumcapital levels.  As the following tableindicates as of September 30, 2006, Skagit State Bancorp, Inc. and Skagit StateBank both exceeded the well-capitalized requirements.   The following table sets forth theirrespective capital positions as of September 30, 2006.
| ** **                           | ** ** | ** ** | ** ** | ** **                 | ** ** | ** **                 | ** ** | ** **                 | ** ** | **To Be Well**   | ** ** |
|--------------------------------------|------------|------------|------------|----------------------------|------------|----------------------------|------------|----------------------------|------------|----------------------------|------------|
| ** **                           | ** ** | ** ** | ** ** | ** **                 | ** ** | ** **                 | ** ** | ** **                 | ** ** | **Capitalized Under** | ** ** |
| ** **                           | ** ** | ** ** | ** ** | ** **                 | ** ** | **For Capital**       | ** ** | **Prompt Corrective** | ** ** |
| ** **                           | ** ** | **Actual** | ** ** | **Adequacy Purposes** | ** ** | **Action Provisions** | ** ** |
| **(dollars in thousands)** | ** ** | **Amount** | ** ** | **Ratio**                  | ** ** | **Amount**                 | ** ** | **Ratio**                  | ** ** | **Amount**                 | ** ** | **Ratio** | ** ** |
| As of September  30, 2006            |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| Total Capital                        |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| (to Risk-Weighted Assets)            |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| Skagit State Bank                    |       | $          | 70,383     |                       | 18.33      | %                          | $          | 30,724                     |       | 3 8.00                | %          | $ | 38,405 |   | 3 10.00 | % |
| Skagit State Bancorp, Inc.           |       | $          | 70,445     |                       | 18.34      | %                          | $          | 30,724                     |       | 3 8.00                | %          | $ | 38,406 |   | 3 10.00 | % |
| Tier I Capital                       |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| (to Risk-Weighted Assets)            |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| Skagit State Bank                    |       | $          | 65,671     |                       | 17.10      | %                          | $          | 15,362                     |       | 3 4.00                | %          | $ | 23,043 |   | 3 6.00 | % |
| Skagit State Bancorp, Inc.           |       | $          | 65,733     |                       | 17.12      | %                          | $          | 15,362                     |       | 3 4.00                | %          | $ | 23,043 |   | 3 6.00 | % |
| Tier I Capital                       |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| (to Average Assets)                  |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| Skagit State Bank                    |       | $          | 65,671     |                       | 12.85      | %                          | $          | 20,442                     |       | 3 4.00                | %          | $ | 25,553 |   | 3 5.00 | % |
| Skagit State  Bancorp, Inc.          |       | $          | 65,733     |                       | 12.86      | %                          | $          | 20,442                     |       | 3  4.00               | %          | $ | 25,553 |   | 3  5.00 | % |

 

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**LIQUIDITY**

The Bank’sliquidity management focuses on the need to meet both short-term fundingrequirements and long-term strategies and goals.  The Bank’s objective is to ensure there isadequate liquidity to accommodate fluctuations in deposit levels, fundoperations, and provide for customer credit needs and to meet other obligationsand commitments on a timely basis. The Bank structures the balance sheet tomeet those objectives. The Bank’s sources of funds are customer deposits, loanrepayments, current earnings, cash and demand balances due from other banks,federal funds, short-term investments and investment securities available forsale with a majority of funding coming from customer deposits within the Bank’smarket area. The Bank has generally been a net seller of federal funds.  At September 30, 2006 and December 31, 2005,the Bank’s federal funds sold were $42.1 million and $88.1 million,respectively. As of September 30, 2006, the Bank had $35.0 million in approvedcredit lines from various financial institutions.

**Item 3.**             QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUTMARKET RISK

The Bank’s resultsof operations are largely dependent upon its ability to manage market riskswhich includes interest rate risk. Interest rate risk refers to the exposure of earnings and capitalarising from changes in interest rates. The Bank is sensitive to potentialchanges in interest rates and the resulting impact on net interest income.Changes in interest rates can have a significant effect on the Bank’s financialcondition and results of operations. The Bank does not use interest rate riskmanagement products such as interest rate swaps, hedges or derivatives nor doesit have a trading portfolio of investment securities.   Other types of market risk such as foreigncurrency exchange rate risk and commodity price risk do not arise in the normalcourse of the Bank’s business activities.

During 2006, dueprimarily to the current market interest rate environment, competition amongfinancial institutions for quality loans and the payoff of certain variablerate adversely classified assets during 2005, the percentage of variable rateloans in the loan portfolio decreased from approximately 77 percent at December31, 2004 to approximately 66 percent as of December 31, 2005 and toapproximately 47 percent at September 30, 2006.

During the firstthree quarters of 2006, prime rate increased 100 basis points and for the year2005, prime rate increased 200 basis points. For the quarter and nine months ended September 30, 2006 and 2005, theincrease in market interest rates had a favorable impact on the Bank’s netinterest income.  The volume ororigination of fixed or variable rate loans, the interest rate sensitivity ofdeposits, the overall level of interest rates and general economic conditionscan have a significant effect on the Bank’s performance in a changing interestrate environment. If interest rates stabilize or otherwise change in thefuture, and/or if the level and relative mix of interest-earning assets andinterest-bearing liabilities change, the Bank may not see the same benefit asresulted from the increase in interest rates in the past.

The Bank believesthat there have not been any other material changes in information about theBank’s market risk that was provided in the Form 10-K for the year endedDecember 31, 2005.

**Item 4.**                CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

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

Changes in Internal Controls

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

**PART II -**                                            OTHERINFORMATION

**Item 1.**                                                           LegalProceedings

From time to time,the Company may be a plaintiff and/or defendant in certain claims and legalactions arising in the ordinary course of commercial banking involving realestate lending transactions and other ordinary routine litigation 

19

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incidental to thebusiness of the Company.  The Company isnot a party to any pending legal proceedings that the Company believes wouldhave a material adverse effect on the financial condition of the Company.

**Item 1A.**  Risk Factors

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

**Item 2.**                                                           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.
| 3.1  | Amended and Restated Articles of Incorporation                                                                                                      |
|------|-----------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.2  | Bylaws                                                                                                                                              |
| 10.1 | Change in Control Severance Agreement for Richard  Humphrey                                                                                         |
| 31.1 | Certification of CEO, Pursuant to Exchange Act Rule  13a-14 (as adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002)                  |
| 31.2 | Certification Chief Financial Officer Pursuant to  Exchange Act Rule 13a-14 (as adopted Pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002) |
| 32   | Certifications Pursuant to 18 U.S.C. Section 1350,  As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002                            |

 

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**SIGNATURES**

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

 
|        | SKAGIT STATE BANCORP, INC. |
|--------|----------------------------|
|   |  (Registrant)         |
|   |                       |
|   |                       |
| Dated: |  November  13, 2006   |   | /s/ Cheryl R. Bishop |   |
|   | Cheryl R. Bishop           |
|   | Chief Executive  Officer   |
|   |                       |
|   |                       |
| Dated: |  November  13, 2006   |   | /s/ Carla F. Tucker |   |
|   | Carla F. Tucker            |
|   | Senior  Vice-President     |
|   | Chief Financial  Officer   |

 

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