**UNITEDSTATES SECURITIES AND EXCHANGE COMMISSON**

**Washington D.C., 20549**

 

**FORM 10-Q**

 

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

 

**For the quarterly period ended March 31,2008**

 

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

 

**For the transition periodfrom                                to                                **

 

**CommissionFile Number  000-52096**

 

**SKAGITSTATE BANCORP, INC.**

(ExactName of Registrant as Specified in Its Charter)

 

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

 

**301 EastFairhaven Avenue**

**Burlington,Washington  98233**

(Addressof Principal Executive Offices) (Zip Code)

 

**(360)755-0411**

(Registrant’sTelephone Number, Including Area Code)

 

Indicate by check mark whether the registrant:  (1) has filed all reports required to befiled by Section 13 or 15(d) of the Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.

 

Yes x  No o

 

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, a non-accelerated filer, or asmaller reporting company. See definitions of “large accelerated filer,”“accelerated filer,” and “smaller reporting company” in Rule 12b-2 of theExchange Act. (Check one):

 

| Large accelerated filer  o                     |   | Accelerated filer o          |
|------------------------------------------------|--------|-----------------------------------|
|                                           |   |                              |
| Non-accelerated filer o                        |   | Smaller reporting  company x |
| (Do not check if a  smaller reporting company) |   |                              |

 

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

 

Yes o  No x

 

Indicate the number of shares outstanding of each of theissuer’s classes of common stock, as of the latest practicable date:

 

The number of shares of the issuer’s Common Stockoutstanding at May 14, 2008 was 588,244.

 

 

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**SKAGITSTATE BANCORP, INC.**

**TABLE OF CONTENTS**

 
| **PART I.**  | **FINANCIAL  INFORMATION** |                                                                                        |
|-------------------|----------------------------|---------------------------------------------------------------------------------------------|
|              |                       |                                                                                        |   |   |
|              | Item 1.                    | Financial Statements                                                                        |   |   |
|              |                       |                                                                                        |   |   |   |
|              |                       |                                                                                        | Consolidated  Balance Sheet as of March 31, 2008 and December 31, 2007 |   |
|              |                       |                                                                                        |   |   |   |
|              |                       |                                                                                        | Consolidated  Statement of Income for the three months ended March 31, 2008 and 2007 |   |
|              |                       |                                                                                        |   |   |   |
|              |                       |                                                                                        | Consolidated Statement of Changes in Stockholders’  Equity and Comprehensive Income for the three months ended March 31,  2008 and 2007 |   |
|              |                       |                                                                                        |   |   |   |
|              |                       |                                                                                        | Consolidated  Statement of Cash Flows for the three months ended March 31, 2008 and  2007 |   |
|              |                       |                                                                                        |   |   |   |
|              |                       |                                                                                        | Notes to Consolidated Financial Statements |   |
|              |                       |                                                                                        |   |   |
|              | Item 2.                    | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |   |
|              |                       |                                                                                        |   |   |   |
|              | Item 3.                    | Quantitative  and Qualitative Disclosures About Market Risk                                 |   |
|              |                       |                                                                                        |   |   |   |
|              | Item 4.                    | Controls and  Procedures                                                                    |   |
|              |                       |                                                                                        |   |   |   |
| **PART II.** | **OTHER INFORMATION**      |                                                                                        |
|              |                       |                                                                                        |   |   |   |
|              | Item 1.                    | Legal Proceedings                                                                           |   |
|              |                       |                                                                                        |   |   |   |
|              | Item 1 A.                  | Risk Factors                                                                                |   |
|              |                       |                                                                                        |   |   |   |
|              | Item 2.                    | Unregistered  Sales of Equity Securities and Use of Proceeds                                |   |
|              |                       |                                                                                        |   |   |   |
|              | Item 3.                    | Defaults  Upon Senior Securities                                                            |   |
|              |                       |                                                                                        |   |   |   |
|              | Item 4.                    | Submission  of Matters to a Vote of Security Holders                                        |   |
|              |                       |                                                                                        |   |   |   |
|              | Item 5.                    | Other Information                                                                           |   |
|              |                       |                                                                                        |   |   |   |
|              | Item 6.                    | Exhibits                                                                                    |   |
|              |                       |                                                                                        |   |   |   |
|              |                       |                                                                                        | Signatures |   |

 

2

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**Item 1.    Financial Statements**

 

**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

**CONSOLIDATED BALANCE SHEET(Unaudited)**

** **
| **(dollars in thousands except share data)**                                                                                                      | ** ** | **March 31, 2008** | ** ** | **December 31, 2007** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|---------------------------------|------------|
| **ASSETS**                                                                                                                                                                 | ** ** | ** **                   | ** ** | ** **                      | ** ** |
| ** **                                                                                                                                                                 | ** ** | ** **                   | ** ** | ** **                      | ** ** |
| **ASSETS**                                                                                                                                                                 | ** ** | ** **                   | ** ** | ** **                      | ** ** |
| Cash and due  from banks                                                                                                                                                   |       | $                            | 13,518     |                            | $          | 16,641 |   |
| Federal funds  sold                                                                                                                                                        |       | 14,353                       |       | 41,195                          |       |
| Investment securities                                                                                                                                                      |       |                         |       |                            |       |
| Available-for-sale,  at fair value                                                                                                                                         |       | 128,458                      |       | 126,953                         |       |
| Held-to-maturity,  at amortized cost                                                                                                                                       |       | 38,714                       |       | 39,926                          |       |
| Loans held for  sale                                                                                                                                                       |       | 403                          |       | —                          |       |
| Loans                                                                                                                                                                      |       | 364,418                      |       | 355,198                         |       |
| Allowance for  loan losses                                                                                                                                                 |       | (4,098                       | )          | (4,535                          | )          |
| Net loans                                                                                                                                                                  |       | 360,320                      |       | 350,663                         |       |
| Bank premises  and equipment, net                                                                                                                                          |       | 11,928                       |       | 12,095                          |       |
| Other real  estate owned                                                                                                                                                   |       | 6,202                        |       | —                          |       |
| Accrued interest  receivable                                                                                                                                               |       | 3,334                        |       | 3,464                           |       |
| Other assets                                                                                                                                                               |       | 1,040                        |       | 1,726                           |       |
| **TOTAL  ASSETS**                                                                                                                                                          |       | $                            | 578,270    |                            | $          | 592,663 |   |
| ** **                                                                                                                                                                 | ** ** | ** **                   | ** ** | ** **                      | ** ** |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                              | ** ** | ** **                   | ** ** | ** **                      | ** ** |
| ** **                                                                                                                                                                 | ** ** | ** **                   | ** ** | ** **                      | ** ** |
| **LIABILITIES**                                                                                                                                                            |       |                         |       |                            |       |
| Deposits                                                                                                                                                                   |       |                         |       |                            |       |
| Interest-bearing                                                                                                                                                           |       | $                            | 424,002    |                            | $          | 422,463 |   |
| Non-interest-bearing                                                                                                                                                       |       | 72,892                       |       | 77,957                          |       |
| Total deposits                                                                                                                                                             |       | 496,894                      |       | 500,420                         |       |
| Securities sold  under agreements to repurchase                                                                                                                            |       | 18,136                       |       | 15,851                          |       |
| Other liabilities                                                                                                                                                          |       | 2,749                        |       | 3,709                           |       |
| Total  liabilities                                                                                                                                                         |       | 517,779                      |       | 519,980                         |       |
|                                                                                                                                                                       |       |                         |       |                            |       |
| **STOCKHOLDERS’  EQUITY**                                                                                                                                             |       |                         |       |                            |       |
| Common stock no  par value, 5,000,000 shares authorized, 585,975 and 670,997 shares issued and  outstanding at March 31, 2008 and December 31, 2007 respectively |       | 18                           |       | 13,564                          |       |
| Accumulated  other comprehensive loss, net of tax                                                                                                                          |       | 1,866                        |       | 694                             |       |
| Retained  earnings                                                                                                                                                         |       | 58,607                       |       | 58,425                          |       |
| Total  stockholders’ equity                                                                                                                                           |       | 60,491                       |       | 72,683                          |       |
| **TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                       |       | $                            | 578,270    |                            | $          | 592,663 |   |

 

*See accompanying notes to theseconsolidated financial statements*

 

3

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**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

**CONSOLIDATED STATEMENT OF INCOME(Unaudited)**

** **
| ** **                                                            | ** ** | **For the three months ended March 31,** | ** ** |
|-----------------------------------------------------------------------|------------|------------------------------------------------------------------------|------------|
| **(dollars in thousands except share data)** | ** ** | **2008**                                                               | ** ** | **2007** | ** ** |
| ** **                                                            | ** ** | ** **                                                             | ** ** | ** ** | ** ** |
| **INTEREST  INCOME**                                                  |       |                                                                   |       |   |   |
| Interest and  fees on loans                                           |       | $                                                                      | 6,441      |   | $ | 7,219 |   |
| Investment  securities                                                |       |                                                                   |       |   |   |
| Taxable                                                               |       | 1,506                                                                  |       | 1,310 |   |
| Exempt from  federal income tax                                       |       | 325                                                                    |       | 221 |   |
| Federal funds  sold                                                   |       | 242                                                                    |       | 420 |   |
| Total interest  income                                                |       | 8,514                                                                  |       | 9,170 |   |
|                                                                  |       |                                                                   |       |   |   |
| **INTEREST  EXPENSE**                                                 |       |                                                                   |       |   |   |
| Deposits                                                              |       | 2,901                                                                  |       | 2,842 |   |
| Securities sold  under agreements to repurchase                       |       | 124                                                                    |       | 132 |   |
| Total interest  expense                                               |       | 3,025                                                                  |       | 2,974 |   |
| **NET  INTEREST INCOME**                                              |       | 5,489                                                                  |       | 6,196 |   |
| Provision  (benefit) for loan losses                                  |       | —                                                                 |       | (150 | ) |
| **NET  INTEREST INCOME AFTER PROVISION (BENEFIT) FOR LOAN LOSSES**    |       | 5,489                                                                  |       | 6,346 |   |
| **NON-INTEREST  INCOME**                                              |       |                                                                   |       |   |   |
| Service charges  on deposits                                          |       | 750                                                                    |       | 548 |   |
| Other                                                                 |       | 200                                                                    |       | 211 |   |
| Gain on sale of  assets                                               |       | 63                                                                     |       | 3 |   |
| Total  non-interest income                                            |       | 1,013                                                                  |       | 762 |   |
| **NON-INTEREST  EXPENSES**                                            |       |                                                                   |       |   |   |
| Salaries                                                              |       | 1,921                                                                  |       | 1,824 |   |
| Payroll taxes  and employee benefits                                  |       | 501                                                                    |       | 491 |   |
| Bank premises  and equipment                                          |       | 275                                                                    |       | 318 |   |
| Occupancy                                                             |       | 186                                                                    |       | 190 |   |
| State business  taxes                                                 |       | 121                                                                    |       | 111 |   |
| Advertising                                                           |       | 150                                                                    |       | 160 |   |
| Other                                                                 |       | 909                                                                    |       | 850 |   |
| Total  non-interest expenses                                          |       | 4,063                                                                  |       | 3,944 |   |
| **INCOME  BEFORE PROVISION FOR INCOME TAX**                           |       | 2,439                                                                  |       | 3,164 |   |
| **PROVISION  FOR INCOME TAX**                                         |       |                                                                   |       |   |   |
| Provision for  Income Tax                                             |       | 539                                                                    |       | 765 |   |
| **NET  INCOME**                                                       |       | $                                                                      | 1,900      |   | $ | 2,399 |   |
| **BASIC  EARNINGS PER SHARE**                                         |       | $                                                                      | 2.85       |   | $ | 3.56 |   |
| **DILUTED  EARNINGS PER SHARE**                                       |       | $                                                                      | 2.83       |   | $ | 3.56 |   |

 

*Seeaccompanying notes to these consolidated financial statements*

 

4

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** **

**SkagitState Bancorp, Inc. and Subsidiary**

**CONSOLIDATED STATEMENT OF CHANGESIN STOCKHOLDERS’ EQUITY**

Threemonths ended March 31, 2008 and 2007

* *
| ** **                                                                                            | ** ** | ** **            | ** ** | ** **        | ** ** | **Accum. Other**  | ** ** | ** **             | ** ** | **Total**         | ** ** | ** ** | ** ** |
|-------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|-------------------|------------|------------------------|------------|------------------------|------------|-------------------|------------|------------|------------|
| ** **                                                                                            | ** ** | **Common Stock** | ** ** | **Comprehensive** | ** ** | **Retained**           | ** ** | **Stockholders’** | ** ** | **Comprehensive** | ** ** |
| **(dollars in thousands except share and per share amounts)** | ** ** | **Shares**            | ** ** | **Amount**        | ** ** | **Income (Loss)** | ** ** | **Earnings**           | ** ** | **Equity**        | ** ** | **Income** | ** ** |
| **BALANCE,****January 1,  2007**                                                                 |       | 673,532               |       | $                 | 13,935     |                   | $          | (269                   | )          | $                 | 52,878     |       | $          | 66,544 |   |   |   |
| Comprehensive  income                                                                                 |       |                  |       |              |       |                   |       |                   |       |              |       |       |       |
| Net income                                                                                            |       | —                |       | —            |       | —                 |       | 2,399                  |       | 2,399             |       | $          | 2,399      |   |
| Other  comprehensive income:                                                                          |       |                  |       |              |       |                   |       |                   |       |              |       |       |       |
| Unrealized gains  on available-for-sale securities, net of taxes of $78                               |       | —                |       | —            |       | 152                    |       | —                 |       | 152               |       | 152        |       |
| Total other  comprehensive income                                                                     |       |                  |       |              |       |                   |       |                   |       |              |       | 152        |       |
| Comprehensive  income                                                                                 |       |                  |       |              |       |                   |       |                   |       |              |       | $          | 2,551      |   |
| Common stock  redemption                                                                              |       | (475                  | )          | (76               | )          | —                 |       | —                 |       | (76               | )          |       |       |
| Stock  compensation expense                                                                           |       |                  |       | 36                |       |                   |       |                   |       | 36                |       |       |       |
| **BALANCE,**March 31, 2007                                                                       |       | 673,057               |       | $                 | 13,895     |                   | $          | (117                   | )          | $                 | 55,277     |       | $          | 69,055 |   |   |   |
|                                                                                                  |       |                  |       |              |       |                   |       |                   |       |              |       |       |       |
| **BALANCE,**January 1, 2008                                                                      |       | 670,997               |       | $                 | 13,564     |                   | $          | 694                    |       | $                 | 58,425     |       | $          | 72,683 |   |   |   |
| Comprehensive  income                                                                                 |       |                  |       |              |       |                   |       |                   |       |              |       |       |       |
| Net income                                                                                            |       | —                |       | —            |       | —                 |       | 1,900                  |       | 1,900             |       | $          | 1,900      |   |
| Other  comprehensive income:                                                                          |       |                  |       |              |       |                   |       |                   |       |              |       |       |       |
| Unrealized gains  on available-for-sale securities, net of taxes of $604                              |       | —                |       | —            |       | 1,172                  |       | —                 |       | 1,172             |       | 1,172      |       |
| Total other  comprehensive income                                                                     |       |                  |       |              |       |                   |       |                   |       |              |       | 1,172      |       |
| Comprehensive  income                                                                                 |       |                  |       |              |       |                   |       |                   |       |              |       | $          | 3,072      |   |
| Common stock  redemption                                                                              |       | (85,022               | )          | (13,586           | )          | —                 |       | (1,718                 | )          | (15,304           | )          |       |       |
| Stock  compensation expense                                                                           |       |                  |       | 40                |       |                   |       |                   |       | 40                |       |       |       |
| **BALANCE,****March 31,  2008**                                                                  |       | 585,975               |       | $                 | 18         |                   | $          | 1,866                  |       | $                 | 58,607     |       | $          | 60,491 |   |   |   |

 

*Seeaccompanying notes to these consolidated financial statements*

 

5

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**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

**CONSOLIDATED STATEMENT OF CASHFLOWS (Unaudited**)

 
| **(dollars in thousands)  Three months ended March 31,** | ** ** | **2008**   | ** ** | **2007**   | ** ** |
|----------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| **CASH  FLOWS FROM OPERATING ACTIVITIES**                                              |       |       |       |       |       |
| Net income                                                                             |       | $          | 1,900      |       | $          | 2,399 |   |
| *Adjustments  to reconcile net income to net cash flows from operating activities*     |       |       |       |       |       |
| Provision  (benefit) for loan losses                                                   |       | —     |       | (150       | )          |
| Depreciation                                                                           |       | 223        |       | 223        |       |
| Loss (gain) on  sale of other real estate owned                                        |       | —     |       | (3         | )          |
| Gains on sale of  loans                                                                |       | (63        | )          | —     |       |
| Amortization of  investment security premiums and discounts, net                       |       | (78        | )          | (53        | )          |
| Stock  compensation for employee services                                              |       | 40         |       | 36         |       |
| *Changes  in operating assets and liabilities*                                         |       |       |       |       |       |
| Originations of  loans held for sale                                                   |       | (5,342     | )          | —     |       |
| Proceeds for  sales of loans held for sale                                             |       | 5,002      |       | —     |       |
| Decrease  (increase) in interest receivable                                            |       | 130        |       | 133        |       |
| Decrease  (increase) in other assets                                                   |       | 82         |       | (675       | )          |
| Increase  (decrease) in other liabilities                                              |       | (960       | )          | 1,122      |       |
| Net cash flows  from operating activities                                              |       | 934        |       | 3,032      |       |
| **CASH  FLOWS FROM INVESTING ACTIVITIES**                                              |       |       |       |       |       |
| Proceeds from  maturities of investment securities – available-for-sale           |       | 19,961     |       | 15,634     |       |
| Purchases of  investment securities – available-for-sale                          |       | (19,612    | )          | (1,899     | )          |
| Proceeds from  maturities of investment securities – held-to-maturity             |       | 1,212      |       | 79         |       |
| Purchases of  investment securities – held-to-maturity                            |       | —     |       | (376       | )          |
| Net decrease  (increase) in federal funds sold                                         |       | 26,842     |       | (36,700    | )          |
| Net decrease  (increase) in loans                                                      |       | (15,859    | )          | 2,341      |       |
| Purchase of  premises and equipment                                                    |       | (206       | )          | (62        | )          |
| Proceeds from  premises and equipment                                                  |       | 150        |       | —     |       |
| Proceeds from  sale of other real estate owned                                         |       | —     |       | 3          |       |
| Net cash flows  from investing activities                                              |       | 12,488     |       | (20,980    | )          |
| **CASH  FLOWS FROM FINANCING ACTIVITIES**                                              |       |       |       |       |       |
| Net increase  (decrease) in demand deposits, money market, NOW and savings accounts    |       | 2,225      |       | (2,661     | )          |
| Net increase  (decrease) in time deposits                                              |       | (5,751     | )          | 17,584     |       |
| Amount paid for  redemption of common stock                                            |       | (15,304    | )          | (76        | )          |
| Net increase  (decrease) in securities sold under agreements to repurchase             |       | 2,285      |       | (272       | )          |
| Net cash flows  from financing activities                                              |       | (16,545    | )          | 14,575     |       |
| **NET  CHANGE IN CASH AND DUE FROM BANKS**                                             |       | (3,123     | )          | (3,373     | )          |
| **CASH  AND DUE FROM BANKS,** beginning of period                                      |       | 16,641     |       | 21,535     |       |
| **CASH  AND DUE FROM BANKS,** end of period                                            |       | $          | 13,518     |       | $          | 18,162 |   |
| **SUPPLEMENTAL  DISCLOSURES OF CASH FLOW INFORMATION**                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash paid during  the period for income taxes                                          |       | $          | 747        |       | $          | 170 |   |
| Cash paid during  the period for interest                                              |       | 3,131      |       | 2,916      |       |
| **NONCASH  FINANCING AND INVESTING TRANSACTIONS**                                      |       |       |       |       |       |
| Property taken  in settlement of loans                                                 |       | 6,202      |       | —     |       |

 

* See accompanying notes to these consolidatedfinancial statements*

 

6

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**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

**Note 1:   BASIS OF PRESENTATION**

 

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

 

Alldollar amounts in tables, except share and per share information, are stated inthousands.

 

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

 

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

 

**Note 3:   RECLASSIFICATIONS**

 

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

 

**Note 4:   EARNINGSPER SHARE**

 

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

 
| (dollars in  thousands except share and per share amounts)                      |       |     |       |     |       |
|---------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
|                                                                            |       |     |       |     |       |
| **Three months ended March 31,**                                           | ** ** | **2008** | ** ** | **2007** | ** ** |
| Numerator:                                                                      |       |     |       |     |       |
| Net income                                                                      |       | $        | 1,900      |     | $          | 2,399 |   |
| Denominator:                                                                    |       |     |       |     |       |
| Denominator for  basic earnings per share - Weighted average shares outstanding |       | 666,325  |       | 673,221  |       |
| Effect of  dilutive securities:                                                 |       |     |       |     |       |
| Stock options  and unvested restricted stock grants                             |       | 4,419    |       | 1,505    |       |
| Denominator for  diluted earning per share Weighted average shares outstanding  |       | 670,744  |       | 674,726  |       |
| Basic earnings  per share                                                       |       | $        | 2.85       |     | $          | 3.56 |   |
| Diluted earnings  per share                                                     |       | $        | 2.83       |     | $          | 3.56 |   |

 

7

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**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

**Note 5:   ALLOWANCE FOR LOAN LOSSES**

 

The allowance for loan losses is maintained at a level deemed adequateto provide for estimated future losses. Bancorp has a systematic methodologyfor evaluating the adequacy of the allowance for loan losses and the allowanceis evaluated on a quarterly basis. The allowance consists of specific, generaland unallocated components.  Theallowance is based upon Bancorp’s periodic evaluation of the pertinent factorsunderlying the quality of the loan portfolio, including changes in size andcomposition of the loan portfolio, levels and trends in losses anddelinquencies, actual loan loss experience, current economic conditions,specific industry conditions, loan concentrations, detailed analysis ofindividual loans for which full collectibility may not be assured and thedetermination of the existence and the realizable value of the collateralsecuring the loans. The general allowance is then calculated, by applying aloss percentage factor to the different loan types and the different riskgradings.  In addition, as part of theprocess, a specific allowance is determined based on Bancorp’s review of classifiedor non-performing loans for specific weaknesses and evaluation of those loansfor impairment and loss exposure. The unallocated component of the allowancereflects the margin of imprecision inherent in the underlying assumptions usedin the methodologies for estimated specific and general losses in the loanportfolio.

 

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

 

**Note 6:   STOCK-BASEDCOMPENSATION**

 

Bancorp has one share-based payment plan, which is shareholderapproved, and permits the grant of share-based awards to its employees anddirectors up to 100,000 shares.  The planaddresses stock options, restricted stock awards and other stock basedcompensation awards.  This plan isprimarily designed to recognize, motivate, reward and retain eligible employeesand to better align the interest of Bancorp’s employees with those of itsshareholders.  In addition to thisshare-based payment plan, Bancorp has outstanding restricted stock awardsgranted pursuant to an employment agreement with an executive officer. Totalequity compensation expense was $40,000 and $36,000 for the three months ended March 31,2008 and March 31, 2007, respectively.

 

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

 

The following assumptions were used in arriving at the fair value ofoptions granted for the three months ended March 31, 2008:

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

 

8

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**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

Historical informationwas the primary basis for the selection of the expected volatility and expecteddividend yield.  As Bancorp does not havea history of stock options, an average or mid-point based on the vesting termand the expiration term was used in determining the weighted average expectedlife on options granted to employees. The risk-free interest rate was selected based upon U.S. Treasury issueswith a term equal to the expected life of the option being valued at the timeof grant.  SFAS 123(R) requires therecognition of equity-based compensation for the number of awards that areexpected to vest.  Estimated forfeitureswill be evaluated in subsequent periods and may change based on new facts andcircumstances. The following table summarizes the activity related to optionsoutstanding during the quarter ended March 31, 2008.

 

(dollars in thousandsexcept share and per share amounts)

 
| ** **                           | ** ** | **Shares** | ** ** | **Weighted Average Exercise/Grant Price** | ** ** | **Weighted Average   Remaining   Contractual Terms   (in years)** | ** ** | **Aggregate Intrinsic   Value** | ** ** |
|--------------------------------------|------------|------------|------------|-------------------------------------------|------------|-------------------------------------------------------------------|------------|---------------------------------|------------|
| Outstanding at  January 1, 2008 |       | 13,275     |       | $                                         | 163.43     |                                                              | 8.16       |                            | $          | 300 |   |
| Granted                              |       | 5,056      |       | $                                         | 189.00     |                                                              | 10.00      |                            | —     |   |
| Exercised                            |       | —     |       | —                                    |       | —                                                            |       | —                          |       |
| Forfeited                            |       | —     |       | —                                    |       | —                                                            |       | —                          |       |
| Outstanding at  March 31, 2008  |       | 18,331     |       | $                                         | 170.48     |                                                              | 8.46       |                            | $          | 541 |   |
| Exercisable at  March 31, 2008  |       | 2,635      |       | $                                         | 163.44     |                                                              | 7.90       |                            | $          | 96 |   |

 

The unrecognized share-based compensation cost relating to stock optionexpense at March 31, 2008 is approximately $536,000, which will berecognized over the remaining vesting schedule through 2013. The weightedaverage grant date fair value of options granted during 2008 was $31.84 pershare.

 

The aggregate intrinsic value in the table above and followingrepresents the total pretax intrinsic value (amount by which the fair value ofthe underlying stock exceeds the exercise price of an option or award, timesthe number of shares).  The followingtable summarizes the activity relating to restricted stock awards outstandingfor the three months ended March 31, 2008.

 

(dollars in thousandsexcept share and per share amounts)

 
| ** **                           | ** ** | **Shares** | ** ** | **Weighted Average  Remaining Contractual   Terms (in years)** | ** ** | **Aggregate   Intrinsic Value** | ** ** |
|--------------------------------------|------------|------------|------------|-----------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| Outstanding at  January 1, 2008 |       | 1,040      |       | 3.68                                                                                    |       | $                                         | 193        |   |
| Granted                              |       | 1,429      |       | 5.00                                                                                    |       | 270                                       |       |
| Vested                               |       | —     |       | —                                                                                  |       | —                                    |       |
| Forfeited                            |       | —     |       | —                                                                                  |       | —                                    |       |
| Outstanding at  March 31, 2008  |       | 2,469      |       | 4.29                                                                                    |       | $                                         | 464        |   |
| Exercisable at  March 31, 2008  |       | —     |       | —                                                                                  |       | —                                    |       |

 

Recipients of restricted stock awards do not pay any cash considerationto Bancorp for the shares and receive all dividends with respect to all suchshares, whether or not shares have vested. The awards vest over a five year period. Bancorp measures the fair value of each stock award at the date of thegrant and recognizes compensation based on the amount, if any, the market priceof Bancorp’s common stock exceeds the exercise price.  The unrecognized share-based compensationcost relating to restricted stock awards expense at March 31, 2008 is$294,000, which will be recognized over the remaining vesting schedule through2013. The weighted average grant date fair value of restricted stock awardsgranted during 2008 was $189.00 per share.

 

9

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**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

Foradditional information on the stock-based equity compensation plan, refer toBancorp’s audited financial statements and footnotes for the most recent annualperiod ended December 31, 2007 contained in the Annual Report on Form 10-K.

 

**Note 7:   INCOMETAXES**

 

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

 

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

 

**Note 8:   FINANCIALINSTRUMENTS**

 

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

 

The following is a summary of the off-balance-sheet financialinstruments or contracts outstanding as of March 31, 2008: (dollars inthousands)

 
| Unfunded  commitments to extend credit  |   | $     | 75,524 |   |
|-----------------------------------------|--------|-------|--------|--------|
| Credit card  arrangements               |   | 8,374 |   |
| Commitments to  fund municipal warrants |   | 1,473 |   |
| Standby letters  of credit              |   | 3,165 |   |

 

**Note 9:   FAIR VALUE**

 

In September 2006,the FASB issued SFAS No. 157, “Fair Value Measures” which defines fairvalue, establishes a framework for measuring fair value in generally acceptedaccounting principles and expands disclosures about fair value measurements.Bancorp adopted this statement effective January 1, 2008. In February 2008,the FASB issued FASB Staff Position FAS 157-2 which defers the effective dateof SFAS No. 157 until January 1, 2009 for nonfinancial asset andliabilities except for those items recognized or disclosed at fair value on anannual or more frequent recurring basis. The adoption of these statements didnot have a material effect on Bancorp’s consolidated financial statements.

 

SFAS No. 157establishes a hierarchy that prioritizes the use of fair value inputs used inthe valuation methodologies into the following three levels:

 

Level 1 – Quoted pricedfor identical instruments in active markets that has the ability to access atthe measurement date.

 

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

 

Level 3 – Significantunobservable inputs that reflect the reporting entity’s own assumption aboutthe assumptions that market participants would use in pricing an asset orliability.

 

10

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**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

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

 

Investment SecuritiesAvailable for Sale – Securities classified as available for sale are reportedat fair value utilizing Level 1 and Level 2 inputs. For these securities,Bancorp obtains fair value measurements from an independent pricingservice.  The fair value measurementsconsiderable observable data that may include dealer quotes, market spreads,cash flows and  the yield curve amongother things.

 

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

 

The table below showsassets measured at fair value on a recurring basis as of March 31, 2008.

 

(dollars in thousands)

 
| ** **                     | ** ** | ** ** | ** ** | **Quoted Prices in  Active Markets  for Identical Assets** | ** ** | **Significant Other  Observable Inputs** | ** ** | **Significant  Unobservable  Inputs** | ** ** |
|--------------------------------|------------|------------|------------|-------------------------------------------------------------------------------------|------------|----------------------------------------------------|------------|---------------------------------------|------------|
| **Description**                | ** ** | **Total**  | ** ** | **(Level 1)**                                                                  | ** ** | **(Level 2)**                                 | ** ** | **(Level 3)**                    | ** ** |
| Available-for-sale  securities |       | $          | 128,458    |                                                                                | $          | —                                             |       | $                                     | 128,458    |   | $ | — |   |
| Total                          |       | $          | 128,458    |                                                                                | $          | —                                             |       | $                                     | 128,458    |   | $ | — |   |

 

The table below showsassets measured at fair value on a non-recurring basis as of March 31,2008.

 

(dollars in thousands)

 
| ** **      | ** ** | ** ** | ** ** | **Significant  Unobservable  Inputs** | ** ** | **Total Gains** | ** ** |
|-----------------|------------|------------|------------|---------------------------------------|------------|----------------------|------------|
| **Description** | ** ** | **Total**  | ** ** | **(Level 3)**                    | ** ** | **(Losses)**         | ** ** |
| Impaired loans  |       | $          | 655        |                                  | $          | 655                  |       | $ | (206 | ) |
| Total           |       | $          | 655        |                                  | $          | 655                  |       | $ | (206 | ) |

 

**Note 10:   NEW ACCOUNTING PRONOUNCEMENTS**

 

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

 

11

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| **Item 2.** | ** ** | **MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND  RESULTS OF OPERATIONS** |
|-------------|------------|-------------------------------------------------------------------------------------------------|

 

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

 

**FORWARDLOOKING STATEMENTS**

** **

Inaddition to historical information, this report contains certain “forwardlooking statements” within the meaning of the Private Securities LitigationReform Act of 1995 (PSLRA).  Thisstatement is included for the express purpose of availing Bancorp of theprotections of the safe harbor provision of the PSLRA.  The forward-looking statements contained inthis report are subject to factors, risk, and uncertainties that may causeactual results to differ materially from those projected.  Important factors that might cause such amaterial difference include, but are not limited to, those discussed in thissection of the report.  In addition, thefollowing items are among the factors that could cause actual results to differmaterially from the forward looking statements in this report: general economicconditions, including the effects of recent world events; business conditionsin the banking industry; the regulatory environment; new legislation; vendorquality and efficiency; employee retention factors; rapidly changing technologyand evolving banking industry standards; competitive factors, includingincreased competition with community, regional, and national financialinstitutions; fluctuating interest rate environments; and similar matters.  Readers are cautioned not to place unduereliance on these forward-looking statements, which reflect management’sanalysis only as of the date of the statement. Bancorp undertakes no obligation to publicly review or update theseforward-looking statements to reflect events or circumstances that arise afterthe date of this report.  Readers shouldcarefully review any risk factors described in this and other documents we filefrom time to time with the Securities and Exchange Commission.

 

**OVERVIEW**

 

Skagit State Bancorp, Inc.is a bank holding company with one wholly owned subsidiary - Skagit State Bank (collectively, “Company” or “Bancorp”). OnJune 30, 2006, at the completion of a corporate reorganization, SkagitState Bank became a wholly-owned subsidiary of Skagit State Bancorp, Inc.Skagit State Bank began operations in 1958 and is headquartered in Burlington(Skagit County), Washington.  The Bankprovides a full range of banking services and products to both businesses andindividuals through 13 full service banking offices located in Skagit,Snohomish and Whatcom counties.

 

Net income was $1.9million and $2.4 million for the quarters ended March 31, 2008 and 2007with diluted earnings per share at $2.83 and $3.56, respectively. The decreasein net income was primarily attributable to a decrease in interest income,which was partially offset by increases in non-interest income. For purposes ofcomparability, the three months ended March 31, 2007 was favorablyimpacted by a $495,000 interest recovery on one loan relationship and a $150,000benefit for loan losses compared to no provision or benefit for loan losses in2008.

 

Annualized return onaverage assets was 1.30 percent and 1.79 percent for the quarters ended March 31,2008 and 2007, respectively.  Annualizedreturn on average equity was 10.78 percent for the quarter ending March 31,2008 compared to 14.19 percent for the same period in 2007.

 

Total assets decreased to$578.3 million at March 31, 2008 compared to $592.7 million at December 31,2007.  The decrease was primarily due toa $15.3 repurchase of company stock. Net loans increased by $9.6 million to$360.3 million compared to $350.7 million at December 31, 2007.

 

**RESULTS OF OPERATIONS**

 

Bancorp’s results ofoperations are dependent to a large degree on net interest income, operatingefficiency and the level of the provision for loan losses. Bancorp’s operationsare sensitive to interest rate changes and the resulting impact on net interestincome. In addition, changes in net interest income are influenced by thevolume of assets and liabilities and the rates earned and paidrespectively.  Bancorp generatesnon-interest income primarily through fees on mortgage loans and servicecharges and other deposit related fees. Bancorp’s non-interest expenses consistprimarily of salaries and employee benefits expense, bank premises andequipment expenses and other operating expenses.

 

**NET INTEREST INCOME        **Netinterest income is Bancorp’s principal source of revenue and is comprised ofinterest income on earnings assets (loans and investment securities) lessinterest expense on interest-bearing liabilities (deposits and borrowings).Interest income and expense are affected significantly by general economicconditions, particularly changes in market interest rates, and by government policiesand the actions of regulatory authorities.

 

12

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Net interest incomedecreased to $5.5 million for the quarter ended March 31, 2008 compared to$6.2 million for the like period in 2007. This decrease was primarily due the fact that the Bancorp was assetsensitive meaning interest-earning assets re-priced more rapidly at lowerinterest rates than interest-bearing liabilities. In addition, for the threemonths ended March 31, 2007, Bancorp recorded a $495,000 interest recoveryon one loan relationship.

 

The net interest marginis net interest income expressed as a percent of average interest-earningassets. Net interest margin is influenced by the level and relative mix ofinterest-earning assets and interest-bearing liabilities as well as levels ofnon-interest bearing liabilities.  In2006, the Federal Reserve increased its targeted federal funds rate by 100basis points to 5.25 percent, where it remained until September 18, 2007when the Federal Reserve began decreasing rates rapidly. The Federal Reservedecreased rates 100 basis points in 2007 and through March 31, 2008 havedecreased another 200 basis points. Bancorp’s prime rate moves in conjunctionwith the federal funds rate.  For thequarter ended March 31, 2008, the net interest margin decreased to 3.98percent from 5.03 percent for the like periods in 2007. The decrease wasprimarily a result of the more rapid decrease in the yield on interest-earningassets than cost of funds with the interest-earning asset yield decreasing 127basis points and cost of funds decreasing 31 basis points.  Also contributing to the decline in netinterest margin, was an interest recovery from one loan relationship ofapproximately $495,000 which contributes 40 basis points to the net interestmargin for the quarter ended March 31, 2007.

 

*Interest-earning assets*

 

The largest component ofinterest income is interest earned on loans. Total interest income earned from loans decreased by $778,000 for thequarter ended March 31, 2008 compared to the like period in 2007.  For the current quarter, this decrease wasprimarily a result of the current declining interest rate environment whichdecreased the yield earned on loans from 9.15 percent to 7.33 percent.  Partially offsetting the decrease in yieldwas an increase in the average balance of loans by $32.5 million compared tothe same time period in 2007.  Inaddition, for the three months ended March 31, 2007, Bancorp recorded a$495,000 interest recovery on one loan relationship.

 

Interest earned oninvestments and federal funds sold increased $122,000 for the quarter ended March 31,2008 compared to the like quarter in 2007. Within the total, interest on federal funds decreased $178,000 which wasthe result of a 130 basis point decrease in yield and a $7.6 million decreasein the average balance. Interest earned on investments increased by $300,000for the quarter ended March 31, 2008, primarily due to a $28.7 millionincrease in the average balance which was partially offset by a decrease inyield from 4.35 percent for the quarter ended March 31, 2007 to 4.28 percent for the current quarter.

 

*Interest- bearing liabilities*

 

Interest expenseincreased $51,000 for the quarter ended March 31, 2008 compared to thelike period in 2007.  For the currentquarter, the increase was the result of a $47.3 million increase in the averagebalance of total interest-bearing liabilities which was partially offset by adecrease in the cost of funds on interest-bearing liabilities from 3.08 percentto 2.77 percent.

 

13

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The following tablespresent information regarding average balances of assets and liabilities aswell as the total amounts of interest income from average interest-earningassets and interest expense on average interest-bearing liabilities, resultingyield and cost ratios, interest rate spread and net interest margin. Tax exemptsecurities, included in investment securities below are stated at theircontractual interest rate. Loan fees of $261,000 and $250,000 for the quarterended March 31, 2008 and March 31, 2007 are included in interestearned on loans. Non-accruing loans have been included in the computation ofaverage loans.

 

**Condensed Average Balance Sheets**

(dollars in thousandsexcept share data)

 

 
| ** **                                         | ** ** | **2008**    | ** ** | ** **   | ** ** | **2007**             | ** ** | ** **  | ** ** |
|----------------------------------------------------|------------|-------------|------------|--------------|------------|----------------------|------------|-------------|------------|
| ** **                                         | ** ** | **Average** | ** ** | ** **   | ** ** | ** **           | ** ** | **Average** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Three months ended  March 31,**             | ** ** | **Balance** | ** ** | **Interest** | ** ** | **Yield /Cost** | ** ** | **Balance** | ** ** | **Interest** | ** ** | **Yield /Cost** | ** ** |
| **Assets**                                         |       |        |       |         |       |                 |       |        |       |   |   |   |   |
| Federal funds  sold                                |       | $           | 29,305     |         | $          | 242                  |       | 3.31        | %          | $ | 36,938 |   | $ | 420 |   | 4.61 | % |
| Taxable  investment securities                     |       | 120,692     |       | 1,506        |       | 5.00                 |       | 103,469     |       | 1,310 |   | 5.13 |   |
| Tax exempt  securities                             |       | 50,726      |       | 325          |       | 2.57                 |       | 39,297      |       | 221 |   | 2.28 |   |
| Loans                                              |       | 352,648     |       | 6,441        |       | 7.33                 |       | 320,115     |       | 7,219 |   | 9.15 |   |
| Total  interest-earning assets                     |       | 553,371     |       | 8,514        |       | 6.17                 | %          | 499,819     |       | 9,170 |   | 7.44 | % |
| Non-interest  earning assets                       |       | 33,251      |       |         |       |                 |       | 35,344      |       |   |   |   |   |
| Total assets                                       |       | $           | 586,622    |         |       |                 |       |        | $          | 535,163 |   |   |   |   |   |
|                                               |       |        |       |         |       |                 |       |        |       |   |   |   |   |
| **Liabilities  and Stockholders’ Equity**     |       |        |       |         |       |                 |       |        |       |   |   |   |   |
| Interest-bearing  demand                           |       | $           | 90,051     |         | $          | 137                  |       | 0.61        | %          | $ | 82,966 |   | $ | 268 |   | 1.31 | % |
| Savings and  money market                          |       | 144,031     |       | 524          |       | 1.46                 |       | 140,505     |       | 745 |   | 2.15 |   |
| Certificates of  deposit                           |       | 188,761     |       | 2,240        |       | 4.76                 |       | 153,516     |       | 1,829 |   | 4.83 |   |
| Total  interest-bearing deposits                   |       | 422,843     |       | 2,901        |       | 2.78                 |       | 376,987     |       | 2,842 |   | 3.06 |   |
| Securities sold  under agreement to repurchase     |       | 15,564      |       | 124          |       | 3.20                 |       | 14,103      |       | 132 |   | 3.80 |   |
| Total  interest-bearing deposits & liabilities |       | 438,407     |       | 3,025        |       | 2.77                 | %          | 391,090     |       | 2,974 |   | 3.08 | % |
| Non interest-bearing  demand deposits              |       | 74,488      |       |         |       |                 |       | 73,110      |       |   |   |   |   |
| Other  non-interest-bearing liabilities            |       | 3,212       |       |         |       |                 |       | 3,323       |       |   |   |   |   |
| Total  liabilities                                 |       | 516,107     |       |         |       |                 |       | 467,523     |       |   |   |   |   |
| Stockholders’  equity                         |       | 70,515      |       |         |       |                 |       | 67,640      |       |   |   |   |   |
| Total  liabilities and stockholders equity         |       | $           | 586,622    |         |       |                 |       |        | $          | 535,163 |   |   |   |   |   |
| Net interest  income                               |       |        |       | $            | 5,489      |                 |       |        |       |   | $ | 6,196 |   |   |   |
| Interest rate  spread                              |       |        |       |         |       | 3.40                 | %          |        |       |   |   | 4.36 | % |
| Net interest  margin                               |       |        |       |         |       | 3.98                 | %          |        |       |   |   | 5.03 | % |

 

14

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

 

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

(dollars in thousandsexcept share data)

 
| ** **                                                                        | ** ** | **Increase (Decrease) Due to** | ** ** |
|-----------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|
| **Three months ended March 31, 2008 vs. 2007** | ** ** | **Volume**                                    | ** ** | **Rate** | ** ** | **Total** | ** ** |
| **Interest-Earning  Assets**                                                      | ** ** | ** **                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Federal funds  sold                                                               |       | $                                             | (75        | ) | $ | (103 | ) | $ | (178 | ) |
| Investment  securities                                                            |       | 475                                           |       | (175 | ) | 300 |   |
| Loans                                                                             |       | 3,676                                         |       | (4,454 | ) | (778 | ) |
| Total net change  in income on interest earning assets                            |       | 4,076                                         |       | (4,732 | ) | (656 | ) |
| **Interest-Bearing  Liabilities**                                                 |       |                                          |       |   |   |   |   |
| Deposits                                                                          |       | 1,122                                         |       | (1,063 | ) | 59 |   |
| Securities sold  under agreements to repurchase                                   |       | 64                                            |       | (72 | ) | (8 | ) |
| Total net change  in expense on interest-bearing liabilities                      |       | 1,186                                         |       | (1,135 | ) | 51 |   |
| Net change in  net interest income                                                |       | $                                             | 2,890      |   | $ | (3,597 | ) | $ | (707 | ) |

 

**NON-INTEREST INCOME               **Non-interestincome, which consists primarily of fees and service charges on deposits andother income, was $1.0 million and $762,000 for the quarter ended March 31,2008 and 2007, respectively. In July 2007, Bancorp began offering a newoverdraft protection product to its checking account customers and dueprimarily to this new product overdraft and non-sufficient fund fees increased$178,000 for the first quarter of 2008 compared to like quarter in 2007.  In addition, during May 2007, Bancorpexpanded its home loan department and as a result brokered loan fees,processing fees and gains on the sale of loans increased $44,000 for thequarter ended March 31, 2008 compared to the like quarter in 2007.

 

**NON-INTEREST EXPENSE             **Non-interestexpense increased $119,000 or 3.0 percent to $4.1 million for the quarter endedMarch 31, 2008 compared to $3.9 million for the same period in 2007. Thisincrease was primarily attributable to increases in salary expense. Salaryexpense increased 5.3 percent to $1.9 million in 2008 and was primarilyattributable to higher salaries, overall growth in employment and equitycompensation expenses.

 

The efficiency ratio iscomputed by dividing total operating expenses by non-interest income and netinterest income after provision for loan losses.  An increase in the efficiency ratio indicatesthat more resources are being utilized to generate the same or greater volumeof income. The efficiency ratio for the quarter ended March 31, 2008 was62.5 percent compared to 55.5 percent for the same time periods in 2007. Theincrease from 2007 was primarily due to decreases in interest income.

 

**INCOMETAX EXPENSE                 **Incometax expense for the quarter ended March 31, 2008 was $539,000 compared to$765,000 for the quarter ended March 31, 2007. Bancorp’s effective taxrates were 22.1 percent and 24.2 percent for the quarter ended March 31,2008 and 2007, respectively. The effective tax rate is lower than the federalstatutory rate due to tax credits from tax-exempt bonds and tax-exempt interestfrom municipal bonds and loans.  As of March 31,2008, Bancorp had $50.7 million in tax-exempt securities compared to $39.9million as of March 31, 2007.

 

**REVIEW OF FINANCIAL CONDITION**

 

Totalassets decreased to $578.3 million at March 31, 2008 compared to $592.7million at December 31, 2007.  Thisdecrease was primarily due to a $15.3 million repurchase of Skagit StateBancorp stock during 2008.

 

**INVESTMENT SECURITIES AND FEDERAL FUNDS SOLD          **Total investment securities increased to$167.2 million at March 31, 2008 compared to $166.9 million at December 31,2007. During 2008,  Bancorp continued toadjust the portfolio mix to decrease the US Agency investments and includeadditional mortgage-backed securities and municipal securities. Securitypurchases were $19.6 million in the first quarter of 2008, which was partiallyoffset by maturities, calls and principal pay-downs of $21.2 million.  Federal funds sold decreased to $14.4 millionat March 31, 2008 compared to $41.2 million at December 31, 2007 anddecreased primarily as a result of the re-purchase of $15.3 million in Bancorpstock and the growth in total loans.

 

15

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Certain investmentsecurities included in the table below currently have fair values less thanamortized cost and, therefore, contain unrealized losses.  Bancorp has evaluated these securities andbelieves that the decline in value is temporary and is related to the changes inmarket interest rates since purchase, with no permanent sector or issuer creditconcerns or impairments.  Bancorpanticipates full recovery of amortized cost with respect to these securities atmaturity or sooner in the event of a more favorable market interest rateenvironment.

 

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 table presents the carryingvalue of the portfolio of investment securities as of the dates indicated.

 

**Investment Securities Composition**

 
| **(dollars in thousands)** | ** ** | **March 31, 2008** | ** ** | **December 31, 2007** | ** ** |
|--------------------------------------|------------|------------------------------|------------|---------------------------------|------------|
| **Held-to-maturity**                 |       |                         |       |                            |       |
| U.S. government  agencies            |       | $                            | —     |                            | $          | — |   |
| State and  political subdivisions    |       | 38,714                       |       | 39,926                          |       |
| Total                                |       | $                            | 38,714     |                            | $          | 39,926 |   |
| **Available-for-sale**               |       |                         |       |                            |       |
| U.S. government  agencies            |       | $                            | 47,728     |                            | $          | 60,420 |   |
| Mortgage-backed-securities           |       | 68,732                       |       | 55,385                          |       |
| State and  political subdivisions    |       | 11,998                       |       | 11,148                          |       |
| Total                                |       | $                            | 128,458    |                            | $          | 126,953 |   |

 

**LOANS                **Net loansincreased 2.7 percent to $360.3 million at March 31, 2008 compared to$350.7 million at December 31, 2007. Bancorp concentrates on five areas of lending: loans to individuals forbusiness purposes, loans for small and medium-sized businesses, agriculturalloans, loans to commercial enterprises for real estate transactions andconsumer purpose loans.  Bancorp’sprimary lending activities include commercial real estate loans, commercialloans which include agriculture production loans and consumer purpose loans.Most of Bancorp’s business activity is with customers located within Skagit,Snohomish and Whatcom Counties. Bancorp originates commercial, real estate andconsumer loans. Generally, loans are secured by accounts receivable, inventory,deposit accounts, personal property or real estate. Rights to collateral varyand are legally documented to the extent practicable.

 

Real estate loanscomprise the largest category of loans with a total of $258.7 million or 70.7percent and $251.1 million or 70.4 percent as of March 31, 2008 and December 31,2007, respectively. At March 31, 2008, $108.9 million of these loansconsist of non-farm non residential owner occupied business loans and farmlandloans.  The primary repayment source ofthese specific loan types are from the cash flows generated by the occupantbusiness or occupant farm operation. Bancorp is committed to providingcompetitive commercial real estate lending within our primary market areas.  Our real estate portfolio consists ofcommercial and residential loans.  Theseloans are secured by property such as office buildings, retail buildings, owneroccupied commercial business properties, farm land, timber land, residentialland development properties and residential properties. While Bancorp hassignificant balances secured by real estate, Bancorp believes that its lendingpolicies and concentration policies are sufficient to minimize risks.  Also, economic conditions may affect aborrower’s ability to meet the stated repayment terms.

 

Residential mortgageloans are offered primarily through Bancorp’s residential lending department.During 2007, Bancorp expanded its home loan department.  Loans originated are primarily for thepurchase or refinance of residential properties.  Bancorp brokers or sells a majority of theseloans.

 

Commercial loans were$71.0 million as of March 31, 2008 and $70.0 million as of December 31,2007.    Commercial loans, secured andunsecured, are made primarily to small and medium-sized businesses includingfarms operating within Skagit, Snohomish and Whatcom Counties.  These loans are available for generaloperating purposes, acquisition of fixed assets, purchases of equipment andmachinery, financing of inventory and accounts receivable, and other businesspurposes.  Bancorp originates SmallBusiness Administration (SBA) loans, including 504 and 7A loans.

 

Consumer loans were $36.1million at March 31, 2008 and $35.4 million at December 31, 2007.Bancorp makes secured and unsecured consumer loans including loans toindividuals, primarily customers of Bancorp, for various purposes, includinghome equity loans, purchases of automobiles, mobile homes, boats and otherrecreational vehicles, home improvement loans and loans for education and personalinvestments.

 

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The extension of creditto individuals and businesses is a significant portion of Bancorp’s principalbusiness activity and requires ongoing portfolio and credit management.  As such, Bancorp has established lendingpolicies and procedures to manage and monitor risk. These lending policies andprocedures include guidelines for concentrations of credit, loan terms,loan-to-value ratios, collateral appraisals and loan approval limits.

 

The following table presents the composition of loansfor Bancorp as of the dates indicated.

 

**Loan Composition**

 
| ** **                                            | ** ** | **March 31, 2008** | ** ** | **December 31, 2007** | ** ** |
|-------------------------------------------------------|------------|------------------------------|------------|---------------------------------|------------|
| **(dollars in thousands)**                  | ** ** | **Amount**                   | ** ** | **%**                           | ** ** | **Amount** | ** ** | **%** | ** ** |
| Real estate –  residential & commercial |       | $                            | 243,532    |                            | 66.6       | % | $ | 229,680 |   | 64.4 | % |
| Real estate  construction                             |       | 15,144                       |       | 4.1                             | %          | 21,468 |   | 6.0 | % |
| Commercial,  industrial & agricultural       |       | 70,986                       |       | 19.4                            | %          | 70,040 |   | 19.6 | % |
| Consumer                                              |       | 36,135                       |       | 9.9                             | %          | 35,411 |   | 10.0 | % |
| Total loans                                           |       | 365,797                      |       | 100                             | %          | 356,599 |   | 100 | % |
| Less:                                                 |       |                         |       |                            |       |   |   |   |   |
| Allowance for  loan losses                            |       | 4,098                        |       |                            |       | 4,535 |   |   |   |
| Deferred loan  fees                                   |       | 1,379                        |       |                            |       | 1,401 |   |   |   |
| Net loans                                             |       | $                            | 360,320    |                            |       |   | $ | 350,663 |   |   |   |

 

*Concentrations*

 

As shown in the tableabove, Bancorp has a concentration in commercial and residential realestate.  Although management believesthat loans within the real estate area have no more than the normal risk ofcollectibility, a substantial decline in the performance of the economy, ingeneral, or a decline in real estate values in our market areas, in particular,could have an adverse impact on collectibility, increase the level of realestate non-performing loans or have other adverse effects which alone or inaggregate could have a material adverse effect on our business, financialcondition, results of operation and cash flows.

 

**PROVISION AND ALLOWANCE FOR LOANLOSSES**          Theallowance for loan losses was $4.1 million as of March 31, 2008 comparedto $4.5 million at December 31, 2007 and reflects management’s currentestimate of the level deemed adequate to provide for estimated future losses.Loans deemed uncollectible, in whole or in part are charged against and reducethe allowance for loan losses. Net charges-offs for the three months ended March 31,2008 were $437,000 compared to $8,000 for the three months ended March 31,2007. For the first quarter of 2008, gross charge-offs included charge-offs ofapproximately $434,000 on one relationship.

 

For the quarters ended March 31,2008, and 2007, Bancorp reported no provision and a $150,000 benefit for loanlosses, respectively. This was primarily related to minimal net charge-offs andno significant changes in credit quality. The provision for loan losses ishighly dependent upon Bancorp’s ability to manage asset quality and control thelevel of net-charge-offs through prudent underwriting standards. In the future,normal growth of the loan portfolio may require an increase in the allowancefor loan losses. In addition, declines in general economic conditions couldincrease future provisions for loan losses and impact Bancorp’s net income.

 

Bancorp has a systematic methodology for evaluatingthe adequacy of the allowance for loan losses and the allowance is evaluated ona quarterly basis and reviewed by the Board of Directors. The allowanceconsists of specific, general and unallocated components.  The allowance is based upon Bancorp’speriodic evaluation of the pertinent factors underlying the quality of the loanportfolio, including changes 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. The general allowance is then calculated, byapplying a loss percentage factor to the different loan types and the differentrisk gradings.  In addition, as part ofthe process, a specific allowance is determined based on Bancorp’s review ofclassified or non-performing loans for specific weaknesses and evaluation ofthose loans for impairment and loss exposure. The unallocated component of theallowance reflects the margin of imprecision in inherent in the underlyingassumptions used in the methodologies for estimated specific and general lossesin the loan portfolio.

 

17

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Bancorp currentlymonitors its loan portfolio for potential risk of loss according to an internalrisk-grading system. Management monitors Bancorp’s credit quality to identifypotential problem credits and any loss exposure in a timely manner.  Additionally, loans are subject toexaminations by regulators, who, based upon their judgment, may require Bancorpto make additional provisions or adjustments to its allowance for loanlosses.  Bancorp has assessed and willcontinue to assess on an on-going basis, the impact of the economy on thecredit risk in the loan portfolio.  WhileBancorp believes that it uses the best information available to determine theallowance for loan losses, unforeseen market conditions could result inadjustments to the allowance for loan losses, and net income could besignificantly affected if circumstances differ substantially from theassumptions used in making the final determination.

 

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

 

**Allowance for Loan Loss Activity**

 
| **(dollars in thousands)**                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
|---------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| **For the three months ended March 31,**    | ** ** | **2008**   | ** ** | **2007**   | ** ** |
| Allowance as of  beginning of year                                        |       | $          | 4,535      |       | $          | 5,176 |   |
| Provision  (benefit) for loan losses                                      |       | —     |       | (150       | )          |
| Charge-offs                                                               |       | (540       | )          | (45        | )          |
| Recoveries                                                                |       | 103        |       | 37         |       |
| Net  (charge-offs) recoveries                                             |       | (437       | )          | (8         | )          |
| Balance at end of  period                                                 |       | $          | 4,098      |       | $          | 5,018 |   |
| Ratio of net  (charge-offs) recoveries to average loans during the period |       | (0.50      | )%         | (0.01      | )%         |
| Ratio of  allowance to net loans at end of period                         |       | 1.14       | %          | 1.58       | %          |
| Ratio of  non-performing loans to allowance                               |       | 15.98      | %          | 106.56     | %          |

 

***ASSET QUALITY*          **Non-performingassets consist of nonaccrual loans, accruing loans past due 90 days or more andother real estate owned and at March 31, 2008 decreased to $6.9 millioncompared to $7.7 million as of December 31, 2007. In 2008, Bancorpforeclosed on two non-accrual credit relationships of approximately $6.2million which were transferred into other real estate owned. At March 31,2008 other real estate owned was $6.2 million and non-accrual loans were$655,000.

 

It is Bancorp’s plan tocontinue its collection efforts and liquidation of collateral, if necessary, torecover as large a portion of the non-accrual assets or other real estate ownedas possible. At March 31, 2008 impaired loans were $655,000 and includedin the allowance for loan losses was a $170,000 specific allocation relating totwo credit relationships. All material loan restructurings have been includedin impaired loans.

 

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

 

**Non-Performing Assets**

 
| **(dollars in thousands)**         | ** ** | **March 31, 2008** | ** ** | **December 31, 2007** | ** ** |
|----------------------------------------------|------------|------------------------------|------------|---------------------------------|------------|
| Non-accrual  loans                           |       | $                            | 655        |                            | $          | 7,690 |   |
| Loans past due  90 days or more              |       | —                       |       | —                          |       |
| Total  non-performing loans                  |       | 655                          |       | 7,690                           |       |
| Other real  estate owned                     |       | 6,202                        |       | —                          |       |
| Total  non-performing assets                 |       | $                            | 6,857      |                            | $          | 7,690 |   |
| Total  non-performing loans to net loans     |       | 0.18                         | %          | 2.19                            | %          |
| Total  non-performing loans to total assets  |       | 0.11                         | %          | 1.30                            | %          |
| Total non-performing  assets to total assets |       | 1.19                         | %          | 1.30                            | %          |

 

**DEPOSITS          **Bancorp offers a full range of depositservices including checking accounts, savings accounts, money market accountsand various types of certificates of deposit. The transaction accounts and certificates of deposit are tailored toBancorp’s primary market area at rates competitive with those offered in thearea. Bancorp offers both interest and non-interest bearing checking accounts.

 

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Total deposits decreasedto $496.9 million at March 31, 2008 compared to $500.4 million at December 31,2007.  Within the total, time depositsdecreased $5.8 million while core deposits increased $2.2 million. Timedeposits decreased to 37.3 percent of deposits at March 31, 2008 comparedto 38.2 percent of deposits at December 31, 2007.

 

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

 

**Deposit Composition**

 
| ** **                           | ** ** | **March 31, 2008** | ** ** | **December 31, 2007** | ** ** |
|--------------------------------------|------------|------------------------------|------------|---------------------------------|------------|
| **(dollars in thousands)** | ** ** | **Amount**                   | ** ** | **% of Total**        | ** ** | **Amount** | ** ** | **% of Total** | ** ** |
| Non-interest  bearing demand         |       | $                            | 72,892     |                            | 14.7       | % | $ | 77,957 |   | 15.5 | % |
| Interest bearing  demand             |       | 88,848                       |       | 17.9                            | %          | 89,830 |   | 18.0 | % |
| Money market                         |       | 73,403                       |       | 14.8                            | %          | 67,857 |   | 13.6 | % |
| Savings                              |       | 76,190                       |       | 15.3                            | %          | 73,464 |   | 14.7 | % |
| Time                                 |       | 185,561                      |       | 37.3                            | %          | 191,312 |   | 38.2 | % |
| Total deposits                       |       | $                            | 496,894    |                            |       |   | $ | 500,420 |   |   |   |

** **

**SECURITIES SOLD UNDER AGREEMENTSTO REPURCHASE           **Asof March 31, 2008 and December 31, 2007, securities sold underagreements to repurchase were $18.1 million and $15.9 million, respectively.These borrowings decrease or increase primarily based on the availability offunds and current competitive interest rates offered.  These borrowings are collateralized by securitieswith an estimated fair value exceeding the face value of the borrowings.

 

**CAPITALRESOURCES**            Stockholders’equity decreased to $60.5 million at March 31, 2008 from $72.7 million at December 31,2007.  This decrease was primarily due toa private stock repurchase of a large block of 85,022 shares from one corporatestockholder for $15.3 million. Book value per share at March 31, 2008 was$103.23 compared to a book value of $108.32 at December 31, 2007.

 

Bancorphas only one class of stock. Bancorp’s stock is not actively traded or quotedand no broker currently makes a market in the stock. However, sales andtransfers of the stock do occur.  SkagitState Bank acts as transfer agent for Bancorp stock.  To facilitate trading, the Bank maintains alist of persons interested (known to the Bank) in either purchasing or sellingBancorp stock.  Purchasers and sellersthen negotiate their own transactions with the Bank acting as transfer agentfor those transactions.

 

Fromtime to time, Bancorp repurchases shares of its common stock. The number of shares of stock that will berepurchased and the price that will be paid is the result of many factorsincluding market and economic conditions, the number of shares available,Bancorp’s liquidity and capital needs and regulatory requirements. For thethree months ended March 31, 2008, Bancorp repurchased 85,022 shares ofstock for an average price of $180 per share.

 

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

 
| ** **                           | ** ** | ** ** | ** ** | ** **                 | ** ** | ** **                 | ** ** | ** **                 | ** ** | **To Be Well**   | ** ** |
|--------------------------------------|------------|------------|------------|----------------------------|------------|----------------------------|------------|----------------------------|------------|----------------------------|------------|
| ** **                           | ** ** | ** ** | ** ** | ** **                 | ** ** | ** **                 | ** ** | ** **                 | ** ** | **Capitalized Under** | ** ** |
| ** **                           | ** ** | ** ** | ** ** | ** **                 | ** ** | **For Capital**       | ** ** | **Prompt Corrective** | ** ** |
| ** **                           | ** ** | **Actual** | ** ** | **Adequacy Purposes** | ** ** | **Action Provisions** | ** ** |
| **(dollars in thousands)** | ** ** | **Amount** | ** ** | **Ratio**                  | ** ** | **Amount**                 | ** ** | **Ratio**                  | ** ** | **Amount**                 | ** ** | **Ratio** | ** ** |
| As of  March 31, 2008           |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| Total Capital                        |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| (to Risk-Weighted  Assets)           |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| Skagit State  Bank                   |       | $          | 62,542     |                       | 13.83      | %                          | $          | 36,181                     | >  | 8.00                       | %          | $ | 45,226 | >  | 10.00 | % |
| Skagit State  Bancorp, Inc.     |       | $          | 62,723     |                       | 13.87      | %                          | $          | 36,188                     | >  | 8.00                       | %          | $ | 45,234 | >  | 10.00 | % |
| Tier I Capital                       |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| (to  Risk-Weighted Assets)           |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| Skagit State  Bank                   |       | $          | 58,444     |                       | 12.92      | %                          | $          | 18,090                     | >  | 4.00                       | %          | $ | 27,136 | >  | 6.00 | % |
| Skagit State  Bancorp, Inc.     |       | $          | 58,625     |                       | 12.96      | %                          | $          | 18,094                     | >  | 4.00                       | %          | $ | 27,141 | >  | 6.00 | % |
| Tier I Capital                       |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| (to Average  Assets)                 |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| Skagit State  Bank                   |       | $          | 58,444     |                       | 9.97       | %                          | $          | 23,453                     | >  | 4.00                       | %          | $ | 29,316 | >  | 5.00 | % |
| Skagit State  Bancorp, Inc.     |       | $          | 58,625     |                       | 10.00      | %                          | $          | 23,453                     | >  | 4.00                       | %          | $ | 29,316 | >  | 5.00 | % |
|                                 |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| As of  December 31, 2007        |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| Total Capital                        |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| (to  Risk-Weighted Assets)           |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| Skagit State  Bank                   |       | $          | 76,354     |                       | 17.25      | %                          | $          | 35,407                     | >  | 8.00                       | %          | $ | 44,259 | >  | 10.00 | % |
| Skagit State  Bancorp, Inc.     |       | $          | 76,524     |                       | 17.29      | %                          | $          | 35,412                     | >  | 8.00                       | %          | $ | 44,265 | >  | 10.00 | % |
| Tier I Capital                       |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| (to  Risk-Weighted Assets)           |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| Skagit State  Bank                   |       | $          | 71,819     |                       | 16.23      | %                          | $          | 17,704                     | >  | 4.00                       | %          | $ | 26,556 | >  | 6.00 | % |
| Skagit State  Bancorp, Inc.     |       | $          | 71,989     |                       | 16.26      | %                          | $          | 17,706                     | >  | 4.00                       | %          | $ | 26,559 | >  | 6.00 | % |
| Tier I Capital                       |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| (to Average  Assets)                 |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| Skagit State  Bank                   |       | $          | 71,819     |                       | 12.39      | %                          | $          | 23,183                     | >  | 4.00                       | %          | $ | 28,979 | >  | 5.00 | % |
| Skagit State  Bancorp, Inc.     |       | $          | 71,989     |                       | 12.42      | %                          | $          | 23,183                     | >  | 4.00                       | %          | $ | 28,979 | >  | 5.00 | % |

 

**LIQUIDITY**

 

Liquidity managementfocuses on the need to meet both short-term funding requirements and long-termstrategies and goals.  The objective ofliquidity management is to ensure Bancorp has adequate liquidity to accommodatefluctuations in deposit levels, fund operations, and provide for customercredit needs and to meet other obligations and commitments on a timely basis.Bancorp’s long term growth objectives are to attract and retain businesscustomer and consumer relationships with a focus on transaction accounts andcommercial and consumer lending.  Bancorpstructures the balance sheet to meet those objectives. The majority of Bancorp’sfunding comes from customer deposits within its market area.

 

Bancorp has generallybeen a net seller of federal funds.  At March 31,2008 and December 31, 2007, Bancorp’s federal funds sold were $14.4million and $41.2 million, respectively. Other sources of potential liquidityinclude loan repayments, investment securities repayments and borrowing throughpre-approved credit lines. Liquidity is also obtained by maintaining assetsthat are readily convertible to cash through maturities and sales.  As of March 31, 2008 Bancorp had $35.0million in approved credit lines from various financial institutions.

 

The analysis of liquidityalso includes a review of the statement of cash flows.  The cash flows detail Bancorp’s operating,investing and financing activities during the year. Cash flows from operationscontribute to liquidity as well as proceeds from the maturities of securities,loan repayments and increasing customer deposits. As indicated in the statementof cash flows, net cash from operating activities contributed $934,000 to liquidityfor the three months ended March 31, 2008 and $3.0 million for the threemonths ended March 31, 2007.

 

20

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

 

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

 

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

 

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

 

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

 

# **Item 4.    CONTROLS AND PROCEDURES**

# ** **

Evaluationof Disclosure Controls and Procedures

 

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

 

Changesin Internal Controls

 

Therehave not been any significant changes in our internal controls or in otherfactors that could significantly affect these controls subsequent to the dateof their evaluation.  Bancorp did notidentify nor implement any corrective actions with regard to any significantdeficiencies or material weaknesses in its internal controls.

 

**PART II -              OTHER INFORMATION**

 

**Item 1.                    Legal Proceedings**

 

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

 

**Item 1A.                 Risk Factors**

 

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

 

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

 

Bancorp’s profitabilityis dependent to a large extent upon net interest income. Earnings and cashflows are largely dependent upon our net interest income.  Net interest income is the difference (or “spread”)between the interest earned on loans, securities and other interest-earningassets and Bancorp’s cost of funds, primarily interest expense on deposits andborrowings. Interest rates are highly sensitive to many factors that are beyondour control including, but not limited to, general economic conditions,policies of various governmental and regulatory agencies. Changes

 

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in monetary policy,including changes in interest rates, impact the level of loans, deposits andinvestments, the credit profile of existing loans and the rates received onloans and investment securities and the rates paid on deposits and borrowings.If the interest on deposits increase at a faster rate than the interestreceived on loans and investment securities, Bancorp’s net interest income, andtherefore earnings could be adversely affected. Earnings could also be adversely affected if interest received on loansand investments decrease faster than interest paid on deposits. In 2006, theFederal Reserve increased its targeted federal funds rate by 100 basis pointsto 5.25 percent, where it remained until September 18, 2007 when theFederal Reserve began decreasing rates rapidly. The Federal Reserve decreasedrates 100 basis points in 2007 and 200 basis points through March 31,2008.

 

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

 

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

 

**Ourallowance for loan losses may not be adequate to cover actual loan losses,which could adversely affect Bancorp’s earnings**

 

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

 

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

 

Real estate loanscomprise the largest category of loans and represent 70.7 percent of totalloans.  Our real estate portfolioconsists of commercial and residential lending. These loans are secured by property such as office buildings, commercialbusiness properties, healthcare buildings, agricultural land, timber land andresidential properties.  Commercial andcommercial real estate loans generally are viewed as having more risk ofdefault than residential real estate loans or certain other types of loans orinvestments.  Typically, these types ofloans are larger than residential real estate loans and other loans.  Because the loan portfolio contains a numberof commercial real estate loans with relatively large balances, thedeterioration of one or a few of these loans may cause a significant increasein nonperforming loans.  An increase innonperforming loans could result in; a loss of earnings from these loans; anincrease in the provision for loan losses; or an increase in loan charge-offs,which could have an adverse impact on our results of operations and financialcondition.

 

**Therehas been an economic downturn in other parts of the country, particularly inthe housing and commercial real estate sectors. The Pacific Northwest economy typically lags the national economy.Accordingly, an economic downturn in the market area we serve may cause us tohave lower earnings and could increase our credit risk associated with our loanportfolio. The inability of borrowers to repay loans can erode our earnings.Substantially all of our loans are to businesses and individuals in Skagit,Snohomish or Whatcom Counties and any decline in the economy of this marketarea could impact us adversely.  As alender, we are exposed to the risk that our customers will be unable to repaytheir loans in accordance with their terms, and that any collateral securingthe payment of their loans may not be sufficient to assure repayment.**

** **

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** **

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

** **

**Item 2.                    Unregistered Sales of Equity Securities and Useof Proceeds**

 

Bancorphas not adopted an official repurchase plan or adapted a maximum shares thatmay be repurchased, however all stock repurchases are approved by the Board ofDirectors on a case by case basis.

 

**ISSURER PURCHASES OF EQUITYSECURITIES**

 
| **Period**                            | ** ** | **Total Number of  Shares Purchased(1)** | ** ** | **Average Price Paid  Per Share** | ** ** | **Total Number of  Shares Purchase as  Part of Publicly  Announced Plans  or Programs** | ** ** | **Maximum Number  of Shares that May  Yet Be Purchased  Under the Plans or  Programs (2)** | ** ** |
|---------------------------------------|------------|---------------------------------------------------------|------------|--------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------|------------|
| January 1 -  March 31, 2008 |       | 85,022                                                  |       | $                                                | 180.00     |                                                                                                                            | 0          |                                                                                                                                         | 0          |   |
|                                       |            |                                                         |            |                                                  |            |                                                                                                                                 |            |                                                                                                                                              |            |  |

 

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(1)  Represents sharesthat were repurchased in a private purchase from one corporate owner.

 

**Item 3.****                                                          Defaults Upon Senior Securities**

 

None

 

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

# ** **

None

 

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

 

None

 

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

 

(a)                                  Exhibits.

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

 

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**SIGNATURES**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 

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

 

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