Tableof Contents

 

 

 

**UNITEDSTATES SECURITIES AND EXCHANGE COMMISSON**

**Washington D.C., 20549**

 

**FORM 10-Q**

 

| **x**      | ** ** | **Quarterly Report Pursuant to  Section 13 or 15(d) of the Securities Exchange Act of 1934**                                                                                                                                                                                                                                                                                                                                                                  |
|------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** ** | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| ** ** | ** ** | **For  the quarterly period ended June 30, 2008**                                                                                                                                                                                                                                                                                                                                                                                                                  |
| ** ** | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| **o**      | ** ** | **Transition Report Under  Section 13 or 15(d) of the Exchange Act**                                                                                                                                                                                                                                                                                                                                                                                          |
| ** ** | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| ** ** | ** ** | **For  the transition period from                                    to                                     ** |

 

**Commission File Number  000-52096**

 

**SKAGIT STATE BANCORP, INC.**

(Exact Name of Registrant asSpecified in Its Charter)

 

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

 

**301 East Fairhaven Avenue**

**Burlington, Washington  98233**

(Address of PrincipalExecutive Offices) (Zip Code)

 

**(360) 755-0411**

(Registrant’s TelephoneNumber, Including Area Code)

 

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

 

Yesx         No o

 

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

 

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

 

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

 

Yeso         No x

 

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

 

Thenumber of shares of the issuer’s Common Stock outstanding at August 14,2008 was 588,244.

 

 

 

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**SKAGIT STATE BANCORP, INC.**

 

**TABLE OF CONTENTS**

 
| **PART I.**  |   | **FINANCIAL INFORMATION** |   |
|-------------------|--------|---------------------------|--------|
|              |   |                      |   |   |   |   |
|              |   | Item 1.                   |   | Financial Statements |   |   |
|              |   |                      |   |   |   |   |
|              |   |                      |   | Consolidated  Balance Sheet as of June 30, 2008   and December 31, 2007 |   | Page 3 |
|              |   |                      |   |   |   |   |
|              |   |                      |   | Consolidated  Statement of Income for the three and six months ended June 30, 2008 and  2007 |   | Page 4 |
|              |   |                      |   |   |   |   |
|              |   |                      |   | Consolidated Statement of Changes in Stockholders’  Equity and Comprehensive Income for the six months ended  June 30, 2008 and 2007 |   | Page 5 |
|              |   |                      |   |   |   |   |
|              |   |                      |   | Consolidated Statement of Cash Flows for the six  months ended June 30, 2008 and 2007 |   | Page 6 |
|              |   |                      |   |   |   |   |
|              |   |                      |   | Notes to Consolidated Financial Statements |   | Pages 7-12 |
|              |   |                      |   |   |   |   |
|              |   | Item 2.                   |   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |   | Pages 12-22 |
|              |   |                      |   |   |   |   |
|              |   | Item 3.                   |   | Quantitative  and Qualitative Disclosures About Market Risk |   | Page 22 |
|              |   |                      |   |   |   |   |
|              |   | Item 4T.                  |   | Controls and  Procedures |   | Page 23 |
|              |   |                      |   |   |   |   |
| **PART II.** |   | **OTHER INFORMATION**     |   |   |
|              |   |                      |   |   |   |   |
|              |   | Item 1.                   |   | Legal Proceedings |   | Page 23 |
|              |   |                      |   |   |   |   |
|              |   | Item 1 A.                 |   | Risk Factors |   | Pages 23-25 |
|              |   |                      |   |   |   |   |
|              |   | Item 2.                   |   | Unregistered  Sales of Equity Securities and Use of Proceeds |   | Page 25 |
|              |   |                      |   |   |   |   |
|              |   | Item 3.                   |   | Defaults  Upon Senior Securities |   | Page 25 |
|              |   |                      |   |   |   |   |
|              |   | Item 4.                   |   | Submission  of Matters to a Vote of Security Holders |   | Page 25 |
|              |   |                      |   |   |   |   |
|              |   | Item 5.                   |   | Other Information |   | Page 25 |
|              |   |                      |   |   |   |   |
|              |   | Item 6.                   |   | Exhibits |   | Page 25 |
|              |   |                      |   |   |   |   |
|              |   |                      |   | Signatures |   | Page 26 |

 

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**Item 1.    FinancialStatements**

 

**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

**CONSOLIDATED BALANCE SHEET(Unaudited)**

** **
| **(dollars in thousands except share data)**                                                                                                            | ** ** | **June 30, 2008** | ** ** | **December 31, 2007** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|---------------------------------|------------|
| ** **                                                                                                                                                                       | ** ** | ** **                  | ** ** | ** **                      | ** ** |
| **ASSETS**                                                                                                                                                                       | ** ** | ** **                  | ** ** | ** **                      | ** ** |
| **ASSETS**                                                                                                                                                                       | ** ** | ** **                  | ** ** | ** **                      | ** ** |
| Cash and due  from banks                                                                                                                                                         |       | $                           | 13,694     |                            | $          | 16,641 |   |
| Federal funds  sold                                                                                                                                                              |       | —                      |       | 41,195                          |       |
| Investment  securities                                                                                                                                                           |       |                        |       |                            |       |
| Available-for-sale,  at fair value                                                                                                                                               |       | 119,511                     |       | 126,953                         |       |
| Held-to-maturity,  at amortized cost                                                                                                                                             |       | 35,821                      |       | 39,926                          |       |
| Loans held for  sale                                                                                                                                                             |       | 763                         |       | —                          |       |
| Loans                                                                                                                                                                            |       | 377,663                     |       | 355,198                         |       |
| Allowance for  loan losses                                                                                                                                                       |       | (4,051                      | )          | (4,535                          | )          |
| Net loans                                                                                                                                                                        |       | 373,612                     |       | 350,663                         |       |
| Bank premises  and equipment, net                                                                                                                                                |       | 11,800                      |       | 12,095                          |       |
| Other real  estate owned                                                                                                                                                         |       | 6,211                       |       | —                          |       |
| Accrued interest  receivable                                                                                                                                                     |       | 2,949                       |       | 3,464                           |       |
| Other assets                                                                                                                                                                     |       | 3,715                       |       | 1,726                           |       |
| **TOTAL  ASSETS**                                                                                                                                                                |       | $                           | 568,076    |                            | $          | 592,663 |   |
| ** **                                                                                                                                                                       |       |                        |       |                            |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                    | ** ** | ** **                  | ** ** | ** **                      | ** ** |
| **LIABILITIES**                                                                                                                                                                  |       |                        |       |                            |       |
| Deposits                                                                                                                                                                         |       |                        |       |                            |       |
| Interest-bearing                                                                                                                                                                 |       | $                           | 411,619    |                            | $          | 422,463 |   |
| Non-interest-bearing                                                                                                                                                             |       | 73,661                      |       | 77,957                          |       |
| Total deposits                                                                                                                                                                   |       | 485,280                     |       | 500,420                         |       |
| Other borrowings                                                                                                                                                                 |       | 21,268                      |       | 15,851                          |       |
| Other  liabilities                                                                                                                                                               |       | 2,931                       |       | 3,709                           |       |
| Total  liabilities                                                                                                                                                               |       | 509,479                     |       | 519,980                         |       |
|                                                                                                                                                                             |       |                        |       |                            |       |
| **STOCKHOLDERS’  EQUITY**                                                                                                                                                   |       |                        |       |                            |       |
| Common stock no  par value, 5,000,000 shares authorized, 585,975 and 670,997 shares issued and  outstanding  at June 30, 2008 and  December 31, 2007 respectively |       | 11,936                      |       | 13,564                          |       |
| Accumulated  other comprehensive (loss) income, net of tax                                                                                                                       |       | (469                        | )          | 694                             |       |
| Retained  earnings                                                                                                                                                               |       | 47,130                      |       | 58,425                          |       |
| Total  stockholders’ equity                                                                                                                                                 |       | 58,597                      |       | 72,683                          |       |
| **TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                             |       | $                           | 568,076    |                            | $          | 592,663 |   |

 

*See accompanying notes to theseconsolidated financial statements*

 

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**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

**CONSOLIDATED STATEMENT OF INCOME(Unaudited)**

** **
| ** **                                                            | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|-----------------------------------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| **(dollars in thousands except share data)** | ** ** | **2008**                                            | ** ** | **2007**                                          | ** ** | **2008** | ** ** | **2007** | ** ** |
| ** **                                                            |       |                                                |       |                                              |       |   |   |   |   |
| **INTEREST  INCOME**                                                  |       |                                                |       |                                              |       |   |   |   |   |
| Interest and  fees on loans                                           |       | $                                                   | 6,230      |                                              | $          | 6,857 |   | $ | 12,671 |   | $ | 14,076 |   |
| Investment  securities                                                |       |                                                |       |                                              |       |   |   |   |   |
| Taxable                                                               |       | 1,363                                               |       | 1,296                                             |       | 2,869 |   | 2,606 |   |
| Exempt from  federal income tax                                       |       | 309                                                 |       | 255                                               |       | 634 |   | 476 |   |
| Federal funds  sold                                                   |       | 31                                                  |       | 542                                               |       | 273 |   | 962 |   |
| Total interest  income                                                |       | 7,933                                               |       | 8,950                                             |       | 16,447 |   | 18,120 |   |
| **INTEREST  EXPENSE**                                                 |       |                                                |       |                                              |       |   |   |   |   |
| Deposits                                                              |       | 2,522                                               |       | 3,127                                             |       | 5,423 |   | 5,969 |   |
| Other borrowed  funds                                                 |       | 129                                                 |       | 153                                               |       | 253 |   | 285 |   |
| Total interest  expense                                               |       | 2,651                                               |       | 3,280                                             |       | 5,676 |   | 6,254 |   |
| **NET  INTEREST INCOME**                                              |       | 5,282                                               |       | 5,670                                             |       | 10,771 |   | 11,866 |   |
| Provision  (benefit) for loan losses                                  |       | —                                              |       | —                                            |       | — |   | (150 | ) |
| **NET  INTEREST INCOME AFTER**                                        |       |                                                |       |                                              |       |   |   |   |   |
| **PROVISION  (BENEFIT) FOR LOAN LOSSES**                              |       | 5,282                                               |       | 5,670                                             |       | 10,771 |   | 12,016 |   |
| **NON-INTEREST  INCOME**                                              |       |                                                |       |                                              |       |   |   |   |   |
| Service charges  on deposits                                          |       | 775                                                 |       | 630                                               |       | 1,525 |   | 1,178 |   |
| Other                                                                 |       | 180                                                 |       | 219                                               |       | 380 |   | 430 |   |
| Gain on sale of  assets                                               |       | 65                                                  |       | 3                                                 |       | 128 |   | 6 |   |
| Total  non-interest income                                            |       | 1,020                                               |       | 852                                               |       | 2,033 |   | 1,614 |   |
| **NON-INTEREST  EXPENSES**                                            |       |                                                |       |                                              |       |   |   |   |   |
| Salaries                                                              |       | 1,959                                               |       | 1,854                                             |       | 3,880 |   | 3,678 |   |
| Payroll taxes  and employee benefits                                  |       | 454                                                 |       | 435                                               |       | 955 |   | 926 |   |
| Bank premises  and equipment                                          |       | 254                                                 |       | 331                                               |       | 529 |   | 649 |   |
| Occupancy                                                             |       | 200                                                 |       | 165                                               |       | 386 |   | 355 |   |
| State business  taxes                                                 |       | 105                                                 |       | 119                                               |       | 226 |   | 230 |   |
| Advertising                                                           |       | 219                                                 |       | 257                                               |       | 369 |   | 417 |   |
| Other                                                                 |       | 945                                                 |       | 887                                               |       | 1,854 |   | 1,737 |   |
| Total  non-interest expenses                                          |       | 4,136                                               |       | 4,048                                             |       | 8,199 |   | 7,992 |   |
| **INCOME  BEFORE PROVISION FOR INCOME TAX**                           |       | 2,166                                               |       | 2,474                                             |       | 4,605 |   | 5,638 |   |
| **PROVISION  FOR INCOME TAX**                                         |       |                                                |       |                                              |       |   |   |   |   |
| Provision for  Income Tax                                             |       | 455                                                 |       | 570                                               |       | 994 |   | 1,335 |   |
| **NET  INCOME**                                                       |       | $                                                   | 1,711      |                                              | $          | 1,904 |   | $ | 3,611 |   | $ | 4,303 |   |
| **BASIC  EARNINGS PER SHARE**                                         |       | $                                                   | 2.92       |                                              | $          | 2.84 |   | $ | 5.77 |   | $ | 6.40 |   |
| **DILUTED  EARNINGS PER SHARE**                                       |       | $                                                   | 2.89       |                                              | $          | 2.82 |   | $ | 5.72 |   | $ | 6.38 |   |
| **DIVIDENDS  DECLARED PER SHARE**                                     |       | $                                                   | 2.25       |                                              | $          | 2.25 |   | $ | 2.25 |   | $ | 2.25 |   |

 

*Seeaccompanying notes to these consolidated financial statements*

 

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**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

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

** **

Six months ended June 30, 2008 and 2007

* *
| ** **                                                                                            | ** ** | ** **            | ** ** | ** **        | ** ** | **Accum. Other**  | ** ** | ** **             | ** ** | **Total**         | ** ** | ** ** | ** ** |
|-------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|-------------------|------------|------------------------|------------|------------------------|------------|-------------------|------------|------------|------------|
| ** **                                                                                            | ** ** | **Common Stock** | ** ** | **Comprehensive** | ** ** | **Retained**           | ** ** | **Stockholders’** | ** ** | **Comprehensive** | ** ** |
| **(dollars in thousands except share and per share amounts)** | ** ** | **Shares**            | ** ** | **Amount**        | ** ** | **Income (Loss)** | ** ** | **Earnings**           | ** ** | **Equity**        | ** ** | **Income** | ** ** |
| **BALANCE,****January 1, 2007**                                                                  |       | 673,532               |       | $                 | 13,935     |                   | $          | (269                   | )          | $                 | 52,878     |       | $          | 66,544 |   |   |   |
| Comprehensive  income                                                                                 |       |                  |       |              |       |                   |       |                   |       |              |       |       |       |
| Net income                                                                                            |       | —                |       | —            |       | —                 |       | 4,303                  |       | 4,303             |       | $          | 4,303      |   |
| Other  comprehensive income:                                                                          |       |                  |       |              |       |                   |       |                   |       |              |       |       |       |
| Unrealized  losses on available-for-sale securities, net of tax benefit of $332                       |       | —                |       | —            |       | (645                   | )          | —                 |       | (645              | )          | (645       | )          |
| Total other  comprehensive loss                                                                       |       |                  |       |              |       |                   |       |                   |       |              |       | (645       | )          |
| Comprehensive  income                                                                                 |       |                  |       |              |       |                   |       |                   |       |              |       | $          | 3,658      |   |
| Cash dividend  declared, $2.25 per share                                                              |       | —                |       | —            |       | —                 |       | (1,517                 | )          | (1,517            | )          |       |       |
| Common stock  redemption                                                                              |       | (2,088                | )          | (368              | )          | —                 |       | —                 |       | (368              | )          |       |       |
| Stock  compensation expense                                                                           |       | —                |       | 68                |       | —                 |       | —                 |       | 68                |       |       |       |
| **BALANCE,****June 30, 2007**                                                                    |       | 671,444               |       | $                 | 13,635     |                   | $          | (914                   | )          | $                 | 55,664     |       | $          | 68,385 |   |   |   |
|                                                                                                  |       |                  |       |              |       |                   |       |                   |       |              |       |       |       |
| **BALANCE,****January 1, 2008**                                                                  |       | 670,997               |       | $                 | 13,564     |                   | $          | 694                    |       | $                 | 58,425     |       | $          | 72,683 |   |   |   |
| Comprehensive  income                                                                                 |       |                  |       |              |       |                   |       |                   |       |              |       |       |       |
| Net income                                                                                            |       | —                |       | —            |       | —                 |       | 3,611                  |       | 3,611             |       | $          | 3,611      |   |
| Other  comprehensive income:                                                                          |       |                  |       |              |       |                   |       |                   |       |              |       |       |       |
| Unrealized  losses on available-for-sale securities, net of tax benefit of $599                       |       | —                |       | —            |       | (1,163                 | )          | —                 |       | (1,163            | )          | (1,163     | )          |
| Total other  comprehensive loss                                                                       |       |                  |       |              |       |                   |       |                   |       |              |       | (1,163     | )          |
| Comprehensive  income                                                                                 |       |                  |       |              |       |                   |       |                   |       |              |       | $          | 2,448      |   |
| Cash dividend  declared, $2.25 per share                                                              |       | —                |       | —            |       |                   |       | (1,323                 | )          | (1,323            | )          |       |       |
| Common stock  redemption                                                                              |       | (85,022               | )          | (1,721            | )          | —                 |       | (13,583                | )          | (15,304           | )          |       |       |
| Stock  compensation expense                                                                           |       | —                |       | 93                |       | —                 |       | —                 |       | 93                |       |       |       |
| **BALANCE,****June 30, 2008**                                                                    |       | 585,975               |       | $                 | 11,936     |                   | $          | (469                   | )          | $                 | 47,130     |       | $          | 58,597 |   |   |   |

 

*Seeaccompanying notes to these consolidated financial statements*

 

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**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

**CONSOLIDATED STATEMENT OF CASHFLOWS**

**(Unaudited**)

* *
| **(dollars in thousands)**                                                                         | ** ** | ** ** | ** ** | ** ** | ** ** |
|--------------------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| **Six months ended June 30,**                                                            | ** ** | **2008**   | ** ** | **2007**   | ** ** |
| **CASH  FLOWS FROM OPERATING ACTIVITIES**                                                                    |       |       |       |       |       |
| Net income                                                                                                   |       | $          | 3,611      |       | $          | 4,303 |   |
| *Adjustments to reconcile net income to net cash  flows from operating activities*                           |       |       |       |       |       |
| Provision  (benefit) for loan losses                                                                         |       | —     |       | (150       | )          |
| Depreciation                                                                                                 |       | 445        |       | 440        |       |
| Loss (gain) on sale  of other real estate owned                                                              |       | —     |       | (6         | )          |
| Gains on sale of  loans                                                                                      |       | (128       | )          | —     |       |
| Amortization of  investment security                                                                         |       |       |       |       |       |
| premiums and  discounts, net                                                                                 |       | (134       | )          | (100       | )          |
| Provision for  deferred income taxes                                                                         |       | (7         | )          | —     |       |
| Stock  compensation for employee services                                                                    |       | 93         |       | 68         |       |
| *Changes  in operating assets and liabilities*                                                               |       |       |       |       |       |
| Originations of  loans held for sale                                                                         |       | (10,889    | )          | —     |       |
| Proceeds for  sales of loans held for sale                                                                   |       | 10,254     |       | —     |       |
| Decrease  (increase) in interest receivable                                                                  |       | 515        |       | (368       | )          |
| Decrease  (increase) in other assets                                                                         |       | (1,384     | )          | (2,061     | )          |
| Increase  (decrease) in other liabilities                                                                    |       | (778       | )          | 520        |       |
| Net cash flows  from operating activities                                                                    |       | 1,598      |       | 2,646      |       |
| **CASH  FLOWS FROM INVESTING ACTIVITIES**                                                                    |       |       |       |       |       |
| Proceeds from  maturities, calls, and principal paydowns of investment securities –  available-for-sale |       | 25,950     |       | 25,539     |       |
| Purchases of  investment securities – available-for-sale                                                |       | (20,135    | )          | (26,924    | )          |
| Proceeds from  maturities, calls, and principal paydowns of investment securities –  held-to-maturity   |       | 4,105      |       | 2,962      |       |
| Purchases of  investment securities – held-to-maturity                                                  |       | —     |       | (5,243     | )          |
| Net decrease  (increase) in federal funds sold                                                               |       | 41,195     |       | (9,140     | )          |
| Net decrease  (increase) in loans                                                                            |       | (29,151    | )          | (14,251    | )          |
| Purchase of  premises and equipment                                                                          |       | (150       | )          | (354       | )          |
| Capitalized  expenditures for improvements to other real estate owned                                        |       | (9         | )          |       |       |
| Proceeds from  sale of other real estate owned                                                               |       | —     |       | 6          |       |
| Net cash flows  from investing activities                                                                    |       | 21,805     |       | (27,405    | )          |
| **CASH  FLOWS FROM FINANCING ACTIVITIES**                                                                    |       |       |       |       |       |
| Net increase  (decrease) in demand deposits, money market, NOW and savings accounts                          |       | (868       | )          | (7,248     | )          |
| Net increase  (decrease) in time deposits                                                                    |       | (14,272    | )          | 25,847     |       |
| Amount paid for  redemption of common stock                                                                  |       | (15,304    | )          | (368       | )          |
| Net increase  (decrease) in federal funds purchased and securities sold under agreements to  repurchase      |       | 5,417      |       | 3,812      |       |
| Cash dividends                                                                                               |       | (1,323     | )          | (1,517     | )          |
| Net cash flows  from financing activities                                                                    |       | (26,350    | )          | 20,526     |       |
| **NET  CHANGE IN CASH AND DUE FROM BANKS**                                                                   |       | (2,947     | )          | (4,233     | )          |
| **CASH  AND DUE FROM BANKS, beginning of period**                                                            |       | 16,641     |       | 21,535     |       |
| **CASH  AND DUE FROM BANKS, end of period**                                                                  |       | $          | 13,694     |       | $          | 17,302 |   |
| **SUPPLEMENTAL  DISCLOSURES OF CASH FLOW INFORMATION**                                                       | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash paid during  the period for income taxes                                                                |       | $          | 947        |       | $          | 1,720 |   |
| Cash paid during  the period for interest                                                                    |       | 5,857      |       | 6,163      |       |
| **NONCASH  FINANCING AND INVESTING TRANSACTIONS**                                                            |       |       |       |       |       |
| Property taken  in settlement of loans                                                                       |       | 6,202      |       | —     |       |

 

*Seeaccompanying notes to these consolidated financial statements*

 

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**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

**Note 1:   BASIS OF PRESENTATION**

 

The accompanyingconsolidated financial statements include the accounts of Skagit State Bancorp, Inc.and its subsidiary Skagit State Bank, (collectively, “Company” or “Bancorp).All significant inter-company accounts and transactions have been eliminated.The consolidated financial statements have been prepared in conformity withaccounting principles generally accepted in the United States of America forinterim financial information and with instructions to Form 10-Q.Accordingly they do not include all of the information and footnotes required byaccounting 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 six months ended June 30,2008 are not necessarily indicative of the results anticipated for the yearending December 31, 2008. For additional information, refer to the auditedfinancial statements and footnotes for the most recent annual period ended December 31,2007 contained in the Annual Report on Form 10-K.

 

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

 

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

 

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

 

**Note 3:   RECLASSIFICATIONS**

 

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

 

**Note 4:   EARNINGSPER SHARE**

 

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

** **

(dollars in thousandsexcept share and per share amounts)

 
| ** **                                                                      | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|---------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                      | ** ** | **2008**                                            | ** ** | **2007**                                          | ** ** | **2008** | ** ** | **2007** | ** ** |
| Numerator:                                                                      |       |                                                |       |                                              |       |   |   |   |   |
| Net income                                                                      |       | $                                                   | 1,711      |                                              | $          | 1,904 |   | $ | 3,611 |   | $ | 4,303 |   |
| Denominator:                                                                    |       |                                                |       |                                              |       |   |   |   |   |
| Denominator for  basic earnings per share - Weighted average shares outstanding |       | 585,975                                             |       | 672,612                                           |       | 626,150 |   | 672,914 |   |
| Effect of  dilutive securities:                                                 |       |                                                |       |                                              |       |   |   |   |   |
| Stock options  and unvested restricted stock grants                             |       | 5,175                                               |       | 1,467                                             |       | 4,797 |   | 1,486 |   |
| Denominator for  diluted earning per share Weighted average shares outstanding  |       | 591,150                                             |       | 674,079                                           |       | 630,947 |   | 674,400 |   |
| Basic earnings  per share                                                       |       | $                                                   | 2.92       |                                              | $          | 2.84 |   | $ | 5.77 |   | $ | 6.40 |   |
| Diluted earnings  per share                                                     |       | $                                                   | 2.89       |                                              | $          | 2.82 |   | $ | 5.72 |   | $ | 6.38 |   |

 

7

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**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

**Note 5:   CASH DIVIDENDS**

 

On May 6, 2008, Bancorp declared a semi-annual cash dividend of$2.25 per share, payable on June 5, 2008 to shareholders of record as ofthe close of business on May 28, 2008.

 

**Note 6:   SUBSEQUENTEVENTS**

 

On July 11, 2008,Bancorp announced the pending sale of Bancorp’s Boulevard branch located at1575 Burlington Boulevard in Burlington, Washington. We anticipate closing thebranch in early November after regulatory approval has been received.  The Burlington Boulevard Office will remainopen until the closure of the sales transaction. This decision was based onmany factors, including the close proximity of other branches, the volume ofbusiness transactions at this branch and the unique opportunity given thelocation of our branch is next to the outlet mall as it undergoes significantexpansion.  Skagit State Bank has noother closures planned.

 

**Note 7:   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 collectability 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 ofclassified or non-performing loans for specific weaknesses and evaluation ofthose loans for impairment and loss exposure. The unallocated component of theallowance reflects the margin of imprecision inherent in the underlyingassumptions used in the methodologies for estimated specific and general lossesin the loan portfolio.

 

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

 

**Note 8:   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 $93,000 and $68,000 for the six months ended June 30,2008 and June 30, 2007, respectively.

 

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

 

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**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

 

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

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

 

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

 

(dollars in thousandsexcept share and per share amounts)

 
| ** **                           | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise/Grant  Price** | ** ** | **Weighted  Average  Remaining  Contractual Terms  (in years)** | ** ** | **Aggregate  Intrinsic Value** | ** ** |
|--------------------------------------|------------|------------|------------|----------------------------------------------|------------|----------------------------------------------------------------------|------------|-------------------------------------|------------|
| Outstanding at  January 1, 2008 |       | 13,275     |       | $                                            | 163.43     |                                                                 | 8.16       |                                | $          | 300 |   |
| Granted                              |       | 5,056      |       | $                                            | 189.00     |                                                                 | 10.00      |                                | —     |   |
| Exercised                            |       | —     |       | —                                       |       | —                                                               |       | —                              |       |
| Forfeited                            |       | —     |       | —                                       |       | —                                                               |       | —                              |       |
| Outstanding at  June 30, 2008   |       | 18,331     |       | $                                            | 170.48     |                                                                 | 8.20       |                                | $          | 541 |   |
| Exercisable at  June 30, 2008   |       | 2,635      |       | $                                            | 163.44     |                                                                 | 7.64       |                                | $          | 96 |   |

 

The unrecognized share-based compensation cost relating to stock optionexpense at June 30, 2008 is approximately $502,000, 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 six months ended June 30, 2008.

 

(dollars in thousands except share and per shareamounts)

 
| ** **                           | ** ** | **Shares** | ** ** | **Weighted Average  Remaining  Contractual Terms (in  years)** | ** ** | **Weighted  Average Grant-  Date Fair Value** | ** ** | ** ** | ** ** |
|--------------------------------------|------------|------------|------------|--------------------------------------------------------------------------|------------|--------------------------------------------------------------|------------|------------|------------|
| Outstanding at  January 1, 2008 |       | 1,040      |       | 3.68                                                                     |       | $                                                            | —     |       |       |   |
| Granted                              |       | 1,429      |       | 5.00                                                                     |       | 270                                                          |       |       |       |
| Vested                               |       | —     |       | —                                                                   |       | —                                                       |       |       |       |
| Forfeited                            |       | —     |       | —                                                                   |       | —                                                       |       |       |       |
| Outstanding at  June 30, 2008   |       | 2,469      |       | 3.93                                                                     |       | $                                                            | —     |       |       |   |
| Exercisable at  June 30, 2008   |       | —     |       | —                                                                   |       | —                                                       |       |       |       |

 

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**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

 

Recipients of restricted stock awards do not pay any cash considerationto Bancorp for the shares and receive all dividends with respect to all suchshares, whether or not shares have vested. The awards vest over a five year period. Bancorp measures the fair value of each stock award at the date of thegrant and recognizes compensation based on the amount, if any, the market priceof Bancorp’s common stock exceeds the exercise price.  The unrecognized share-based compensationcost relating to restricted stock awards expense at June 30, 2008 is$274,000, which will be recognized over the remaining vesting schedule through2013. The weighted average grant date fair value of restricted stock awardsgranted during 2008 was $189.00 per share.

 

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

 

**Note 9:   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 accountingfor income taxes. FIN 48 provides guidance on de-recognition, classification,interest and penalties and accounting in interim periods and requires expandeddisclosure with respect to uncertainty in income taxes.  Our accounting policy with respect tointerest and penalties arising from income tax settlements is to recognize themas non-interest expense.

 

**Note 10: FINANCIALINSTRUMENTS**

 

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

 

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

 
| Unfunded  commitments to extend credit  |   | $     | 70,021 |   |
|-----------------------------------------|--------|-------|--------|--------|
| Credit card  arrangements               |   | 9,903 |   |
| Commitments to  fund municipal warrants |   | 1,473 |   |
| Standby letters  of credit              |   | 3,325 |   |

 

**Note 11:   FAIR VALUE**

 

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

 

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

 

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

 

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

 

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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 2 inputs. For these securities, Bancorp obtainsfair value measurements from an independent pricing service.  The fair value measurements includesconsiderable observable data that may include dealer quotes, market spreads,cash flows and the yield curve among other things.

 

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

 

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

 

(dollars in thousands)

 
| ** **                     | ** ** | ** ** | ** ** | **Quoted Prices  in Active  Markets for  Identical Assets** | ** ** | **Significant  Other  Observable  Inputs** | ** ** | **Significant  Unobservable  Inputs** | ** ** |
|--------------------------------|------------|------------|------------|---------------------------------------------------------------------------------|------------|--------------------------------------------|------------|---------------------------------------|------------|
| **Description**                | ** ** | **Total**  | ** ** | **(Level 1)**                                                              | ** ** | **(Level 2)**                         | ** ** | **(Level 3)**                    | ** ** |
| Available-for-sale  securities |       | $          | 119,511    |                                                                            | $          | —                                     |       | $                                     | 119,511    |   | $ | — |   |
| Total                          |       | $          | 119,511    |                                                                            | $          | —                                     |       | $                                     | 119,511    |   | $ | — |   |

 

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

 

(dollars in thousands)

 
| ** **      | ** ** | ** ** | ** ** | **Quoted Prices  in Active  Markets for  Identical Assets** | ** ** | **Significant  Other  Observable  Inputs** | ** ** | **Significant  Unobservable  Inputs** | ** ** |
|-----------------|------------|------------|------------|---------------------------------------------------------------------------------|------------|--------------------------------------------|------------|---------------------------------------|------------|
| **Description** | ** ** | **Total**  | ** ** | **(Level 1)**                                                              | ** ** | **(Level 2)**                         | ** ** | **(Level 3)**                    | ** ** |
| Impaired loans  |       | $          | 2,058      |                                                                            | $          | —                                     |       | $                                     | —     |   | $ | 2,058 |   |
| Total           |       | $          | 2,058      |                                                                            | $          | —                                     |       | $                                     | —     |   | $ | 2,058 |   |

 

In accordance with FASBStatement No. 114, “Accounting for Creditors for Impairment of a Loan”,impaired loans, with carrying amounts of $2.1 million had specific reserveallocations totaling $193,000, which were included in the allowance for loanlosses.

 

**Note 12:   NEW ACCOUNTING PRONOUNCEMENTS**

 

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

 

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**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

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

 

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

 

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

* *

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

 

**FORWARD LOOKING STATEMENTS**

** **

Inaddition to historical information, this report contains certain “forwardlooking statements” within the meaning of the Private Securities LitigationReform Act of 1995 (PSLRA).  Thisstatement is included for the express purpose of availing Bancorp of theprotections of the safe harbor provision of the PSLRA.  The forward-looking statements contained inthis report are subject to factors, risk, and uncertainties that may causeactual results to differ materially from those projected.  Important factors that might cause such amaterial difference include, but are not limited to, those discussed in thissection of the report.  In addition, thefollowing items are among the factors that could cause actual results to differmaterially from the forward looking statements in this report: general economicconditions, including the continued softening of the real estate market;business conditions in the banking industry; the regulatory environment; new legislation;vendor quality and efficiency; employee retention factors; rapidly changingtechnology and evolving banking industry standards; competitive factors,including increased competition with community, regional, and nationalfinancial institutions; fluctuating interest rate environments; and similarmatters.  Readers are cautioned not toplace undue reliance on these forward-looking statements, which reflectmanagement’s analysis only as of the date of the statement.  Bancorp undertakes no obligation to publiclyreview or update these forward-looking statements to reflect events orcircumstances that arise after the date of this report.  Readers should carefully review any riskfactors described in this and other documents we file from time to time with theSecurities and Exchange Commission.

 

**OVERVIEW**

 

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

 

Net income was $1.7million and $1.9 million for the quarters ended June 30, 2008 and 2007with diluted earnings per share at $2.89 and $2.82, respectively. Net incomewas $3.6 million and $4.3 million for the six months ended June 30, 2008and 2007 with diluted earnings per share at $5.72 and $6.38, respectively.  The decreases in net income were primarilyattributable to decreases in interest income, which was partially offset byincreases in non-interest income. For purposes of comparability, the six monthsended June 30, 2007 was favorably impacted by a $495,000 interest recoveryon one loan relationship and a $150,000 benefit for loan losses compared tozero provision for loan losses in 2008.

 

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Annualized return onaverage assets was 1.19 percent and 1.24 percent for the quarter and six monthsending June 30, 2008 compared to 1.38 percent and 1.59 percent during thesame time periods in 2007.  Annualizedreturn on average equity was 11.47 percent and 10.98 percent for the quarterand six months ending June 30, 2008 compared to 11.06 percent and 12.63percent, respectively, for the same time periods in 2007.

 

Total assets decreased to$568.1 million at June 30, 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 $22.9 million to$373.6 million at June 30, 2008, compared to $350.7 million at December 31,2007.

 

**RESULTS OF OPERATIONS**

 

Bancorp’s results ofoperations are dependent to a large degree on net interest income, operatingefficiency and the level of the provision for loan losses. Bancorp’s operationsare sensitive to interest rate changes and the resulting impact on net interestincome. In addition, changes in net interest income are influenced by thevolume of assets and liabilities and the rates earned and 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 governmentpolicies and the actions of regulatory authorities.

 

Net interest income was$5.3 million and $10.8 million for the quarter and six months ended June 30,2008 compared to $5.7 million and $11.9 million for the like periods in 2007.  These decreases were primarily due to thefact that interest-earning assets re-priced more rapidly at lower interestrates than interest-bearing liabilities. In addition, for the six months ended June 30,2007, Bancorp recorded a $495,000 interest recovery on 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.  TheFederal Reserve decreased rates 100 basis points in 2007 and through June 30,2008 have decreased rates another 225 basis points. Bancorp’s prime rate movesin conjunction with the federal funds rate. For the quarter and six months ended June 30, 2008, the netinterest margin decreased to 3.97 percent and 3.98 percent from 4.39 percentand 4.71 percent for the like periods in 2007, respectively. These decreaseswere primarily a result of the more rapid decrease in the yield oninterest-earning assets than cost of funds as our assets tend to reprice morequickly than our deposits.  Alsocontributing to the decline in net interest margin, was an interest recoveryfrom one loan relationship of approximately $495,000 which contributed 19 basispoints to the net interest margin for the six months ended June 30, 2007.

 

*Interest-earning assets*

 

The largest component ofinterest income is interest earned on loans. Total interest income earned from loans was $6.2 million and $12.7million for the quarter and six months ended June 30, 2008 compared to$6.9 million and $14.1 for the like periods in 2007.  For the current quarter, this decrease wasprimarily a result of the current declining interest rate environment whichdecreased the yield earned on loans from 8.35 percent to 6.84 percent.  Partially offsetting the decrease in yieldwas an increase in the average balance of loans by $37.1 million compared tothe same time period in 2007.  For thesix months ended June 30, 2008 compared to the like period in 2007, yieldearned on loans decreased from 8.72 percent to 7.09 percent.  Partially offsetting the decrease in yieldwas an increase in the average balance of loans by $33.7 million compared tothe same time period in 2007.  Inaddition, for the six months ended June 30, 2007, Bancorp recorded a$495,000 interest recovery on one loan relationship.

 

Interest earned oninvestments and federal funds sold decreased $390,000 and $268,000 for thequarter and six months ended June 30, 2008 compared to the like periods in2007. Interest earned on investments increased by $121,000 and $421,000 for thequarter and six months ended June 30, 2008, compared to the like periodsin 2007.  This was primarily due to increasedaverage balances.  Within the investmenttotal, interest on federal funds decreased $511,000 and $689,000 for thequarter and six months ended June 30, 2008 compared to the like periods in2007. This was the result of a 313 basis point and 225 basis point decrease inyield and a $37.1 million and $18.7 million decrease in the average balance forthe quarter and six months ended June 30, 2008 and 2007, respectively.

 

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*Interest- bearing liabilities*

 

Interest expensedecreased to $2.7 million and $5.7 million from $3.3 million and $6.3 millionfor the quarter and six months ended June 30, 2008 and 2007, respectively.These decreases were a result of a 79 basis point and a 55 basis point decreasein the cost of funds for the quarter and six months ended June 30, 2008compared to 2007. Partially offsetting the decreases in the cost of funds wasan increase in the average balance of interest bearing liabilities to $438.9million and to $438.2 million for the quarter and six months ended June 30,2008. The majority of our deposits are short term and re-price within a 12month period.

 

The following tablespresent information regarding average balances of assets and liabilities aswell as the total amounts of interest income from average interest-earningassets and interest expense on average interest-bearing liabilities, resultingyield and cost ratios, interest rate spread and net interest margin. Tax exemptsecurities, included in investment securities below are stated at theircontractual interest rate. Loan fees of $282,000 and $543,000 for the quarterand six months ended June 30, 2008, and $283,000 and $533,000 for thequarter and six months ended June 30, 2007, respectively, are included ininterest earned on loans. Non-accruing loans have been included in thecomputation of average loans.

 

**CondensedAverage Balance Sheets**

(dollars in thousands except share data)

 
| ** **                                          | ** ** | **2008**    | ** ** | **2007**     | ** ** |
|-----------------------------------------------------|------------|-------------|------------|--------------|------------|
| ** **                                          | ** ** | **Average** | ** ** | ** **   | ** ** | **Yield** | ** ** | **Average** | ** ** | ** ** | ** ** | **Yield** | ** ** |
| **Three months ended June 30,** | ** ** | **Balance** | ** ** | **Interest** | ** ** | **/Cost** | ** ** | **Balance** | ** ** | **Interest** | ** ** | **/Cost** | ** ** |
| **Assets**                                          |       |        |       |         |       |   |   |   |   |   |   |   |   |
| Federal funds  sold                                 |       | $           | 6,888      |         | $          | 31 |   | 1.81 | % | $ | 43,978 |   | $ | 542 |   | 4.94 | % |
| Taxable  investment securities                      |       | 111,518     |       | 1,363        |       | 4.92 |   | 101,881 |   | 1,296 |   | 5.10 |   |
| Tax exempt  securities                              |       | 49,916      |       | 309          |       | 2.49 |   | 42,717 |   | 255 |   | 2.39 |   |
| Loans                                               |       | 366,429     |       | 6,230        |       | 6.84 |   | 329,322 |   | 6,857 |   | 8.35 |   |
| Total  interest-earning assets                      |       | 534,751     |       | 7,933        |       | 5.97 | % | 517,898 |   | 8,950 |   | 6.93 | % |
| Non-interest  earning assets                        |       | 38,381      |       |         |       |   |   | 34,633 |   |   |   |   |   |
| Total assets                                        |       | $           | 573,132    |         |       |   |   |   | $ | 552,531 |   |   |   |   |   |
|                                                |       |        |       |         |       |   |   |   |   |   |   |   |   |
| **Liabilities  and Stockholders’ Equity**      |       |        |       |         |       |   |   |   |   |   |   |   |   |
| Interest-bearing  demand                            |       | $           | 89,688     |         | $          | 116 |   | 0.52 | % | $ | 84,960 |   | $ | 272 |   | 1.28 | % |
| Savings and  money market                           |       | 148,368     |       | 515          |       | 1.40 |   | 142,077 |   | 789 |   | 2.23 |   |
| Certificates of  deposit                            |       | 181,450     |       | 1,891        |       | 4.19 |   | 165,991 |   | 2,066 |   | 4.99 |   |
| Total  interest-bearing deposits                    |       | 419,506     |       | 2,522        |       | 2.42 |   | 393,028 |   | 3,127 |   | 3.19 |   |
| Federal Funds  purchased and                        |       |        |       |         |       |   |   |   |   |   |   |   |   |
| repurchase  agreements                              |       | 19,385      |       | 129          |       | 2.68 |   | 15,470 |   | 153 |   | 3.97 |   |
| Total  interest-bearing deposits                    |       |        |       |         |       |   |   |   |   |   |   |   |   |
| &  liabilities                                  |       | 438,891     |       | 2,651        |       | 2.43 | % | 408,498 |   | 3,280 |   | 3.22 | % |
| Non  interest-bearing demand                        |       |        |       |         |       |   |   |   |   |   |   |   |   |
| deposits                                            |       | 71,623      |       |         |       |   |   | 71,352 |   |   |   |   |   |
| Other  non-interest-bearing                         |       |        |       |         |       |   |   |   |   |   |   |   |   |
| liabilities                                         |       | 2,946       |       |         |       |   |   | 3,794 |   |   |   |   |   |
| Total  liabilities                                  |       | 513,460     |       |         |       |   |   | 483,644 |   |   |   |   |   |
| Stockholders’  equity                          |       | 59,672      |       |         |       |   |   | 68,887 |   |   |   |   |   |
| Total  liabilities and stockholders                 |       |        |       |         |       |   |   |   |   |   |   |   |   |
| equity                                              |       | $           | 573,132    |         |       |   |   |   | $ | 552,531 |   |   |   |   |   |
| Net interest  income                                |       |        |       | $            | 5,282      |   |   |   |   |   | $ | 5,670 |   |   |   |
| Interest rate  spread                               |       |        |       |         |       | 3.54 | % |   |   |   |   | 3.71 | % |
| Net interest  margin                                |       |        |       |         |       | 3.97 | % |   |   |   |   | 4.39 | % |

 

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**CondensedAverage Balance Sheets**

(dollars in thousands except share data)

 
| ** **                                        | ** ** | **2008**    | ** ** | **2007**     | ** ** |
|---------------------------------------------------|------------|-------------|------------|--------------|------------|
| ** **                                        | ** ** | **Average** | ** ** | ** **   | ** ** | **Yield** | ** ** | **Average** | ** ** | ** ** | ** ** | **Yield** | ** ** |
| **Six months ended June 30,** | ** ** | **Balance** | ** ** | **Interest** | ** ** | **/Cost** | ** ** | **Balance** | ** ** | **Interest** | ** ** | **/Cost** | ** ** |
| **Assets**                                        |       |        |       |         |       |   |   |   |   |   |   |   |   |
| Federal funds  sold                               |       | $           | 18,631     |         | $          | 273 |   | 2.95 | % | $ | 37,323 |   | $ | 962 |   | 5.20 | % |
| Taxable investment  securities                    |       | 116,054     |       | 2,869        |       | 4.97 |   | 103,636 |   | 2,606 |   | 5.07 |   |
| Tax exempt  securities                            |       | 50,265      |       | 634          |       | 2.54 |   | 41,169 |   | 476 |   | 2.33 |   |
| Loans                                             |       | 359,369     |       | 12,671       |       | 7.09 |   | 325,625 |   | 14,076 |   | 8.72 |   |
| Total  interest-earning assets                    |       | 544,319     |       | 16,447       |       | 6.08 | % | 507,753 |   | 18,120 |   | 7.20 | % |
| Non-interest  earning assets                      |       | 35,788      |       |         |       |   |   | 35,062 |   |   |   |   |   |
| Total assets                                      |       | $           | 580,107    |         |       |   |   |   | $ | 542,815 |   |   |   |   |   |
|                                              |       |        |       |         |       |   |   |   |   |   |   |   |   |
| **Liabilities  and Stockholders’ Equity**    |       |        |       |         |       |   |   |   |   |   |   |   |   |
| Interest-bearing  demand                          |       | $           | 90,015     |         | $          | 253 |   | 0.57 | % | $ | 83,635 |   | $ | 540 |   | 1.30 | % |
| Savings and  money market                         |       | 145,715     |       | 1,039        |       | 1.43 |   | 140,993 |   | 1,533 |   | 2.19 |   |
| Certificates of  deposit                          |       | 185,040     |       | 4,131        |       | 4.49 |   | 159,463 |   | 3,896 |   | 4.93 |   |
| Total  interest-bearing deposits                  |       | 420,770     |       | 5,423        |       | 2.61 |   | 384,091 |   | 5,969 |   | 3.13 |   |
| Federal Funds  purchased and                      |       |        |       |         |       |   |   |   |   |   |   |   |   |
| repurchase  agreements                            |       | 17,381      |       | 253          |       | 2.93 |   | 14,923 |   | 285 |   | 3.85 |   |
| Total  interest-bearing deposits                  |       |        |       |         |       |   |   |   |   |   |   |   |   |
| &  liabilities                                |       | 438,151     |       | 5,676        |       | 2.61 | % | 399,014 |   | 6,254 |   | 3.16 | % |
| Non  interest-bearing demand                      |       |        |       |         |       |   |   |   |   |   |   |   |   |
| deposits                                          |       | 73,079      |       |         |       |   |   | 72,143 |   |   |   |   |   |
| Other  non-interest-bearing                       |       |        |       |         |       |   |   |   |   |   |   |   |   |
| liabilities                                       |       | 3,126       |       |         |       |   |   | 3,508 |   |   |   |   |   |
| Total  liabilities                                |       | 514,356     |       |         |       |   |   | 474,665 |   |   |   |   |   |
| Stockholders’  equity                        |       | 65,751      |       |         |       |   |   | 68,150 |   |   |   |   |   |
| Total  liabilities and stockholders equity        |       | $           | 580,107    |         |       |   |   |   | $ | 542,815 |   |   |   |   |   |
| Net interest  income                              |       |        |       | $            | 10,771     |   |   |   |   |   | $ | 11,866 |   |   |   |
| Interest rate  spread                             |       |        |       |         |       | 3.47 | % |   |   |   |   | 4.04 | % |
| Net interest  margin                              |       |        |       |         |       | 3.98 | % |   |   |   |   | 4.71 | % |

 

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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 thousands exceptper share amounts)

 
| ** **                                             | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|--------------------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                             | ** ** | **2008 vs. 2007**                         | ** ** | **2008 vs. 2007**                       | ** ** |
| ** **                                             | ** ** | **Increase (Decrease) Due to**       | ** ** | **Increase (Decrease) Due to**     | ** ** |
| ** **                                             | ** ** | **Rate**                                            | ** ** | **Volume**                                        | ** ** | **Total** | ** ** | **Rate** | ** ** | **Volume** | ** ** | **Total** | ** ** |
| **Interest-Earning  Assets**                           | ** ** | ** **                                          | ** ** | ** **                                        | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Federal funds  sold                                    |       | $                                                   |  (219 | )                                                 | $          |  (292 | ) | $ |  (511 | ) | $ |  (320 | ) | $ |  (369 | ) | $ |  (689 | ) |
| Investment  securities                                 |       | (245                                                | )          | 366                                               |       | 121 |   | (95 | ) | 516 |   | 421 |   |
| Loans                                                  |       | (4,208                                              | )          | 3,581                                             |       | (627 | ) | (4,686 | ) | 3,281 |   | (1,405 | ) |
| Total net change  in income on Interest-earning assets |       | (4,672                                              | )     | 3,655                                             |       | (1,017 | )   | (5,101 | )   | 3,428 |   | (1,673 | ) |
|                                                   |       |                                                |       |                                              |       |   |   |   |   |   |   |   |   |
| **Interest-Bearing  Liabilities**                      |       |                                                |       |                                              |       |   |   |   |   |   |   |   |   |
| Deposits                                               |       | (2,059                                              | )          | 1,454                                             |       | (605 | ) | (2,056 | ) | 1,510 |   | (546 | ) |
| Federal funds  purchased and repurchase agreements     |       | (188                                                | )     | 164                                               |       | (24 | )   | (131 | )   | 99 |   | (32 | ) |
| Interest-bearing  liabilities                          |       | (2,247                                              | )     | 1,618                                             |       | (629 | )   | (2,187 | )   | 1,609 |   | (578 | ) |
|                                                   |       |                                                |       |                                              |       |   |   |   |   |   |   |   |   |
| Net change in  net interest income                     |       | $                                                   | (2,425     | )                                                 | $          | 2,037 |   | $ | (388 | ) | $ | (2,914 | ) | $ | 1,819 |   | $ | (1,095 | ) |

 

**NON-INTEREST INCOME               **Non-interestincome, which consists primarily of fees and service charges on deposits andother income, was $1.0 million and $2.0 million for the quarter and six monthsended June 30, 2008 compared to $852,000 and $1.6 million for the quarterand six months ended June 30, 2007. In July 2007, Bancorp beganoffering a new overdraft protection product to its checking account customersand due primarily to this new product overdraft and non-sufficient fund feesincreased $120,000 and $297,000 for the quarter and six months ended June 30,2008 compared to like periods in 2007. In addition, during May 2007, Bancorp expanded its home loandepartment and as a result brokered loan fees, processing fees and gains on thesale of loans increased $18,000 and $62,000 for the quarter and six monthsended June 30, 2008 compared to the like periods in 2007.

 

**NON-INTEREST EXPENSE             **Non-interestexpense was $4.1 million and $8.2 million for the quarter and six months ended June 30,2008 compared to $4.0 million and $8.0 million in the like periods in2007.  These increases were primarilyattributable to increases in salary expense. Salary expense increased 5.7percent and 5.5 percent for the quarter and six months ended June 30, 2008compared to the like periods in 2007.

 

The efficiency ratio iscomputed by dividing total operating expenses by non-interest income and netinterest income after provision for loan losses.  An increase in the efficiency ratio indicatesthat more resources are being utilized to generate the same or greater volumeof income. The efficiency ratio for the quarter and six months ended June 30,2008 was 65.6 percent and 64.0 percent compared to 62.1 percent and 58.6percent for the same time periods in 2007. The increase from 2007 was primarilydue to decreases in interest income.

 

**INCOMETAX EXPENSE                 **Incometax expense for the quarter and six months ended June 30, 2008 was $455,000 and$994,000 million compared to $570,000 and $1.3 million for the quarter and sixmonths ended June 30, 2007, respectively. Bancorp’s effective tax rateswere 21.6 percent and 23.7 percent for the six months ended June 30, 2008and 2007, respectively. The effective tax rate is lower than the federal statutoryrate due to tax credits from tax-exempt bonds and tax-exempt interest frommunicipal bonds and loans.  As of June 30,2008, Bancorp had $48.1 million in tax-exempt securities compared to $43.6million as of June 30, 2007.

 

**REVIEW OF FINANCIAL CONDITION**

** **

Total assets decreased to$568.1 million at June 30, 2008 compared to $592.7 million at December 31,2007.  This decrease was primarily due toa $15.3 million repurchase of Skagit State Bancorp stock during 2008, a $15.1million decrease in deposits, and a $52.7 million decrease in federal fundssold and investment securities.  Totalloans increased $22.9 million during the same time period.

 

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** **

**INVESTMENTSECURITIES AND FEDERAL FUNDS SOLD  **Totalinvestment securities decreased to $155.3 million at June 30, 2008compared to $166.9 million at December 31, 2007. Security purchases were$20.1 million in the first six months of 2008, which was partially offset bymaturities, calls and principal pay-downs of $30.1 million.  Bancorp had no federal funds sold as of June 30,2008 compared to $41.2 million at December 31, 2007.  This decreased primarily as a result of there-purchase of $15.3 million in Bancorp stock and the growth in total loans.

 

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

 

Certain investmentsecurities included in the table below currently have fair values less thanamortized cost and, therefore, contain unrealized losses.  Bancorp has evaluated these securities andbelieves that the decline in value is temporary and is related to the changesin market interest rates since purchase, with no permanent sector or issuercredit concerns or impairments.

 

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

 

**Investment Securities Composition**

**June 30, 2008** (dollars in thousands)

 
| **AFS Securities**           | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses (less  than 12  months)** | ** ** | **Gross  Unrealized  Losses (12  months or  more)** | ** ** | **Aggregate  Fair Value** | ** ** |
|-----------------------------------|------------|---------------------|------------|------------------------------|------------|-----------------------------------------------------------------|------------|---------------------------------------------------------------|------------|--------------------------------|------------|
| US Government  Agencies           |       | $                   | 43,680     |                         | $          | 454                                                             |       | $                                                             | 134        |                           | $          | — |   | $ | 44,000 |   |
| Mortgage-backed-securities        |       | 64,330              |       | 94                           |       | 1,155                                                           |       | —                                                        |       | 63,269                         |       |
| State and  Political subdivisions |       | 12,212              |       | 78                           |       | 48                                                              |       | —                                                        |       | 12,242                         |       |
|                              |       | 120,222             |       | 626                          |       | 1,337                                                           |       | —                                                        |       | 119,511                        |       |
|                              |       |                |       |                         |       |                                                            |       |                                                          |       |                           |       |
| **HTM  Securities**               |       |                |       |                         |       |                                                            |       |                                                          |       |                           |       |
| State and  political subdivisions |       | 35,821              |       | 101                          |       | 6                                                               |       | 193                                                           |       | 35,723                         |       |
|                              |       | 35,821              |       | 101                          |       | 6                                                               |       | 193                                                           |       | 35,723                         |       |
|                              |       |                |       |                         |       |                                                            |       |                                                          |       |                           |       |
| Total                             |       | $                   | 156,043    |                         | $          | 727                                                             |       | $                                                             | 1,343      |                           | $          | 193 |   | $ | 155,234 |   |

** **

**December 31, 2007** (dollars in thousands)

 
| ** **

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

 

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**LOANS                **Netloans increased 6.5 percent to $373.6 million at June 30, 2008 compared to$350.7 million at December 31, 2007. The total loan portfolio represented 65.8 percent of total assets at June 30,2008.

 

Bancorpconcentrates on five areas of lending: loans to individuals for businesspurposes, loans for small and medium-sized businesses, agricultural loans,loans to commercial enterprises for real estate transactions and consumerpurpose loans.  Bancorp’s primary lendingactivities include commercial real estate loans, commercial loans which includeagriculture production loans and consumer purpose loans. Most of Bancorp’sbusiness activity is with customers located within Skagit, Snohomish andWhatcom Counties. Bancorp originates commercial, real estate and consumerloans.

 

*Real Estate Loans:*Real estate loans comprise the largest category of loans and our real estateportfolio consists of commercial and residential loans which are secured byproperty such as office buildings, retail buildings, owner occupied commercialbusiness properties, farm land, timber land, residential land developmentproperties and residential properties. The primary repayment source of these specific loan types are from thecash flows generated by the occupant business or occupant farm operation. WhileBancorp has significant balances secured by real estate, Bancorp believes thatits lending policies and concentration policies are sufficient to minimizerisks.  However, economic conditions mayaffect a borrower’s ability to meet the stated repayment terms. Bancorp iscommitted to providing competitive commercial real estate lending within ourprimary market areas.

 

*Commercial Loans*:Commercial loans, secured and unsecured, are made primarily to small andmedium-sized businesses including farms operating within Skagit, Snohomish andWhatcom Counties.  These loans areavailable for general operating purposes, acquisition of fixed assets, purchasesof equipment and machinery, financing of inventory and accounts receivable, andother business purposes.  Bancorporiginates Small Business Administration (SBA) loans, including 504 and 7Aloans.

 

*Consumer Loans:*Bancorp makes secured and unsecured consumer loans including loans toindividuals, primarily customers of Bancorp, for various purposes, includinghome equity loans, purchases of automobiles, mobile homes, boats and otherrecreational vehicles, home improvement loans and loans for education andpersonal investments.

 

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

 

**Loan Composition**

 
| ** **                                            | ** ** | **June 30, 2008** | ** ** | **December 31, 2007** | ** ** |
|-------------------------------------------------------|------------|-----------------------------|------------|---------------------------------|------------|
| **(dollars in thousands)**                  | ** ** | **Amount**                  | ** ** | **%**                           | ** ** | **Amount** | ** ** | **%** | ** ** |
| Real estate –  residential & commercial |       | $                           | 244,793    |                            | 64.6       | % | $ | 229,680 |   | 64.4 | % |
| Real estate  construction                             |       | 16,153                      |       | 4.3                             | %          | 21,468 |   | 6.0 | % |
| Commercial,  industrial & agricultural       |       | 80,228                      |       | 21.1                            | %          | 70,040 |   | 19.6 | % |
| Consumer                                              |       | 37,831                      |       | 10.0                            | %          | 35,411 |   | 10.0 | % |
| Total loans                                           |       | 379,005                     |       | 100                             | %          | 356,599 |   | 100 | % |
| Less:                                                 |       |                        |       |                            |       |   |   |   |   |
| Allowance for  loan losses                            |       | (4,051                      | )          |                            |       | (4,535 | ) |   |   |
| Deferred loan  fees                                   |       | (1,342                      | )          |                            |       | (1,401 | ) |   |   |
| Net loans                                             |       | $                           | 373,612    |                            |       |   | $ | 350,663 |   |   |   |

* *

*Concentrations*

* *

As shown in the tableabove a concentration in commercial and residential real estate existed as of June 30,2008.  At June 30, 2008, Bancorp’s portfolio included $59.0 millionin raw land, land development and construction loans, $64.2 million innon-owner non-occupied non-farm commercial real estate, $46.4 million inone-to-four family residential loans with the remaining real estate loanscentered primarily in owner-occupied non residential real estate loans andfarmland loans.  Although management believes that loans within the realestate area have no more than the normal risk of collectability, a substantialdecline in the performance of the economy, in general, or a decline in realestate values in our market areas, in particular, could have an adverse impacton collectability, increase the level of real estate non-performing loans orhave other adverse effects which alone or in aggregate could have a materialadverse effect on our business, financial condition, results of operation andcash flows.

 

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**PROVISIONAND ALLOWANCE FOR LOAN LOSSES**          Theallowance for loan losses was $4.1 million or 1.08 percent of net loans as of June 30,2008.  This compares to $4.5 million or1.29 percent of total loans as of December 31, 2007.

 

The allowance for loan losses reflectsmanagement’s current estimate of the level deemed adequate to provide forestimated future losses. Bancorp has a systematic methodology for evaluating the adequacy of theallowance for loan losses and the allowance is evaluated on a quarterly basisand reviewed by the Board of Directors. The allowance consists of specific,general and 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 collectability 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 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.

 

Bancorp monitors its loanportfolio for potential risk of loss according to an internal risk-gradingsystem. And  monitors its credit qualityto identify potential problem credits and any loss exposure in a timely manner.  Bancorp has assessed and will continue toassess on an on-going basis, the impact of the economy on the credit risk inthe loan portfolio.  While Bancorpbelieves that it uses the best information available to determine the allowancefor loan losses, unforeseen market conditions could result in adjustments tothe allowance for loan losses, and net income could be significantly affectedif circumstances differ substantially from the assumptions used in making thefinal determination.  Additionally, loansare subject to examinations by regulators, who, based upon their judgment, mayrequire Bancorp to make additional provisions or adjustments to its allowancefor loan losses.

 

Loans deemeduncollectible, in whole or in part are charged against and reduce the allowancefor loan losses. Net charges-offs for the quarter and six months ended June 30,2008 were $47,000 and $484,000 compared to $152,000 and $160,000 for the likeperiods in 2007. For the first quarter of 2008, gross charge-offs includedcharge-offs of approximately $434,000 on one credit relationship.

 

For the quarter end andsix months ended June 30, 2008, Bancorp reported no provision, compared tono provision and a $150,000 benefit for loan losses, for the like periods in2007. The provision for loan losses is highly dependent upon Bancorp’s abilityto manage asset quality and control the level of net-charge-offs throughprudent underwriting standards. In the future, normal growth of the loanportfolio may require an increase in the allowance for loan losses. In addition,declines in general economic conditions could increase future provisions forloan losses and impact Bancorp’s net income.

 

*Credit Risk Management*

* *

The extension of creditto individuals and businesses is a significant portion of Bancorp’s principal businessactivity 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.

 

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

 

**Allowance for Loan LossesActivity**

** **
| ** **                                                   | ** ** | **Three months ended,** | ** ** | **Six months ended,** | ** ** |
|--------------------------------------------------------------|------------|-----------------------------------|------------|---------------------------------|------------|
| **(dollars in thousands)**                         | ** ** | **2008**                          | ** ** | **2007**                        | ** ** | **2008** | ** ** | **2007** | ** ** |
| Allowance as  of  beginning of year                     |       | $                                 | 4,098      |                            | $          | 5,018 |   | $ | 4,535 |   | $ | 5,176 |   |
| Provision  (benefit) for loan losses                         |       | —                            |       | —                          |       | — |   | (150 | ) |
| Charge-offs                                                  |       | (94                               | )          | (286                            | )          | (634 | ) | (331 | ) |
| Recoveries                                                   |       | 47                                |       | 134                             |       | 150 |   | 171 |   |
| Net charge-offs                                              |       | (47                               | )          | (152                            | )          | (484 | ) | (160 | ) |
| Balance at end  of period                                    |       | $                                 | 4,051      |                            | $          | 4,866 |   | $ | 4,051 |   | $ | 4,866 |   |
| Ratio of net  charge-offs to average loans during the period |       | (0.05                             | )%         | (0.18                           | )%         | (0.27 | )% | (0.10 | )% |
| Ratio of allowance  to net loans at end of period            |       | 1.08                              | %          | 1.45                            | %          | 1.08 | % | 1.45 | % |
| Ratio of  non-performing loans to allowance                  |       | 50.80                             | %          | 111.59                          | %          | 50.80 | % | 111.59 | % |

** **

***ASSETQUALITY*    **Non-performingassets consist of nonaccrual loans, accruing loans past due 90 days or more andother real estate owned and at June 30, 2008 increased to $8.3 million or1.46 percent of total assets compared to $7.7 million or 1.30 percent as of December 31,2007.

 

*Non-accrualand impaired loans* - It is Bancorp’s policy to discontinuethe accrual of interest on all loans that are 90 days or more past due andplace them on non-accrual.  When a loanis placed on non-accrual status, any accrued but unpaid interest on that dateis removed from interest income. For the six month ended June 30, 2008,$1.4 million additional loans were put on non-accrual status.  Non-accruing loans were $2.1 million as of June 30,2008 compared to $7.7 million as of December 31, 2007 with $6.9 million ofthe December 2007 balance transferring into other real estate owned duringthe six months ended June 30, 2008.

 

At June 30, 2008impaired loans decreased to $2.1 million compared to $7.7 million at December 31,2007.  As noted above, $6.9 million inimpaired loans was transferred to other real estate owned during the six monthsended June 30, 2008. As of June 30, 2008, a $170,000 specificallocation relating to two credit relationships was included in the allowancefor loan losses. One acquisition and development loan, represented by onecredit relationship of $1.1 million, accounted for 55.4 percent of impairedloans as of June 30, 2008. Subsequent to June 30, 2008, this property was transferred intoother real estate owned. All material loan restructurings have been included inimpaired loans.

 

*Otherreal estate owned* – For the six months ended June 30,2008, Bancorp foreclosed on three non-accrual credit relationships which weretransferred into other real estate owned. These represent three separate landdevelopment projects consisting of finished lots.  The carrying value of those properties was$6.2 million as of June 30, 2008. Subsequent to June 30, 2008, an additional $1.1 million propertywas transferred into other real estate owned.

 

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. The following table presents non-performing asset informationrelated to loans accounted for on a non-accrual basis, accruing loans 90 daysor more past due and other real estate owned for the dates indicated.

 

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**Non-Performing Assets**

** **
| **(dollars in thousands)**         | ** ** | **June 30, 2008** | ** ** | **December 31, 2007** | ** ** |
|----------------------------------------------|------------|-----------------------------|------------|---------------------------------|------------|
| Non-accrual  loans                           |       | $                           | 2,058      |                            | $          | 7,690 |   |
| Loans past due  90 days or more              |       | —                      |       | —                          |       |
| Total  non-performing loans                  |       | 2,058                       |       | 7,690                           |       |
| Other real  estate owned                     |       | 6,211                       |       | —                          |       |
| Total  non-performing assets                 |       | $                           | 8,269      |                            | $          | 7,690 |   |
| Total  non-performing loans to net loans     |       | 0.55                        | %          | 2.19                            | %          |
| Total  non-performing loans to total assets  |       | 0.36                        | %          | 1.30                            | %          |
| Total  non-performing assets to total assets |       | 1.46                        | %          | 1.30                            | %          |

** **

**DEPOSITS****          **Bancorp offers afull range of deposit services including checking accounts, savings accounts,money market accounts and various types of certificates of deposit.  The transaction accounts and certificates ofdeposit are tailored to Bancorp’s primary market area at rates competitive withthose offered in the area. Bancorp offers both interest and non-interestbearing checking accounts.

 

Total deposits decreasedto $485.3 million at June 30, 2008 compared to $500.4 million at December 31,2007.  Within the total, time depositsdecreased $14.3 million while core deposits decreased $868,000. Time depositsdecreased to 36.4 percent of deposits at June 30, 2008 compared to 38.2percent 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**

** **
| ** **                           | ** ** | **June 30, 2008** | ** ** | **December 31, 2007** | ** ** |
|--------------------------------------|------------|-----------------------------|------------|---------------------------------|------------|
| **(dollars in thousands)** | ** ** | **Amount**                  | ** ** | **% of Total**        | ** ** | **Amount** | ** ** | **% of Total** | ** ** |
| Non-interest  bearing demand         |       | $                           | 73,661     |                            | 15.2       | % | $ | 77,957 |   | 15.5 | % |
| Interest bearing  demand             |       | 88,190                      |       | 18.2                            | %          | 89,830 |   | 18.0 | % |
| Money market                         |       | 71,403                      |       | 14.7                            | %          | 67,857 |   | 13.6 | % |
| Savings                              |       | 74,986                      |       | 15.5                            | %          | 73,464 |   | 14.7 | % |
| Time                                 |       | 177,040                     |       | 36.4                            | %          | 191,312 |   | 38.2 | % |
| Total deposits                       |       | $                           | 485,280    |                            | 100.0      | % | $ | 500,420 |   | 100.0 | % |

** **

**BORROWINGS     **Total borrowings, includingsecurities sold under agreements to repurchase and federal funds purchased,increased to $21.3 million at June 30, 2008 compared to $15.9 million asof December 31, 2007. Federal funds purchased are typically used to fundshort-term liquidity needs and securities sold under agreement to repurchasedecrease or increase primarily based on the availability of funds and currentcompetitive interest rates offered. Securities sold under agreement to repurchase are collateralized bysecurities with an estimated fair value exceeding the face value of theborrowings.

 

**CAPITAL RESOURCES**    Stockholders’ equity decreasedto $58.6 million at June 30, 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 during the first quarter of 2008. Book value pershare at June 30, 2008 was $100.00 compared to a book value of $108.32 at December 31,2007.

 

Bancorp has only oneclass of stock. Bancorp’s stock is not actively traded or quoted and no brokercurrently makes a market in the stock. However, sales and transfers of thestock do occur.  Skagit State Bank actsas transfer agent for Bancorp stock.  Tofacilitate trading, the Bank maintains a list of persons interested (known tothe Bank) in either purchasing or selling Bancorp stock.  Purchasers and sellers then negotiate theirown transactions with the Bank acting as transfer agent for those transactions.

 

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

 

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

 

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| ** **                                | ** ** | ** ** | ** ** | ** **                 | ** ** | ** **                 | ** ** | ** **                 | ** ** | **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  June 30, 2008                 |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| Total Capital  (to Risk-Weighted Assets)  |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |   |
| Skagit State  Bank                        |       | $          | 62,966     |                       | 13.74      | %                          | $          | 36,672                     | >  |                       | 8.00       | % | $ | 45,839 | >  |   | 10.00 | % |
| Skagit State  Bancorp, Inc.          |       | $          | 63,117     |                       | 13.77      | %                          | $          | 36,682                     | >  |                       | 8.00       | % | $ | 45,852 | >  |   | 10.00 | % |
| Tier I Capital  (to Risk-Weighted Assets) |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |   |   |
| Skagit State  Bank                        |       | $          | 58,915     |                       | 12.85      | %                          | $          | 18,336                     | >  |                       | 4.00       | % | $ | 27,504 | >  |   | 6.00 | % |
| Skagit State  Bancorp, Inc.          |       | $          | 59,066     |                       | 12.88      | %                          | $          | 18,341                     | >  |                       | 4.00       | % | $ | 27,511 | >  |   | 6.00 | % |
| Tier I Capital  (to Average Assets)       |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |   |   |
| Skagit State  Bank                        |       | $          | 58,915     |                       | 10.31      | %                          | $          | 22,850                     | >  |                       | 4.00       | % | $ | 28,562 | >  |   | 5.00 | % |
| Skagit State  Bancorp, Inc.          |       | $          | 59,066     |                       | 10.34      | %                          | $          | 22,850                     | >  |                       | 4.00       | % | $ | 28,562 | >  |   | 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**

** **

The principal objectiveof liquidity management is to maintain the Bank’s ability to meet the day today cash flow requirements of either its depositors wanting to withdraw fundsor to provide for customers credit needs. Liquidity is generated from bothinternal and external sources. The majority of funding comes from customerdeposits within the Bank’s market area. These funds, together with loanrepayments, investment securities repayments, earnings and other borrowingthrough pre-approved credit lines are used to provide liquidity.  Liquidity is can also obtained by maintainingassets that are readily convertible to cash through maturities and sales.  As of June 30, 2008 Bancorp had $35.0million in approved credit lines from various financial institutions.

 

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

 

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

** **

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

 

Bancorp maintains anasset/liability management program which is the responsibility of theAsset/Liability Committee.  The objectiveof asset/liability management is to maximize long-term stockholder returns andto manage, protect and stabilize Bancorp’s net interest income from undueinterest rate risk through various interest 

 

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rate cycles within theconstraints of credit quality, interest rate risk policies, levels of capitaland adequate levels of liquidity.  Thecommittee meets to monitor the composition of the balance, to review projectedearnings trends, and to formulate strategies consistent with these objectives forliquidity, interest rate risk, and capital adequacy.

 

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

 

# **Item 4T.**CONTROLS AND PROCEDURES

# ** **

Evaluation of DisclosureControls and Procedures

 

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

 

Changes in InternalControls

 

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

 

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

 

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

 

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

 

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

** **

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

 

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

** **

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

 

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

** **

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

 

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**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 time thereare loans included in the portfolio that will result in losses, but that havenot 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 financial conditionof borrowers, such as may result from changes in economic conditions, or as aresult 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 68.9 percent of totalloans.  Our real estate portfolioconsists of commercial and residential lending. These loans are secured by property such as office buildings, commercialbusiness properties, healthcare buildings, agricultural land, timber land andresidential properties.  Commercial andcommercial real estate loans generally are viewed as having more risk ofdefault than residential real estate loans or certain other types of loans orinvestments.  Typically, these types ofloans are larger than residential real estate loans and other loans.  Because the loan portfolio contains a numberof commercial real estate loans with relatively large balances, thedeterioration of one or a few of these loans may cause a significant increasein nonperforming loans.  An increase innonperforming loans could result in; a loss of earnings from these loans; anincrease in the provision for loan losses; or an increase in loan charge-offs,which could have an adverse impact on our results of operations and financialcondition.

 

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

** **

**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 greater financialresources than we do.  We compete forfunds with other financial institutions that, in most cases, are larger andable to provide a greater variety of services than we do and thus may obtaindeposits at lower rates of interest.  Ifwe are unable to effectively compete in our market area, our business andresults 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.

 

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

** **

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

 

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

** **

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

 

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

** **

**The FDIClikely will increase insurance premiums to rebuild and maintain the federaldeposit insurance fund.**

** **

Based on recent eventsand the state of the economy, it is likely that the FDIC may increase federaldeposit insurance premiums as early as September 2008.  Depending on circumstances, this increase maybe relatively significant and will add to our cost of operations.  It is too soon to predict the exact amount ofany premium increase or the impact on the Company.

 

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

** **

                None

 

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

** **

**               **None

** **

# **Item 4.**                    Submission ofMatters to a Vote of Security Holders

# ** **

(a)   Skagit State Bancorp’s, Inc.Annual Shareholder Meeting was held on April 22, 2008.

(b)   Not Applicable

(c)   A brief description of eachmatter voted upon at the Annual Meeting and number of votes cast for, againstor withheld, including a separate tabulation with respect to each nominee toserve on the Board is presented below:

 

(1)   Election of two (2) directorsfor terms expiring in 2011 or until their successor is nominated and hasqualified.

 
| Directors:      |    |
|-----------------|---------|
| Cheryl Bishop   |    |
| Votes For:      | 541,442 |   |
| Votes Withheld: | 1,320   |   |
| B. Marvin Omdal |    |   |
| Votes For:      | 541,442 |   |
| Votes Withheld: | 1,320   |   |

 

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

** **

                None

 

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

** **

(a)           Exhibits.

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

 

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**SIGNATURES**

 

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

 

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

                     |   | Executive  Vice-President   |
|   |                              |   | Chief Financial Officer     |

 

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