Table of Contents

 

 

 

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**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 March 31, 2010** |
| ** **                                             | ** **                                                                                             |
| **o**                                                  | **Transition Report Under Section 13 or 15(d) of  the Exchange Act**                         |

 

**For thetransition period from                   to                  **

 

**CommissionFile Number  000-52096**

 

**SKAGIT STATE BANCORP, INC.**

(Exact Name of Registrant asSpecified in Its Charter)

 

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

 

**301 East Fairhaven Avenue**

**Burlington, Washington  98233**

(Address of PrincipalExecutive Offices) (Zip Code)

 

**(360) 755-0411**

(Registrant’s TelephoneNumber, Including Area Code)

 

Indicate by check mark whether the registrant:  (1) has filed all reports required to befiled by Section 13 or 15(d) of the Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filing requirementsfor the past 90 days.  Yes x  No o

 

Indicate by check mark whether the registrant has submittedelectronically and posted on its corporate Web site, if any, every InteractiveData File required to be submitted and posted pursuant to Rule 405 ofRegulation S-T (§232.405 of this chapter) during the preceding 12 months (orfor such shorter period that the registrant was required to submit and postsuch files).  Yes  o  No o

 

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated 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 | Accelerated  filer o         |
|--------------------------------|-----------------------------------|
|                           |                              |
| Non-accelerated filer o   | Smaller  Reporting Company x |

 

Indicate by check mark whether the registrant is a shell company (asdefined in Rule 12b-2 of the Exchange  Yes o  No x

 

**Indicate the number of sharesoutstanding of each of the issuer’s classes of common stock, as of the latestpracticable date:**

 

The number of shares of the issuer’s Common Stockoutstanding at May 13, 2010 was 588,469.

 

 

 

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**SKAGIT STATE BANCORP, INC.**

**TABLE OF CONTENTS**

 
| **PART I.**  | **FINANCIAL INFORMATION** |                                                                                                                                              |
|-------------------|---------------------------|---------------------------------------------------------------------------------------------------------------------------------------------------|
|              |                      |                                                                                                                                              |   |
|              | Item 1.                   | Financial Statements                                                                                                                              |   |
|              |                      |                                                                                                                                              |   |
|              |                      | Consolidated  Balance Sheet as of March 31, 2010 and December 31, 2009                                                                  | Page 3 |
|              |                      |                                                                                                                                              |   |
|              |                      | Consolidated  Statement of Income for the three months ended March 31, 2010 and 2009                                                         | Page 4 |
|              |                      |                                                                                                                                              |   |
|              |                      | Consolidated Statement of Changes in Stockholders’  Equity and Comprehensive Income for the three months ended March 31,  2010 and 2009 | Page 5 |
|              |                      |                                                                                                                                              |   |
|              |                      | Consolidated Statement of Cash Flows for the three  months ended March 31, 2010 and 2009                                                     | Page 6 |
|              |                      |                                                                                                                                              |   |
|              |                      | Notes to Consolidated Financial Statements                                                                                                        | Pages 7-15 |
|              |                      |                                                                                                                                              |   |
|              | Item 2.                   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                                       | Pages 15-27 |
|              |                      |                                                                                                                                              |   |
|              | Item 3.                   | Quantitative  and Qualitative Disclosures About Market Risk                                                                                       | Page 27 |
|              |                      |                                                                                                                                              |   |
|              | Item 4T.                  | Controls and  Procedures                                                                                                                          | Page 27 |
|              |                      |                                                                                                                                              |   |
| **PART II.** | **OTHER INFORMATION**     |                                                                                                                                              |
|              |                      |                                                                                                                                              |   |
|              | Item 1.                   | Legal Proceedings                                                                                                                                 | Page 27 |
|              |                      |                                                                                                                                              |   |
|              | Item 1 A.                 | Risk Factors                                                                                                                                      | Page 27-30 |
|              |                      |                                                                                                                                              |   |
|              | Item 2.                   | Unregistered Sales of Equity Securities  and Use of Proceeds                                                                                      | Page 30 |
|              |                      |                                                                                                                                              |   |
|              | Item 3.                   | Defaults Upon Senior Securities                                                                                                                   | Page 30 |
|              |                      |                                                                                                                                              |   |
|              | Item 4.                   | Removed and Reserved                                                                                                                              | Page 30 |
|              |                      |                                                                                                                                              |   |
|              | Item 5.                   | Other Information                                                                                                                                 | Page 30 |
|              |                      |                                                                                                                                              |   |
|              | Item 6.                   | Exhibits                                                                                                                                          | Page 30 |
|              |                      |                                                                                                                                              |   |
|              |                      | Signatures                                                                                                                                        | Pages 31 |

 

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**Item 1.   FinancialStatements**

 

**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

**CONSOLIDATED BALANCE SHEET(Unaudited)**

** **
| **(dollars  in thousands except share data)**                                                                                                                               | ** ** | **March 31, 2010** | ** ** | **December 31, 2009** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|----------------------------|------------|
| ** **                                                                                                                                                                  | ** ** | ** **              | ** ** | ** **                 | ** ** |
| **ASSETS**                                                                                                                                                                  | ** ** |
| ** **                                                                                                                                                                  | ** ** | ** **              | ** ** | ** **                 | ** ** |
| **ASSETS**                                                                                                                                                                  | ** ** | ** **              | ** ** | ** **                 | ** ** |
| Cash  and due from banks                                                                                                                                                    |       | $                       | 10,102     |                       | $          | 14,441 |   |
| Federal  funds sold                                                                                                                                                         |       | 94,089                  |       | 62,531                     |       |
| Investment  securities                                                                                                                                                      |       |                    |       |                       |       |
| Available-for-sale,  at fair value                                                                                                                                          |       | 115,727                 |       | 118,561                    |       |
| Held-to-maturity,  at amortized cost                                                                                                                                        |       | 40,725                  |       | 40,298                     |       |
| Loans  held for sale                                                                                                                                                        |       | 661                     |       | 574                        |       |
| Loans                                                                                                                                                                       |       | 389,457                 |       | 393,532                    |       |
| Allowance  for loan losses                                                                                                                                                  |       | (7,280                  | )          | (6,883                     | )          |
| Net  loans                                                                                                                                                                  |       | 382,177                 |       | 386,649                    |       |
| Bank  premises and equipment, net                                                                                                                                           |       | 11,168                  |       | 10,944                     |       |
| Other  real estate owned                                                                                                                                                    |       | 7,344                   |       | 6,284                      |       |
| Accrued  interest receivable                                                                                                                                                |       | 2,386                   |       | 2,531                      |       |
| Other  assets                                                                                                                                                               |       | 4,958                   |       | 5,075                      |       |
| **TOTAL ASSETS**                                                                                                                                                            |       | $                       | 669,337    |                       | $          | 647,888 |   |
| ** **                                                                                                                                                                  | ** ** | ** **              | ** ** | ** **                 | ** ** |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                              | ** ** |
| ** **                                                                                                                                                                  | ** ** | ** **              | ** ** | ** **                 | ** ** |
| **LIABILITIES**                                                                                                                                                             |       |                    |       |                       |       |
| Deposits                                                                                                                                                                    |       |                    |       |                       |       |
| Interest-bearing                                                                                                                                                            |       | $                       | 496,099    |                       | $          | 471,597 |   |
| Non-interest-bearing                                                                                                                                                        |       | 71,763                  |       | 73,839                     |       |
| Total  deposits                                                                                                                                                             |       | 567,862                 |       | 545,436                    |       |
| Other  borrowings                                                                                                                                                           |       | 35,178                  |       | 38,128                     |       |
| Other  liabilities                                                                                                                                                          |       | 1,615                   |       | 1,467                      |       |
| Total  liabilities                                                                                                                                                          |       | 604,655                 |       | 585,031                    |       |
|                                                                                                                                                                        |       |                    |       |                       |       |
| **STOCKHOLDERS’ EQUITY**                                                                                                                                               |       |                    |       |                       |       |
| Common  stock no par value, 5,000,000 shares authorized, 587,194 and 586,905 shares  issued and outstanding at March 31, 2010 and December 31, 2009  respectively |       | 12,367                  |       | 12,303                     |       |
| Accumulated  other comprehensive income, net of tax                                                                                                                         |       | 2,424                   |       | 1,872                      |       |
| Retained  earnings                                                                                                                                                          |       | 49,891                  |       | 48,682                     |       |
| Total  stockholders’ equity                                                                                                                                            |       | 64,682                  |       | 62,857                     |       |
| **TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                         |       | $                       | 669,337    |                       | $          | 647,888 |   |

 

*See accompanying notes to theseconsolidated financial statements*

 

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**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

**CONSOLIDATED STATEMENT OF INCOME(Unaudited)**

 
| ** **                                                  | ** ** | **For the three months ended March 31,** | ** ** |
|-------------------------------------------------------------|------------|-----------------------------------------------|------------|
| **(dollars  in thousands except per share data)**           | ** ** | **2010**                                      | ** ** | **2009** | ** ** |
| ** **                                                  |       |                                          |       |   |   |
| **INTEREST INCOME**                                         |       |                                          |       |   |   |
| Interest  and fees on loans                                 |       | $                                             | 5,640      |   | $ | 5,907 |   |
| Investment  securities                                      |       |                                          |       |   |   |
| Taxable                                                     |       | 1,018                                         |       | 1,070 |   |
| Exempt  from federal income tax                             |       | 274                                           |       | 281 |   |
| Federal  funds sold                                         |       | 49                                            |       | 1 |   |
| Total  interest income                                      |       | 6,981                                         |       | 7,259 |   |
| **INTEREST EXPENSE**                                        |       |                                          |       |   |   |
| Deposits                                                    |       | 1,520                                         |       | 1,734 |   |
| Other  borrowings                                           |       | 82                                            |       | 89 |   |
| Total  interest expense                                     |       | 1,602                                         |       | 1,823 |   |
| **NET INTEREST INCOME**                                     |       | 5,379                                         |       | 5,436 |   |
| Provision  for loan losses                                  |       | 550                                           |       | 450 |   |
| **NET INTEREST INCOME AFTER****PROVISION FOR  LOAN LOSSES** |       | 4,829                                         |       | 4,986 |   |
| **NON-INTEREST INCOME**                                     |       |                                          |       |   |   |
| Service  charges on deposits                                |       | 713                                           |       | 708 |   |
| Other                                                       |       | 181                                           |       | 200 |   |
| Gain  on sale of loans                                      |       | 51                                            |       | 52 |   |
| Total  non-interest income                                  |       | 945                                           |       | 960 |   |
| **NON-INTEREST EXPENSES**                                   |       |                                          |       |   |   |
| Salaries                                                    |       | 1,905                                         |       | 1,981 |   |
| Payroll  taxes and employee benefits                        |       | 496                                           |       | 515 |   |
| Provision  for other real estate owned losses               |       | 20                                            |       | — |   |
| Bank  premises and equipment                                |       | 228                                           |       | 242 |   |
| Occupancy                                                   |       | 197                                           |       | 224 |   |
| State  business taxes                                       |       | 91                                            |       | 98 |   |
| Advertising                                                 |       | 157                                           |       | 149 |   |
| Deposit  Insurance                                          |       | 230                                           |       | 293 |   |
| Other                                                       |       | 1,023                                         |       | 1,036 |   |
| Total  non-interest expenses                                |       | 4,347                                         |       | 4,538 |   |
| **INCOME BEFORE PROVISION FOR INCOME TAX**                  |       | 1,427                                         |       | 1,408 |   |
| **PROVISION FOR INCOME TAX**                                |       |                                          |       |   |   |
| Provision  for Income Tax                                   |       | 218                                           |       | 210 |   |
| **NET INCOME**                                              |       | $                                             | 1,209      |   | $ | 1,198 |   |
| **BASIC EARNINGS PER SHARE**                                |       | $                                             | 2.06       |   | $ | 2.04 |   |
| **DILUTED EARNINGS PER SHARE**                              |       | $                                             | 2.05       |   | $ | 2.03 |   |

 

*Seeaccompanying notes to these consolidated financial statements*

 

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**SKAGIT STATE BANCORP, INC. ANDSUBSIDIARY**

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

Three months ended March 31, 2010 and 2009

 
| ** **                                                               | ** ** | ** **       | ** ** | ** **        | ** ** | **Accum. Other** | ** ** | ** **             | ** ** | **Total**         | ** ** | ** ** | ** ** |
|--------------------------------------------------------------------------|------------|------------------|------------|-------------------|------------|------------------|------------|------------------------|------------|-------------------|------------|------------|------------|
| ** **                                                               | ** ** | **Common Stock** | ** ** | **Comprehensive** | ** ** | **Retained**     | ** ** | **Stockholders’** | ** ** | **Comprehensive** | ** ** |
| **(dollars  in thousands except share and per share amounts)**           | ** ** | **Shares**       | ** ** | **Amount**        | ** ** | **Income**       | ** ** | **Earnings**           | ** ** | **Equity**        | ** ** | **Income** | ** ** |
| **BALANCE,**January 1,  2009                                        |       | 586,285          |       | $                 | 12,042     |             | $          | 2,325                  |       | $                 | 47,434     |       | $          | 61,801 |   |   |   |
| Comprehensive income:                                                    |       |             |       |              |       |             |       |                   |       |              |       |       |       |
| Net income                                                               |       | —           |       | —            |       | —           |       | 1,198                  |       | 1,198             |       | $          | 1,198      |   |
| Other comprehensive income:                                              |       |             |       |              |       |             |       |                   |       |              |       |       |       |
| Unrealized gains on available-for-sale securities,  net of taxes of $50  |       | —           |       | —            |       | 98               |       | —                 |       | 98                |       | 98         |       |
| Total other comprehensive income                                         |       |             |       |              |       |             |       |                   |       |              |       | 98         |       |
| Comprehensive income                                                     |       |             |       |              |       |             |       |                   |       |              |       | $          | 1,296      |   |
| Stock options exercised                                                  |       | 25               |       | 4                 |       | —           |       | —                 |       | 4                 |       |       |       |
| Stock compensation expense and restricted stock  awards                  |       | 285              |       | 64                |       | —           |       | —                 |       | 64                |       |       |       |
| **BALANCE,**March 31,  2009                                         |       | 586,595          |       | $                 | 12,110     |             | $          | 2,423                  |       | $                 | 48,632     |       | $          | 63,165 |   |   |   |
|                                                                     |       |             |       |              |       |             |       |                   |       |              |       |       |       |
| **BALANCE,**January 1,  2010                                        |       | 586,905          |       | $                 | 12,303     |             | $          | 1,872                  |       | $                 | 48,682     |       | $          | 62,857 |   |   |   |
| Comprehensive income:                                                    |       |             |       |              |       |             |       |                   |       |              |       |       |       |
| Net income                                                               |       | —           |       | —            |       | —           |       | 1,209                  |       | 1,209             |       | $          | 1,209      |   |
| Other comprehensive income:                                              |       |             |       |              |       |             |       |                   |       |              |       |       |       |
| Unrealized gains on available-for-sale securities,  net of taxes of $284 |       | —           |       | —            |       | 552              |       | —                 |       | 552               |       | 552        |       |
| Total other comprehensive income                                         |       |             |       |              |       |             |       |                   |       |              |       | 552        |       |
| Comprehensive income                                                     |       |             |       |              |       |             |       |                   |       |              |       | $          | 1,761      |   |
| Stock compensation expense and restricted stock  awards                  |       | 289              |       | 64                |       | —           |       | —                 |       | 64                |       |       |       |
| **BALANCE,**March 31,  2010                                         |       | 587,194          |       | $                 | 12,367     |             | $          | 2,424                  |       | $                 | 49,891     |       | $          | 64,682 |   |   |   |

 

*Seeaccompanying notes to these consolidated financial statements*

 

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**SKAGIT STATE BANCORP, INC. ANDSUBSIDIARY**

**CONSOLIDATED STATEMENT OF CASHFLOWS (Unaudited**)

 
| **(dollars  in thousands)**                                                                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
|-------------------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| **Three  months ended March 31,**                                                                      | ** ** | **2010**   | ** ** | **2009**   | ** ** |
| **CASH FLOWS FROM OPERATING  ACTIVITIES**                                                                   |       |       |       |       |       |
| Net income                                                                                                  |       | $          | 1,209      |       | $          | 1,198 |   |
| *Adjustments to reconcile net  income to net**cash flows from operating activities*                         |       |       |       |       |       |
| Provision for loan losses                                                                                   |       | 550        |       | 450        |       |
| Provision for other real estate owned losses                                                                |       | 20         |       | —     |       |
| Depreciation                                                                                                |       | 212        |       | 219        |       |
| Gains on sale of loans                                                                                      |       | (51        | )          | (52        | )          |
| Amortization of investment securitypremiums and discounts, net                                              |       | (29        | )          | (40        | )          |
| Stock compensation for employee services                                                                    |       | 64         |       | 64         |       |
| *Changes in operating assets and  liabilities*                                                              |       |       |       |       |       |
| Originations of loans held for sale                                                                         |       | (3,976     | )          | (4,314     | )          |
| Proceeds from sales of loans held for sale                                                                  |       | 3,940      |       | 4,560      |       |
| Decrease (increase) in interest receivable                                                                  |       | 145        |       | (56        | )          |
| (Increase) decrease in other assets                                                                         |       | (167       | )          | 689        |       |
| (Decrease) increase in other liabilities                                                                    |       | 148        |       | (1,327     | )          |
| Net cash flows from operating activities                                                                    |       | 2,065      |       | 1,391      |       |
| **CASH FLOWS FROM INVESTING  ACTIVITIES**                                                                   |       |       |       |       |       |
| Proceeds from maturities, calls, and principal  payments of investment securities – available-for-sale |       | 8,697      |       | 2,573      |       |
| Purchases of investment securities –  available-for-sale                                               |       | (5,000     | )          | —     |       |
| Proceeds from maturities, calls, and principal  payments of investment securities – held-to-maturity   |       | 1,032      |       | 355        |       |
| Purchases of investment securities –  held-to-maturity                                                 |       | (1,457     | )          | (1,308     | )          |
| Net increase in federal funds sold                                                                          |       | (31,558    | )          | (18,642    | )          |
| Net decrease in loans                                                                                       |       | 2,503      |       | 8,848      |       |
| Purchase of premises and equipment                                                                          |       | (97        | )          | (52        | )          |
| Capitalized expenditures for improvements to other  real estate owned                                       |       | —     |       | (69        | )          |
| Net cash flows from investing activities                                                                    |       | (25,880    | )          | (8,295     | )          |
| **CASH FLOWS FROM FINANCING  ACTIVITIES**                                                                   |       |       |       |       |       |
| Net increase in demand deposits, money market, NOW  and savings accounts                                    |       | 13,884     |       | 12,580     |       |
| Net increase in time deposits                                                                               |       | 8,542      |       | 9,489      |       |
| Net decrease in other borrowings                                                                            |       | (2,950     | )          | (17,377    | )          |
| Proceeds from exercise of stock options                                                                     |       | —     |       | 4          |       |
| Net cash flows from financing activities                                                                    |       | 19,476     |       | 4,696      |       |
| **NET CHANGE IN CASH AND DUE FROM  BANKS**                                                                  |       | (4,339     | )          | (2,208     | )          |
| **CASH AND DUE FROM BANKS,**beginning of  period                                                            |       | 14,441     |       | 11,954     |       |
| **CASH AND DUE FROM BANKS,** end of period                                                                  |       | $          | 10,102     |       | $          | 9,746 |   |
| **SUPPLEMENTAL DISCLOSURES OF CASH  FLOW INFORMATION**                                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash paid during the period for income taxes                                                                |       | $          | 375        |       | $          | 166 |   |
| Cash paid during the period for interest                                                                    |       | $          | 1,663      |       | $          | 1,808 |   |
| **NONCASH FINANCING AND INVESTING  TRANSACTIONS**                                                           |       |       |       |       |       |
| Property taken in settlement of loans                                                                       |       | $          | 1,419      |       | $          | 1,163 |   |

 

* See accompanying notes to these consolidatedfinancial statements*

 

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**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

**Note 1:  BASISOF PRESENTATION**

The accompanyingconsolidated financial statements include the accounts of Skagit State Bancorp, Inc.and its subsidiary Skagit State Bank, (collectively, “Company” or “Bancorp”).All significant inter-company accounts and transactions have been eliminated.The consolidated financial statements have been prepared in conformity withaccounting principles generally accepted in the United States of America forinterim financial information and with instructions to Form 10-Q.Accordingly they do not include all of the information and footnotes requiredby accounting principles generally accepted in the United States of America forcomplete financial statements. In the opinion of management, all adjustments(consisting of normal recurring accruals) considered necessary for a fairpresentation have been included. Operating results for the three months ended March 31,2010 are not necessarily indicative of the results anticipated for the yearending December 31, 2010. For additional information, refer to the auditedfinancial statements and footnotes for the most recent annual period ended  December 31, 2009 contained in theAnnual Report on Form 10-K.  Alldollar amounts in tables, except share and per share information, are stated inthousands.

 

**Note 2:  CRITICALACCOUNTING 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. Bancorpconsiders accounting estimates to be critical to reported financial results if (i) theaccounting estimate requires management to make assumptions about matters thatare highly uncertain and (ii) different estimates that managementreasonably could have used for the accounting estimate in the current period,or changes in the accounting estimate that are reasonably likely to occur fromperiod to period, could have a material impact on Bancorp’s financialstatements. Management has identified specific accounting policies that due tojudgments, estimates and assumptions and economic assumptions which may proveinaccurate or are subject to variation that may significantly affect ourreported results of operations and financial positions for the periodspresented or in future periods.  Thesepolicies relate to the determination of the allowance for loan losses, deferredincome taxes and the valuation of real estate owned and investment securities.These policies and the judgments, estimates and assumptions are described inthe Annual Report on Form 10-K for the year ended December 31, 2009.

 

**Note 3:  RECLASSIFICATIONS**

Certain reclassificationshave been made to the 2009 financial statements to conform to the 2010presentation. Such classifications have no affect on net income.

 

**Note 4:  SUBSEQUENTEVENTS**

Subsequent events areevents or transactions that occur after the balance sheet date, but beforefinancial statements are issued. Recognized subsequent events are events or transactions that provideadditional evidence about conditions that existed at the date of the balancesheet.  Non-recognized subsequent eventsare events that provided evidence about conditions that did not exist at thedate of the balance sheet, but arose after that date.

 

**Note 5:  NEW ACCOUNTINGPRONOUNCEMENTS**

In January 2010, theFASB issued ASU 2010-06, an update to ASC 820-10, “Fair Value Measurements”.This update adds a new requirement to disclose transfers in and out of level 1and level 2, along with the reasons for the transfers, and requires a grosspresentation of purchases and sales of level 3 activities. Additionally, theupdate clarifies that entities provide fair value measurement disclosures foreach class of assets and liabilities and that entities provide enhanceddisclosures around level 2 valuation techniques and inputs. Bancorp adopted thedisclosure requirements for level 1 and level 2 transfers and the expanded fairvalue measurement and valuation disclosures effective January 1, 2010. Thedisclosure requirements for level 3 activities are effective for Bancorp on January 1,2011. The adoption of the disclosure requirements for level 1 and level 2transfers and the expanded qualitative disclosures had no impact on Bancorp’sfinancial position, results of operations, and earnings per share. Bancorp doesnot expect the adoption of the level 3 disclosure requirements to have animpact on its financial position, results of operations, and earnings pershare.

 

On February 24,2010, the FASB issued ASU 2010-09, “Subsequent Events’ Amendments to Certain Recognitionand Disclosure Requirements”.  ASU2010-09 amends ASC 855 to address certain implementation issues related to anentity’s requirement to perform and disclose subsequent events. It requiresmost entities to evaluate subsequent events through the date the financialstatements are issued and it exempts SEC filers from disclosing the datethrough which subsequent events have been evaluated. The implementation of thisguidance was effective for

 

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**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

**NOTESTO CONSOLIDATED FINANCIAL STATEMENTS**

 

interim and annualperiods ending after June 15, 2009. The implementation of this guidance did not have a material impact onthe consolidated financial statements.

 

**Note 6:  EARNINGS PER SHARE**

Basic earnings per shareamounts are computed based on the weighted average number of sharesoutstanding. Diluted earnings per share is calculated by dividing net income bydiluted weighted average shares outstanding, which includes common stockequivalents outstanding using the treasury stock method.

 

(dollars in thousandsexcept share and per share amounts)

 
| **Three  months ended March 31,**                                          | ** ** | **2010** | ** ** | **2009** | ** ** |
|---------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| Numerator:                                                                      |       |     |       |     |       |
| Net  income                                                                     |       | $        | 1,209      |     | $          | 1,198 |   |
| Denominator:                                                                    |       |     |       |     |       |
| Denominator  for basic earnings per share - Weighted average shares outstanding |       | 587,043  |       | 586,443  |       |
| Effect  of dilutive securities:                                                 |       |     |       |     |       |
| Stock  options and unvested restricted stock grants                             |       | 1,472    |       | 4,985    |       |
| Denominator  for diluted earning per share Weighted average shares outstanding  |       | 588,515  |       | 591,428  |       |
| Basic  earnings per share                                                       |       | $        | 2.06       |     | $          | 2.04 |   |
| Diluted  earnings per share                                                     |       | $        | 2.05       |     | $          | 2.03 |   |

 

**Note 7:  STOCK-BASED COMPENSATION**

Bancorp has oneshare-based payment plan, which is shareholder approved, and permits the grantof share-based awards to its employees and directors up to 100,000 shares andat March 31, 2010 there were 68,710 common shares available for grant.Total equity compensation expense was $64,000 for the three months ended March 31,2010 and 2009, respectively.

 

**Stock Options**: No grants of options were awarded forthe quarter ended March 31, 2010. All options granted during 2009 were Incentive Stock Options and weregranted at a price equal to the market value of the stock on the grant date,have a term of 10 years and vest over a five year period.  Bancorp measures the fair value of each stockoption at the date of the grant, using the Black Scholes option valuationmodel.  The application of this valuationmodel involves assumptions that are judgmental and sensitive in thedetermination of compensation expense. The unrecognized share-based compensation cost relating to stock optionexpense at March 31, 2010 was $461,000, which will be recognized over theremaining vesting schedule through 2014.

 

The following tablesummarizes the activity related to options outstanding during the three monthsended March 31, 2010. The aggregate intrinsic value represents the totalpretax intrinsic value (amount by which the fair value of the underlying stockexceeds the exercise price of an option or award, times the number of shares):

 

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**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

(dollars in thousandsexcept share and per share amounts)

 
| ** **                           | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise/Grant  Price** | ** ** | **Weighted  Average  Remaining  Contractual Terms** | ** ** | **Aggregate  Intrinsic Value** | ** ** |
|--------------------------------------|------------|------------|------------|----------------------------------------------|------------|-----------------------------------------------------|------------|--------------------------------|------------|
| Outstanding  at January 1, 2010 |       | 28,761     |       | $                                            | 179.40     |                                                | 7.58       |                           | $          | — |   |
| Granted                              |       | —     |       | —                                       |       | —                                              |       | —                         |       |
| Exercised                            |       | —     |       | —                                       |       | —                                              |       | —                         |       |
| Forfeited                            |       | —     |       | —                                       |       | —                                              |       | —                         |       |
| Outstanding  at March 31, 2010  |       | 28,761     |       | $                                            | 179.40     |                                                | 7.33       |                           | $          | — |   |
| Exercisable  at March 31, 2010  |       | 12,043     |       | $                                            | 173.21     |                                                | 6.75       |                           | $          | — |   |

 

**Stock Awards**: Recipients of restricted stock awardsdo not pay any cash consideration to Bancorp for the shares and receive alldividends with respect to all such shares, whether or not shares havevested.  The awards vest over a five yearperiod.  Bancorp measures the fair valueof each stock award at the date of the grant and recognizes compensation basedon the amount the market price of Bancorp’s common stock exceeds the exerciseprice.  The unrecognized share-basedcompensation cost relating to restricted stock awards expense at March 31,2010 was $188,000, which will be recognized over the remaining years of theoriginal five year vesting period of the awards.  There were no awards granted for the three monthsended March 31, 2010.   The totalintrinsic value of stock awards exercised and vested during the months ended March 31,2010 was $45,000.

 

The aggregate intrinsicvalue in the table above and following represents the total pretax intrinsicvalue (amount by which the fair value of the underlying stock exceeds theexercise price of an option or award, times the number of shares).  The following table summarizes the activityrelating to restricted stock awards outstanding for the three months ended March 31,2010.

 

(dollars in thousandsexcept share and per share amounts)

 
|                                 |   |   |   | **Shares** | ** ** | **Weighted  Average  Remaining  Contractual Terms (in  years)** | ** ** | **Aggregate  Intrinsic Value** | ** ** |
|--------------------------------------|--------|--------|--------|------------|------------|-----------------------------------------------------------------|------------|--------------------------------|------------|
| Outstanding  at January 1, 2010 |   |   |   | 1,564      |       | 2.80                                                            |       | $                              | 145        |   |
| Granted                              |   |   |   | —     |       | —                                                          |       | —                         |       |
| Vested                               |   |   |   | 289        |       | —                                                          |       | 45                             |       |
| Forfeited                            |   |   |   | —     |       | —                                                          |       | —                         |       |
| Outstanding  at March 31, 2010  |   |   |   | 1,275      |       | 2.48                                                            |       | $                              | 204        |   |
| Exercisable  at March 31, 2010  |   |   |   | —     |       | —                                                          |       | —                         |       |

 

Foradditional information on the stock-based equity compensation plan, refer toBancorp’s audited financial statements and footnotes for the most recent annualperiod ended December 31, 2009 contained in the Annual Report on Form 10-K.

 

**Note 8:  INVESTMENTSECURITIES**

The following tables summarize the aggregateamortized cost and estimated fair value of investment securities as of thedates indicated.

 

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**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

**March 31, 2010**

 
|                              |   |          |       |                 |       |          |       |           |       |   |   |    |   |   |   |   |   |   |   |
|-----------------------------------|--------|---------------|------------|----------------------|------------|---------------|------------|----------------|------------|--------|--------|---------|--------|--------|--------|--------|--------|--------|--------|
|                              |   | **Amortized** | ** ** | **Gross Unrealized** | ** ** | **Estimated** | ** ** |
| **(dollars in thousands)**        |   | **Cost**      | ** ** | **Gains**            | ** ** | **Losses**    | ** ** | **Fair Value** | ** ** |
| *Available-For-Sale Securities*   |   |          |       |                 |       |          |       |           |       |
| U.S.  government agencies         |   | $             | 39,682     |                 | $          | 266           |       | $              | 27         |   | $      | 39,921  |   |
| Mortgage-backed  securities       |   | 62,993        |       | 3,107                |       | 32            |       | 66,068         |       |
| State  and political subdivisions |   | 9,379         |       | 382                  |       | 23            |       | 9,738          |       |
| Total  available-for-sale         |   | 112,054       |       | 3,755                |       | 82            |       | 115,727        |       |
| *Held-To-Maturity Securities*     |   |          |       |                 |       |          |       |           |       |
| State  and political subdivisions |   | 40,725        |       | 925                  |       | 355           |       | 41,295         |       |
| Total  held-to-maturity           |   | 40,725        |       | 925                  |       | 355           |       | 41,295         |       |
| Total  investment securities      |   | $             | 152,779    |                 | $          | 4,680         |       | $              | 437        |   | $      | 157,022 |   |

 

**December 31, 2009**

 
|                              |       |          |       |                  |       |          |       |            |       |   |   |    |   |   |   |   |   |   |   |
|-----------------------------------|------------|---------------|------------|-----------------------|------------|---------------|------------|-----------------|------------|--------|--------|---------|--------|--------|--------|--------|--------|--------|--------|
| ** **                        | ** ** | **Amortized** | ** ** | **Gross  Unrealized** | ** ** | **Estimated** | ** ** |
| **(dollars in thousands)**        | ** ** | **Cost**      | ** ** | **Gains**             | ** ** | **Losses**    | ** ** | **Fair  Value** | ** ** |
| *Available-For-Sale Securities*   |       |          |       |                  |       |          |       |            |       |
| U.S.  government agencies         |       | $             | 39,698     |                  | $          | 274           |       | $               | 132        |   | $      | 39,840  |   |
| Mortgage-backed  securities       |       | 66,640        |       | 2,556                 |       | 200           |       | 68,996          |       |
| State  and political subdivisions |       | 9,387         |       | 366                   |       | 28            |       | 9,725           |       |
| Total  available-for-sale         |       | 115,725       |       | 3,196                 |       | 360           |       | 118,561         |       |
| *Held-To-Maturity Securities*     |       |          |       |                  |       |          |       |            |       |
| State  and political subdivisions |       | 40,298        |       | 889                   |       | 626           |       | 40,561          |       |
| Total  held-to-maturity           |       | 40,298        |       | 889                   |       | 626           |       | 40,561          |       |
| Total  investment securities      |       | $             | 156,023    |                  | $          | 4,085         |       | $               | 986        |   | $      | 159,122 |   |

 

The following tables showthe aggregate gross unrealized losses and fair value of securities with anamortized cost greater than the fair value as of the dates indicated;

 

**March 31, 2010**

 
|                              |       |                    |       |                     |       |           |       |                   |       |           |       |                   |       |   |   |   |   |   |   |
|-----------------------------------|------------|-------------------------|------------|--------------------------|------------|----------------|------------|------------------------|------------|----------------|------------|------------------------|------------|--------|--------|--------|--------|--------|--------|
| ** **                        | ** ** | **Less Than 12 Months** | ** ** | **12 Months or Greater** | ** ** | **Total**      | ** ** |
| **(dollars  in thousands)**       | ** ** | **Fair Value**          | ** ** | **Unrealized  Losses**   | ** ** | **Fair Value** | ** ** | **Unrealized  Losses** | ** ** | **Fair Value** | ** ** | **Unrealized  Losses** | ** ** |
| *Available-For-Sale Securities*   |       |                    |       |                     |       |           |       |                   |       |           |       |                   |       |
| U.S.  government agencies         |       | $                       | 7,037      |                     | $          | 27             |       | $                      | —     |           | $          | —                 |       | $      | 7,037  |   | $      | 27     |   |
| Mortgage-backed  securities       |       | 10,817                  |       | 32                       |       | —         |       | —                 |       | 10,817         |       | 32                     |       |
| State  and political subdivisions |       | —                  |       | —                   |       | 475            |       | 23                     |       | 475            |       | 23                     |       |
| Total  available-for-sale         |       | 17,854                  |       | 59                       |       | 475            |       | 23                     |       | 18,329         |       | 82                     |       |
| *Held-To-Maturity Securities*     |       |                    |       |                     |       |           |       |                   |       |           |       |                   |       |
| State  and political subdivisions |       | —                  |       | —                   |       | 12,951         |       | 355                    |       | 12,951         |       | 355                    |       |
| Total  held-to-maturity           |       | —                  |       | —                   |       | 12,951         |       | 355                    |       | 12,951         |       | 355                    |       |
| Total  investment securities      |       | $                       | 17,854     |                     | $          | 59             |       | $                      | 13,426     |           | $          | 378                    |       | $      | 31,280 |   | $      | 437    |   |

 

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**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

**December 31, 2009**

 
|                              |       |                    |       |                     |       |           |       |                   |       |           |       |                   |       |   |   |   |   |   |   |
|-----------------------------------|------------|-------------------------|------------|--------------------------|------------|----------------|------------|------------------------|------------|----------------|------------|------------------------|------------|--------|--------|--------|--------|--------|--------|
| ** **                        | ** ** | **Less Than 12 Months** | ** ** | **12 Months or Greater** | ** ** | **Total**      | ** ** |
| **(dollars  in thousands)**       | ** ** | **Fair Value**          | ** ** | **Unrealized  Losses**   | ** ** | **Fair Value** | ** ** | **Unrealized  Losses** | ** ** | **Fair Value** | ** ** | **Unrealized  Losses** | ** ** |
| *Available-For-Sale Securities*   |       |                    |       |                     |       |           |       |                   |       |           |       |                   |       |
| U.S.  government agencies         |       | $                       | 18,933     |                     | $          | 132            |       | $                      | —     |           | $          | —                 |       | $      | 18,933 |   | $      | 132    |   |
| Mortgage-backed  securities       |       | 10,916                  |       | 200                      |       | —         |       | —                 |       | 10,916         |       | 200                    |       |
| State  and political subdivisions |       | $                       | 221        |                     | $          | 1              |       | $                      | 470        |           | $          | 27                     |       | $      | 691    |   | $      | 28     |   |
| Total  available-for-sale         |       | 30,070                  |       | 333                      |       | 470            |       | 27                     |       | 30,540         |       | 360                    |       |
| *Held-To-Maturity Securities*     |       |                    |       |                     |       |           |       |                   |       |           |       |                   |       |
| State  and political subdivisions |       | 15,725                  |       | 626                      |       | —         |       | —                 |       | 15,725         |       | 626                    |       |
| Total  held-to-maturity           |       | 15,725                  |       | 626                      |       | —         |       | —                 |       | 15,725         |       | 626                    |       |
| Total  investment securities      |       | $                       | 45,795     |                     | $          | 959            |       | $                      | 470        |           | $          | 27                     |       | $      | 46,265 |   | $      | 986    |   |

 

Inestimating other-than-temporary impairment losses, management considers, amongother things, the length of time and the extent to which the fair values hasbeen less than cost, the financial condition and near-terms prospects of theissuer, and the intent and ability of Bancorp to retain its investment in theissue for a period of time sufficient to allow for any anticipated recovery incosts. The assessment of whether an other-than-temporary decline existsinvolves a high degree of subjectivity and judgment and is based on theinformation available to management at a point in time. If Bancorp intends tosell the security or it is more likely than not that it will be required tosell the security, the other-than-temporary impairment will be recognized inearnings equal to the entire difference between the cost basis and fairvalue.  If Bancorp does not intend to sellthe security and it is not more likely than not that Bancorp will sell thesecurity before recovery of its cost basis, the difference between the costbasis and fair value is reflected in earnings as realized losses to the extentthe impairment is related to credit losses. The amount of the impairment related to other factors is recognized inother comprehensive income. The previous cost basis less theother-than-temporary impairment recognized in earnings becomes the new costbasis of the security.

 

Managementhas the ability and intent to hold securities classified as held-to-maturityuntil they mature, at which time Bancorp will receive full value for thesecurities.  In addition, management doesnot have the intent to sell any of the securities classified as available forsale and believes that it is more likely than not that Bancorp will not have tosell any such securities before a recovery of the cost basis.  At March 31, 2010, the unrealized lossesare largely due to increases in market interest rates over the yields availableat the time the underlying securities were purchased.  The fair value isexpected to recover as the bonds approach their maturity date or repricing dateor if market yields for such investments decline.  Bancorp believes thatthe decline in fair value is temporary, with no permanent sector or issuercredit concerns or impairments.  Accordingly, management believes anyimpairments as of March 31, 2010 are temporary and thus, did not recognizeany other-than-temporary impairment losses.

 

At March 31, 2010,Bancorp held one security in the available-for-sale portfolio and tensecurities in the held-to-maturity portfolio that had an unrealized loss formore than one year.

 

Available-for-saleinvestment securities with a carrying value of $103.4 and $101.3 million  as of March 31, 2010 and December 31,2009, were pledged as collateral for public fund deposits, securities soldunder agreement to repurchase, Treasury Tax and Loan payments, and FederalReserve Bank discount window borrowings.

 

**Note 9:  ALLOWANCE FORLOAN LOSSES**

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

 

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**SKAGIT STATEBANCORP, INC. AND SUBSIDIARY**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

**Allowance for Loan LossesActivity**

(dollars in thousands)

 
| **For  the three months ended March 31,**               | ** ** | **2010** | ** ** | **2009** | ** ** |
|--------------------------------------------------------------|------------|----------|------------|----------|------------|
| Allowance  as of beginning of year                           |       | $        | 6,883      |     | $          | 5,450 |   |
| Provision  for loan losses                                   |       | 550      |       | 450      |       |
| Charge-offs                                                  |       | (188     | )          | (314     | )          |
| Recoveries                                                   |       | 35       |       | 51       |       |
| Net  (charge-offs) recoveries                                |       | (153     | )          | (263     | )          |
| Balance  at end of period                                    |       | $        | 7,280      |     | $          | 5,637 |   |
| Ratio  of net charge-offs to average loans during the period |       | 0.16     | %          | 0.27     | %          |
| Ratio  of allowance to net loans at end of period            |       | 1.90     | %          | 1.47     | %          |
| Ratio  of non-performing loans to allowance                  |       | 139.22   | %          | 95.23    | %          |

 

Impaired loanswere $22.4 million and $24.4 million, respectively at March 31, 2010 and December 31,2009.

 

**Note 10:  COMMITMENTS**

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

 

The following is a summary of the off-balance-sheet financialinstruments or contracts outstanding as of March 31, 2010: (dollars inthousands)

 
| Unfunded  commitments to extend credit  |   | $      | 60,964 |   |
|-----------------------------------------|--------|--------|--------|--------|
| Credit  card arrangements               |   | 11,652 |   |
| Commitments  to fund municipal warrants |   | 3,303  |   |
| Standby  letters of credit              |   | 1,545  |   |

 

**Note 11:  INCOMETAXES**

Bancorp files aconsolidated federal income tax return. Bancorp accounts for income taxes using the liability method anddeferred taxes are reflected at currently enacted income tax rates applicableto the period in which the deferred tax assets or liabilities are expected tobe realized or settled.  Deferred taxesresult from temporary differences in the recognition of certain income andexpense amounts between Bancorp’s financial statements and its tax returns.As changes in tax laws or rates areenacted, deferred tax assets and liabilities are adjusted through the provisionfor income taxes.

 

FASB ASC 740, “Accountingfor Uncertainty in Income Taxes” seeks to reduce the diversity in practiceassociated with certain aspects of measurement and recognition in accountingfor income taxes. ASC 740 provides guidance on de-recognition, classification,interest and penalties and accounting in interim periods and requires expandeddisclosure with respect to uncertainty in income taxes.  As a result of the implementation of ASC 740,Bancorp recognized no adjustments for unrecognized income tax benefits, all ofwhich would affect Bancorp’s effective income tax rate if recognized.  Our accounting policy with respect tointerest and penalties arising from income tax settlements is to recognize themas non-interest expense.

 

**Note 12:  FAIR VALUEMEASUREMENTS**

Disclosures regarding thefair value of financial asset and liabilities, including those financial assetsand liabilities that are not measured and reported at fair value on a recurringbasis or non-recurring basis are required disclosures.  The estimated fair values have beendetermined by Bancorp using available market information and appropriatevaluation methodologies and considerable judgment is necessary to interpretmarket data in the development of the estimates of fair value.  The use of different market assumptionsand/or estimation methodologies may have a material effect on the estimatedfair value amounts. In that regard, the fair value estimates cannot besubstantiated by

 

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**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

comparison to independentmarkets and, in many cases, could not be realized in immediate settlement onthe instrument. Accordingly, the aggregate fair value amounts presented do notrepresent the underlying value of Bancorp.

 

***FinancialInstruments***

*Cash,Due From Banks, Federal Funds Sold, Other Borrowings****andAccrued Interest Receivable and Payable**—*The carrying amount of these financialassets and liabilities approximates fair value.

 

*InvestmentSecurities —*The securities classified as available for sale arereported at fair value utilizing Level 2 inputs. The fair values for held-to-maturity securitiesincluding fixed rate warrants and qualified zone academy bonds, included instate and political subdivisions investment securities, are estimated usingdiscounted cash flow analysis using interest rates currently being offered forwarrants of similar terms or the current qualified zone academy bond interestrates.

 

*Loans**—* The fair value of loans is estimated bydiscounting anticipated future cash flows using interest rates currently beingoffered for loans with similar terms to borrowers of similar credit quality asof the balance sheet date.  An overallliquidity discount was also used for 2010 to reflect the decline of loan salesin the marketplace.  Impaired loans werenot subjected to discounted cash flow analysis as they are already consideredto be held at fair value.

 

*Deposits**—* The fair values disclosed for demand,savings, and money market accounts are equal to their carrying amounts. Thefair values for fixed-rate time deposits are estimated using a discounted cashflow analysis that applies interest rates currently being offered oncertificates to a schedule of aggregated expected maturities on time deposits.

 

*Off-Balance-SheetInstruments**—* Commitments to extend credit and standbyletters of credit represent the principal categories of off-balance financialinstruments (See Note 10).  The fairvalue of these instruments is not considered material since they are forrelatively short periods of time and are subject to customary credit terms,which would not include terms that would expose Bancorp to significant gains orlosses.

 

The carrying amounts andestimated fair values of Bancorp’s financial instruments at March 31, 2010are as follows:

 
| ** **                   | ** ** | **March 31, 2010** | ** ** | **December 31, 2009** | ** ** |
|------------------------------|------------|-------------------------|------------|----------------------------|------------|
| ** **                   | ** ** | **Carrying**            | ** ** | ** **                 | ** ** | **Carrying** | ** ** | ** ** | ** ** |
| **(dollars  in thousands)**  | ** ** | **Amount**              | ** ** | **Fair Value**             | ** ** | **Amount** | ** ** | **Fair Value** | ** ** |
| *Financial Assets*           | * *   | * *                | * *   | * *                   | * *   | * * | * * | * * | * * |
| Cash  and due from banks     |       | $                       | 10,102     |                       | $          | 10,102 |   | $ | 14,441 |   | $ | 14,441 |   |
| Federal  funds sold          |       | 94,089                  |       | 94,089                     |       | 62,531 |   | 62,531 |   |
| Investment  securities       |       | 156,452                 |       | 157,022                    |       | 158,859 |   | 159,122 |   |
| Net  loans                   |       | 382,177                 |       | 357,178                    |       | 386,649 |   | 361,780 |   |
| Accrued  interest receivable |       | 2,386                   |       | 2,386                      |       | 2,531 |   | 2,531 |   |
|                         |       |                    |       |                       |       |   |   |   |   |
| *Financial Liabilities*      |       |                    |       |                       |       |   |   |   |   |
| Demand  and savings deposits |       | 352,885                 |       | 352,885                    |       | 339,001 |   | 339,001 |   |
| Time  deposits               |       | 214,977                 |       | 216,797                    |       | 206,435 |   | 208,142 |   |
| Other  borrowings            |       | 35,178                  |       | 35,178                     |       | 38,128 |   | 38,128 |   |
| Accrued  interest payable    |       | 305                     |       | 305                        |       | 366 |   | 366 |   |
|                              |            |                         |            |                            |            |  |  |  |  |  |  |  |  |

 

***Fair Value Hierarchy***

 

FASBASC 820 establishes a hierarchy that prioritizes the use of fair value inputsused in the 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.

 

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**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

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.

 

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.

 

***Assetsand Liabilities Measured at Fair Value on a Recurring Basis***

 

Thetable below shows assets measured at fair value on a recurring basis as of thedates indicated.

 

(dollars in thousands)

 
| ** **                          | ** ** | ** ** | ** ** | **Quoted Prices  in Active  Markets for  Identical Assets** | ** ** | **Significant  Other  Observable  Inputs** | ** ** | **Significant  Unobservable  Inputs** | ** ** |
|-------------------------------------|------------|------------|------------|-------------------------------------------------------------|------------|--------------------------------------------|------------|---------------------------------------|------------|
| **Description**                     | ** ** | ** ** | ** ** | **(Level 1)**                                               | ** ** | **(Level 2)**                              | ** ** | **(Level 3)**                         | ** ** |
| **March 31, 2010**             |       |       |       |                                                        |       |                                       |       |                                  |       |
| Available-for-sale  debt securities |       |       |       |                                                        |       |                                       |       |                                  |       |
| U.S.  government agencies           |       | $          | 39,921     |                                                        | $          | —                                     |       | $                                     | 39,921     |   | $ | — |   |
| Mortgage-backed-securities          |       | 66,068     |       | —                                                      |       | 66,068                                     |       | $                                     | —     |   |
| State  and political subdivisions   |       | 9,738      |       | —                                                      |       | 9,738                                      |       | $                                     | —     |   |
| Total                               |       | $          | 115,727    |                                                        | $          | —                                     |       | $                                     | 115,727    |   | $ | — |   |
|                                |       |       |       |                                                        |       |                                       |       |                                  |       |
| **December 31, 2009**          |       |       |       |                                                        |       |                                       |       |                                  |       |
| Available-for-sale  debt securities |       |       |       |                                                        |       |                                       |       |                                  |       |
| U.S.  government agencies           |       | $          | 39,840     |                                                        | $          | —                                     |       | $                                     | 39,840     |   | $ | — |   |
| Mortgage-backed-securities          |       | 68,996     |       | —                                                      |       | 68,996                                     |       | $                                     | —     |   |
| State  and political subdivisions   |       | 9,725      |       | —                                                      |       | 9,725                                      |       | $                                     | —     |   |
| Total                               |       | $          | 118,561    |                                                        | $          | —                                     |       | $                                     | 118,561    |   | $ | — |   |

 

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, the treasury yield curve, yield/spread relationships, consensusprepayment rates, and the bonds terms and conditions,  among other things.

 

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**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

***Assetsand Liabilities Measured at Fair Value on a Nonrecurring Basis***

 

The table below showsassets measured at fair value on a non-recurring basis as of the datesindicated.

 

(dollars in thousands)

 
| ** **                 | ** ** | ** ** | ** ** | **Quoted Prices  in Active  Markets for  Identical Assets** | ** ** | **Significant  Other  Observable  Inputs** | ** ** | **Significant  Unobservable  Inputs** | ** ** |
|----------------------------|------------|------------|------------|-------------------------------------------------------------|------------|--------------------------------------------|------------|---------------------------------------|------------|
| **Description**            | ** ** | ** ** | ** ** | **(Level 1)**                                               | ** ** | **(Level 2)**                              | ** ** | **(Level 3)**                         | ** ** |
| **March 31, 2010**    |       |       |       |                                                        |       |                                       |       |                                  |       |
| Impaired  loans            |       | $          | 21,164     |                                                        | $          | —                                     |       | $                                     | —     |   | $ | 21,164 |   |
| Other  real estate owned   |       | 7,344      |       | —                                                      |       | —                                     |       | 7,344                                 |       |
| Total                      |       | $          | 28,508     |                                                        | $          | —                                     |       | $                                     | —     |   | $ | 28,508 |   |
|                       |       |       |       |                                                        |       |                                       |       |                                  |       |
| **December 31, 2009** |       |       |       |                                                        |       |                                       |       |                                  |       |
| Impaired  loans            |       | $          | 23,188     |                                                        | $          | —                                     |       | $                                     | —     |   | $ | 23,188 |   |
| Other  real estate owned   |       | 6,284      |       | —                                                      |       | —                                     |       | 6,284                                 |       |
| Total                      |       | $          | 29,472     |                                                        | $          | —                                     |       | $                                     | —     |   | $ | 29,472 |   |

 

*Impaired Loans* — Impaired loans are reported at thelower of the recorded amount of the loan or fair value of the underlyingcollateral, if the loan is collateral dependent.  Impaired loans were written down $49,000 viapartial charge-offs and in addition had specific reserve allocation increasesof $127,000, which was recorded through the allowance for loan losses for thethree months ended March 31, 2010. Impaired loans were written down $1.7 million via partial charge-offsand in addition had specific reserve allocation increases of $1.3 million whichwas recorded through the allowance for loan losses for the twelve months ended December 31,2009.

 

*Other Real Estate Owned* — Other real estate owned includesproperties acquired through foreclosure. These properties are recorded at the lower of the recorded amount of theloan, or estimated fair value less estimated costs to sell based on periodicevaluations using Level 3 inputs. Valuation of the property occurs when it is foreclosed upon and annuallythereafter.  Write-downs arising from theacquisition of property, in full or partial satisfaction of loans, are chargedto the allowance for loan losses. Subsequent write-downs after acquisition, identified through management’speriodic valuations, are written down through non-interest expenses. Other realestate owned with a carrying amount of $7.4 million, were written down to theirfair value of $7.3 million, resulting in write-downs of $20,000, which wascharged against earnings for the three months ended March 31, 2010.  Other real estate owned with a carryingamount of $7.5 million, were written down to their fair value of $6.3 million,resulting in write-downs of $1.2 million, which was charged against earningsfor the twelve months ended December 31, 2009.

 

**Item 2.  MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

*The following discussion shouldbe read in conjunction with the consolidated financial statements and notesthereto presented elsewhere in this report. For additional information, refer to the financial statements andfootnotes for the year ended December 31, 2009 in the Annual Report on Form 10-K.*

 

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**FORWARDLOOKING STATEMENTS**

This Form 10-Q maycontain forward-looking statements within the meaning of the Private SecuritiesLitigation Reform Act of 1995.  Theseforward-looking statements include, but are not limited to, statements aboutmanagement’s plans, objectives, expectations and intentions that are nothistorical facts, and other statements identified by words such as “expects,” “anticipates,”“intends,” “plans,” “believes,” “should,” “projects,” “seeks,” “estimates” orwords of similar meaning. These forward-looking statements are based on currentbeliefs and expectations of management and are inherently subject tosignificant business, economic and competitive uncertainties and contingencies,many of which are beyond Bancorp’s control. In addition, these forward-lookingstatements are subject to assumptions with respect to future business strategiesand decisions that are subject to change. The following factors, among others,could cause actual results to differ materially from the anticipated results orother expectations in the forward-looking statements, including those set forthin this Form 10-Q, or the documents incorporated by reference:

 
| · | the risks associated with lending and potential  adverse changes in credit quality;                                                                                                      |
|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| · | increased loan delinquency rates;                                                                                                                                                        |
| · | the risks presented by a continued economic  slowdown, which could adversely affect credit quality, loan collateral  values, investment values, liquidity levels, and loan originations; |
| · | changes in market interest rates, which could  adversely affect our net interest income and profitability;                                                                               |
| · | legislative or regulatory changes that adversely  affect our business or our ability to complete pending or prospective future  acquisitions;                                            |
| · | reduced demand for banking products and services;                                                                                                                                        |
| · | competition from other financial services companies  in our markets; and                                                                                                                 |
| · | Bancorp’s success in managing risks involved in the  foregoing.                                                                                                                     |

 

Additional factors thatcould cause actual results to differ materially from those expressed in theforward-looking statements are discussed in Risk Factors in Item 1A. Pleasetake into account that forward-looking statements speak only as of the date ofthis Form 10-Q or documents incorporated by reference. Bancorp does notundertake any obligation to publicly correct or update any forward-lookingstatement if we later become aware that it is not likely to be achieved.

 

**BUSINESS**

Skagit State Bancorp, Inc.is a bank holding company with one wholly owned subsidiary - Skagit State Bank(collectively, “Company” or “Bancorp”). Skagit State Bank began operations in 1958 and is headquartered inBurlington (Skagit County), Washington. The Bank provides a full range of banking services and products to bothbusinesses and individuals through 12 full service banking offices, a consumerloan center, and a business banking center located in Skagit, Snohomish andWhatcom counties.

 

**OVERVIEW**

Net income was $1.2million for the quarters ended March 31, 2010, and 2009 with dilutedearnings per share at $2.05 and $2.03, respectively.  The increase in net income was primarilyattributable to a decrease in non-interest expenses which were partially offsetby an increase in the provision for loan losses and a decrease in net interestincome.  Annualized return on averageassets was 0.75 percent and 0.86 percent for the quarters ended March 31,2010, and 2009.  Annualized return onaverage equity was 7.69 percent and 7.77 percent for the quarters ending March 31,2010, and 2009, respectively.

 

The provision for loanlosses was $550,000 and $450,000 for the quarters ended March 31, 2010,and 2009. The increase in the provision is primarily attributable to thecontinued deterioration in the Pacific Northwest economy, declines in realestate values, and internal downgrades of credit within the loan portfolio. The provision for loan losses increased Bancorp’s totalallowance for loan losses to 1.90 percent of net loans at March 31, 2010compared to 1.78 percent at December 31, 2009.  For the quarter and ended March 31,2010 and 2009, respectively, net charge-offs were $153,000and $263,000.

 

Non-interest expense was$4.3 million for the quarter ended March 31, 2010 compared to $4.5 millionin the like period in 2009.  For the 2010quarter compared to the 2009 quarter, the decrease was primarily attributableto decreases in salary expenses and FDIC deposit insurance premiums.

 

Total assets increased to$669.3 million at March 31, 2010, compared to $647.9 million at December 31,2009.  The increase was primarily due todeposit growth of $22.4 million.  Netloans decreased by $4.5 million or 1.2 percent to $382.2 million at March 31,2010, compared to $386.6 million at December 31, 2009.  During 2010 and 2009, Bancorp continued tooriginate and fund loans to credit-worthy customers within our markets.  However, decreased loan balances reflect thecurrent market conditions and the lower demand and lower availability ofquality loans.

 

**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 and service charges on depositaccounts and gains on the sale of mortgage loans. Bancorp’s non-interestexpenses consist primarily of salaries and employee benefits expense, bankpremises and equipment expenses and other operating expenses.

 

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

 

Net interest income was$5.4 million for the quarters ended March 31, 2010 and 2009.  The net interest margin is net interestincome expressed as a percent of average interest-earning assets. Net interestmargin is influenced by the level and relative mix of interest-earning assetsand interest-bearing liabilities as well as levels of non-interest bearingliabilities.  For the quarter ended March 31,2010, the net interest margin decreased to 3.53 percent compared to 4.13percent for the like period in 2009.  Thedecrease is primarily due to a decrease in the average yield on securities andthe negative impact of the change in the interest-earning asset compositionwith lower yielding federal funds sold comprising a higher percentage of totalinterest-earning assets.

 

*Interest-earning assets*

The largest component ofinterest income is interest earned on loans. Total interest income earned from loans was $5.6 million for the quarterended March 31, 2010 compared to $5.9 million for the like period in2009.  For the current quarter, thisdecrease was primarily a result of the current interest rate environment whichdecreased the loan yield from 6.14 percent to 5.95 percent. Also contributingto the decline was a $5.7 million reduction in the average loans outstanding atMarch 31, 2010 compared to March 31, 2009.

 

Interest earned oninvestments and federal funds sold decreased $11,000 for the quarter ended March 31,2010 compared to the like period in 2009. Total interest earned on securitiesdecreased $59,000  and interest onfederal funds sold increased $48,000. The decrease in interest on securities was attributable to decreases inyield which resulted from the current interest rate environment; as securitieswere called or matured in 2010 and 2009, they were replaced with lower-yieldingsecurities. The increase in interest on federal funds sold was a result of a$73.4 million increase in the average balance. As of March 31, 2010, federal funds sold represented 37.55 percentof investments compared to 11.92 percent as of March 31, 2009.

 

*Interest- bearing liabilities*

Interest expensedecreased to $1.6 million from $1.8 million for the quarters ended March 31,2010 and 2009, respectively. The decrease was a result of a 46 basis pointbasis point decrease in the cost of funds including a 106 basis point decreasein time deposits, for the quarter ended March 31, 2010 compared to 2009.The majority of our deposits are short term and re-price within a twelve monthperiod.

 

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$174,000 and $223,000 for the quarter ended March 31, 2010 and 2009,respectively, are included in interest earned on loans. Non-accruing loans havebeen included in the computation of average loans.

 

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**Condensed Average Balance Sheets**

(dollars in thousandsexcept share data)

 
| ** **                                        | ** ** | **2010**             | ** ** | **2009**     | ** ** |
|---------------------------------------------------|------------|----------------------|------------|--------------|------------|
| **Three  months ended March 31,**            | ** ** | **Average  Balance** | ** ** | **Interest** | ** ** | **Yield  /Cost** | ** ** | **Average  Balance** | ** ** | **Interest** | ** ** | **Yield  /Cost** | ** ** |
| **Assets**                                        |       |                 |       |         |       |   |   |   |   |   |   |   |   |
| Federal funds sold                                |       | $                    | 78,298     |         | $          | 49 |   | 0.25 | % | $ | 4,948 |   | $ | 1 |   | 0.08 | % |
| Taxable investment securities                     |       | 104,867              |       | 1,018        |       | 3.94 |   | 90,056 |   | 1,070 |   | 4.82 |   |
| Tax exempt securities                             |       | 49,614               |       | 274          |       | 2.24 |   | 48,255 |   | 281 |   | 2.36 |   |
| Loans                                             |       | 384,601              |       | 5,640        |       | 5.95 |   | 390,280 |   | 5,907 |   | 6.14 |   |
| Total interest-earning assets                     |       | 617,380              |       | 6,981        |       | 4.59 | % | 533,539 |   | 7,259 |   | 5.52 | % |
| Non-interest earning assets                       |       | 35,957               |       |         |       |   |   | 32,234 |   |   |   |   |   |
| Total assets                                      |       | $                    | 653,337    |         |       |   |   |   | $ | 565,773 |   |   |   |   |   |
|                                              |       |                 |       |         |       |   |   |   |   |   |   |   |   |
| **Liabilities and Stockholders’  Equity**    | ** ** | ** **           | ** ** | ** **   | ** ** | ** ** |   |   |   |   |   |   |   |
| Interest-bearing demand                           |       | $                    | 101,409    |         | $          | 84 |   | 0.34 | % | $ | 87,139 |   | $ | 71 |   | 0.33 | % |
| Savings and money market                          |       | 167,364              |       | 355          |       | 0.86 |   | 152,200 |   | 377 |   | 1.00 |   |
| Certificates of deposit                           |       | 210,840              |       | 1,081        |       | 2.08 |   | 166,056 |   | 1,286 |   | 3.14 |   |
| Total interest-bearing deposits                   |       | 479,613              |       | 1,520        |       | 1.29 |   | 405,395 |   | 1,734 |   | 1.73 |   |
| Other borrowings                                  |       | 37,465               |       | 82           |       | 0.89 |   | 23,931 |   | 89 |   | 1.51 |   |
| Total interest-bearing deposits & liabilities |       | 517,078              |       | 1,602        |       | 1.26 | % | 429,326 |   | 1,823 |   | 1.72 | % |
| Non interest-bearing demand deposits              |       | 71,007               |       |         |       |   |   | 71,809 |   |   |   |   |   |
| Other non-interest-bearing liabilities            |       | 1,510                |       |         |       |   |   | 2,128 |   |   |   |   |   |
| Total liabilities                                 |       | 589,595              |       |         |       |   |   | 503,263 |   |   |   |   |   |
| Stockholders’ equity                         |       | 63,742               |       |         |       |   |   | 62,510 |   |   |   |   |   |
| Total liabilities and stockholders equity         |       | $                    | 653,337    |         |       |   |   |   | $ | 565,773 |   |   |   |   |   |
| Net interest income                               |       |                 |       | $            | 5,379      |   |   |   |   |   | $ | 5,436 |   |   |   |
| Interest rate spread                              |       |                 |       |         |       | 3.33 | % |   |   |   |   | 3.80 | % |
| Net interest margin                               |       |                 |       |         |       | 3.53 | % |   |   |   |   | 4.13 | % |

 

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

 

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

 

(dollars in thousandsexcept share data)

 
| ** **                                                   | ** ** | **Increase (Decrease) Due to** | ** ** |
|--------------------------------------------------------------|------------|--------------------------------|------------|
| **Three  months ended March 31, 2010 vs. 2009**         | ** ** | **Volume**                     | ** ** | **Rate** | ** ** | **Total** | ** ** |
| **Interest-Earning Assets**                                  | ** ** | ** **                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| Federal  funds sold                                          |       | $                              | 42         |   | $ | 6 |   | $ | 48 |   |
| Investment  securities                                       |       | 766                            |       | (825 | ) | (59 | ) |
| Loans                                                        |       | (85                            | )          | (182 | ) | (267 | ) |
| Total  net change in income on interest earning assets       |       | 723                            |       | (1,001 | ) | (278 | ) |
| **Interest-Bearing Liabilities**                             |       |                           |       |   |   |   |   |
| Deposits                                                     |       | 1,275                          |       | (1,489 | ) | (214 | ) |
| Other  borrowings                                            |       | 168                            |       | (175 | ) | (7 | ) |
| Total  net change in expense on interest-bearing liabilities |       | 1,443                          |       | (1,664 | ) | (221 | ) |
| Net  change in net interest income                           |       | $                              | (720       | ) | $ | 663 |   | $ | (57 | ) |

 

**PROVISION FOR LOAN LOSSES          **The provision for loan losses was$550,000 and $450,000 for the quarters ended March 31, 2010, and 2009,respectively. The increase in provision was primarily attributable to thecontinued deterioration in the Pacific Northwest economy, declines in realestate values, and internal downgrades of credit within the loan portfolio. Forthe quarter ended March 31, 2010, net charge-offs were $153,000 compared to $263,000 for the like periods in2009

 

The provision for loanlosses is highly dependent upon Bancorp’s ability to manage asset quality andcontrol the level of charge-offs through prudent underwriting standards. In thefuture, continued growth of the loan portfolio may or further declines ineconomic conditions and real estate values could increase future provisions forloan losses and impact Bancorp’s net income. Additional discussion on loanquality and the allowance for loan losses is provided under Allowance for LoanLosses and Asset Quality.

 

**NON-INTEREST INCOME          **Non-interest income, which consistsprimarily of fees and service charges on deposits and other income, was$945,000 and $960,000 for the quarters ended March 31, 2010 and 2009,respectively. The decrease of $15,000 was primarily attributable to reducedoverdraft fees and non-sufficient funds fees collected.

 

**NON-INTEREST EXPENSE          **Non-interest expense was $4.3 million forthe quarter March 31, 2010 compared to $4.5 million in the like period in2009.  For the 2010 quarter, the decreasewas attributable to decreases in salaries and FDIC insurance premiums.  FDIC insurance premiums decreased to $230,000for the quarter ended March 31, 2010 compared to $293,000 for the likeperiod in 2009.  Salary expense decreased3.8% to $1.9 million for the quarter ended March 31, 2010 compared to $2.0million for the like period in 2009.

 

The efficiency ratio iscomputed by dividing total operating expenses by non-interest income and netinterest income before provision for loan losses.  An increase in the efficiency ratio indicatesthat more resources are being utilized to generate the same or greater volumeof income. The efficiency ratio for the quarter ended March 31, 2010 was68.7 percent compared to 71.0 percent for the same time period in 2009.

 

**INCOME TAX EXPENSE          **Income tax expense for the quarter ended March 31,2010 was $218,000 compared to $210,000 for the like quarter of 2009. Bancorp’seffective tax rates were 15.3 percent and 14.9 percent for the quarters ended March 31,2010, and 2009, respectively. The effective tax rate is lower than the federalstatutory rate due to tax credits from tax-exempt bonds and tax-exempt interestfrom municipal bonds and loans.  As of March 31,2010, Bancorp had $50.5 million in tax-exempt securities compared to $48.9million as of March 31, 2009.

 

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**REVIEW OF FINANCIAL CONDITION**

Total assets increased to$669.3 million at March 31, 2010 compared to $647.9 million at December 31,2009.  This increase was primarily due toa $22.4 million increase in deposits to $567.9 million. Net loans decreased$4.5 million to $382.2 million during the same time period.

 

**INVESTMENTSECURITIES AND FEDERAL FUNDS SOLD**Total investment securities, including federal fundssold, increased to $250.5 million at March 31, 2010 compared to $221.4million at December 31, 2009. Federal funds sold increased to $94.1million at March 31, 2010 from $62.5 million as of December 31, 2009.This increase resulted primarily from the growth in deposits.

 

The available-for-saleinvestment portfolio is comprised of 57.1 percent Government Sponsored Agenciesand Government Agencies mortgage-backed pass-through securities, 8.4 percent ofstate and municipals and 34.5 percent of Government Sponsored Agencies andGovernment Agencies securities.  Theheld-to-maturity portfolio is concentrated in municipal securities andQualified Zone Academy Bonds. Security purchases for the quarter ended March 31,2010 were $6.5 million.  Securitymaturities, calls, and pay-downs were $9.7 million for the quarter ended March 31,2010.

 

The amortized cost andestimated fair value of investment securities at March 31, 2010, bycontractual maturity, are shown in the following table.  Actual maturities may differ from contractualmaturities because issuers may have the right to call or prepay obligationswith or without call or prepayments penalties. Mortgage-backed securities are not all due at a single maturity date,therefore, they are disclosed separately.

 
|                         |       |                   |       |                 |       |          |       |           |       |   |   |   |   |
|------------------------------|------------|------------------------|------------|----------------------|------------|---------------|------------|----------------|------------|--------|--------|--------|--------|
| ** **                   | ** ** | **2010**               | ** ** |
| ** **                   | ** ** | **Available-For-Sale** | ** ** | **Held-To-Maturity** | ** ** |
| ** **                   | ** ** | **Amortized**          | ** ** | **Estimated**        | ** ** | **Amortized** | ** ** | **Estimated**  | ** ** |
| **(dollars  in thousands)**  | ** ** | **Cost**               | ** ** | **Fair Value**       | ** ** | **Cost**      | ** ** | **Fair Value** | ** ** |
| 0-1  year                    |       | $                      | 3,509      |                 | $          | 3,570         |       | $              | 4,645      |   | $      | 4,651  |   |
| 1-5  years                   |       | 36,161                 |       | 36,641               |       | 14,100        |       | 14,403         |       |
| 5-10  years                  |       | 7,891                  |       | 7,951                |       | 9,906         |       | 10,200         |       |
| Over  10 years               |       | 1,500                  |       | 1,497                |       | 12,074        |       | 12,041         |       |
| Mortgage-backed  securities  |       | 62,993                 |       | 66,068               |       | —        |       | —         |       |
| Total  investment securities |       | $                      | 112,054    |                 | $          | 115,727       |       | $              | 40,725     |   | $      | 41,295 |   |

 

**LOANS          **Net loans decreased 1.2 percent to $382.2million at March 31, 2010 compared to $386.6 million at December 31,2009.  Net loans represented 57.1 percentof total assets at March 31, 2010. During 2010 and 2009, Bancorp continued to originate and fund loans tocredit-worthy customers within our markets. However, decreased loan balances reflect the current market conditionsand the lower demand and lower availability of quality loans.

 

Bancorp concentrates onfive areas of lending: loans to individuals for business purposes, loans forsmall and medium-sized businesses, agricultural loans, loans to commercialenterprises for real estate transactions and consumer purpose loans.  Bancorp’s primary lending activities includecommercial real estate loans, commercial loans which include agriculture productionloans and consumer purpose loans. Most of Bancorp’s business activity is withcustomers located within Skagit, Snohomish and Whatcom Counties. Bancorporiginates commercial, real estate and consumer loans.

 

*Real Estate Loans:* Real estate loans comprise the largestcategory of loans and our real estate portfolio consists of commercial andresidential loans which are secured by property such as office buildings,retail buildings, owner occupied commercial business properties, farm land,timber land, residential land development properties and residentialproperties.  Real estate loanscompromised 66.9% of total loans at March 31, 2010.  The primary repayment source of thesespecific loan types are from the cash flows generated by the occupant business,occupant farm operation, or the sale of properties. While Bancorp hassignificant balances secured by real estate, Bancorp believes that its lendingpolicies and concentration policies are sufficient to minimize risks.  However, economic conditions may affect aborrower’s ability to meet the stated repayment terms.

 

*Commercial Loans*: Commercial loans, secured andunsecured, are made primarily to small and medium-sized businesses includingfarms operating within Skagit, Snohomish and Whatcom Counties.  These loans are available for generaloperating purposes, acquisition of fixed assets, purchases of equipment andmachinery, financing of 

 

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inventory and accountsreceivable, and other business purposes. Bancorp originates Small Business Administration (SBA) loans, including504 and 7A loans.

 

*ConsumerLoans:* 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 tablepresents the composition of loans for Bancorp as of the dates indicated.

 

**Loan Composition**

** **
| ** **                                            | ** ** | **March 31, 2010** | ** ** | **December 31, 2009** | ** ** |
|-------------------------------------------------------|------------|-------------------------|------------|----------------------------|------------|
| **(dollars  in thousands)**                           | ** ** | **Amount**              | ** ** | **%**                      | ** ** | **Amount** | ** ** | **%** | ** ** |
| Real  estate — residential & commercial |       | $                       | 249,361    |                       | 63.9       | % | $ | 248,658 |   | 63.0 | % |
| Real  estate construction                             |       | 11,652                  |       | 3.0                        | %          | 13,261 |   | 3.4 | % |
| Commercial,  industrial & agricultural       |       | 73,761                  |       | 18.9                       | %          | 76,716 |   | 19.4 | % |
| Consumer                                              |       | 55,604                  |       | 14.2                       | %          | 55,910 |   | 14.2 | % |
| Total  loans                                          |       | 390,378                 |       | 100                        | %          | 394,545 |   | 100 | % |
| Less:                                                 |       |                    |       |                       |       |   |   |   |   |
| Allowance  for loan losses                            |       | 7,280                   |       |                       |       | 6,883 |   |   |   |
| Deferred  loan fees                                   |       | 921                     |       |                       |       | 1,013 |   |   |   |
| Net  loans                                            |       | $                       | 382,177    |                       |       |   | $ | 386,649 |   |   |   |

 

*Concentrations*

As shown in the tableabove, a concentration of loans in commercial and residential real estateexisted as of March 31, 2010.  At March 31, 2010, Bancorp’s realestate portfolio included $155.8 million in non-farm non-residential realestate loans of which $95.9 million is owner occupied. Total loans alsoincluded $51.1 million in raw land, land development and construction loans and$63.6 million in one-to-four family residential loans.

 

During 2006, the FDICissued guidance entitled “Concentrations in Commercial Real Estate Lending,Sound Risk Management Practices”.  The guidance set forth two thresholdsto identify institutions with Commercial Real Estate (CRE) loan concentrations.Financial institutions are deemed to have a CRE concentration if  loansfor construction, land development, and other land represent 100 percent ormore of total  capital or if loans for construction, land development, andother land and loans secured by multifamily and nonfarm nonresidentialproperty(excluding loans secured by owner-occupied properties) represent 300percent or more of total capital. Bancorp’s construction, land development, rawland, multifamily and nonfarm nonresidential non-owner occupied real estateloans (total commercial real estate) were 170% and 198% of total risk basedcapital for March 31, 2010 and 2009, respectively. Total reported loansfor construction, land development, and raw land were 76% and 90% of total riskbased capital for March 31, 2010 and 2009, respectively. Bancorp considersboth ratios noted above to be within acceptable levels of concentration risk.

 

Management employs riskmanagement practices, including board and management oversight and strategicplanning, development of underwriting standards, risk assessment and monitoringthrough stress testing.  In addition,Bancorp monitors concentrations of commercial real estate for which the cashflow from the real estate is the primary source of repayment rather than loansto a borrower for which real estate collateral is taken as a secondary sourceof repayment. These types of commercial real estate loans have risk profileswhich are more sensitive to changes in market demand, vacancy rates, rents orchanges in capitalization rates. Included in these commercial real estateconcentrations are loans for construction, land development, raw land,multifamily, and nonfarm nonresidential non-owner occupied properties.  Excluded from these commercial real estateconcentrations are nonfarm nonresidential owner occupied properties where theprimary source of repayment is the cash flow from the ongoing operations andactivities conducted by the party, or affiliate of the party, who owns theproperty.

 

*Credit Risk Management*

The extension of creditto individuals and businesses is a significant portion of Bancorp’s principalbusiness activity and requires ongoing portfolio and credit management.  Bancorp has established lending policies andprocedures to manage and monitor risk. These lending policies and proceduresinclude guidelines for concentrations of credit, loan terms, loan-to-valueratios, collateral appraisals and loan approval limits. In addition, Bancorpmonitors its loan portfolio for potential risk of loss according to an internalrisk-grading system and monitors its credit quality to

 

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identify potentialproblem 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.

 

Further declines in theperformance of the economy, in general, or further declines in real estatevalues in our market areas, in particular, could have an adverse impact oncollectability, increase the level of real estate non-performing loans or haveother adverse effects which alone or in aggregate could have a material adverseeffect on our business, financial condition, results of operation and cashflows.  In addition, most of Bancorp’s business activity is with customerslocated within Skagit, Snohomish and Whatcom Counties

 

**ALLOWANCE FOR LOAN LOSSES**          Theallowance for loan losses was $7.3 million or 1.90 percent of net loans as of March 31,2010 compared to $6.9 million or 1.78 percent of net loans as of December 31,2009. The increase in the allowance for loan losses is primarily due to thecontinued deterioration of the economy and declines in real estate values. Additions to the allowance, in the formof provision, are reflected in current operating results, while charge-offs tothe allowance are made when a loss is determined to have occurred. Theprovision for loan losses was $550,000 for the quarter ended March 31,2010 compared to $450,000 for the like period in 2009. For the quarter ended March 31,2010, net charge-offs were $153,000 compared to$263,000 for the like period in 2009.

 

The allowance consists ofspecific, general and unallocated components; (i) a specific valuationallowance based on a review of classified or non-performing loans for specificweaknesses and evaluation of those loans for impairment and loss exposure; (ii) ageneral allowance which is based on historical loan loss experience fordifferent loan types and different risk gradings with adjustments for currentevents and conditions.  Bancorp’s processis designed to account for credit deterioration as it occurs.  The adjustments are a result of management’sjudgment about risks inherent in the portfolio and include such factors as loanquality trends, levels of and trends of non-accrual loans, past due loans,potential problem loans, criticized loan balances, net charge-offs and currenteconomic and business conditions, among other factors and (iii) unallocatedgeneral allowances determined based on general economic conditions and otherqualitative risk factors.  Theunallocated allowance provides for other credit losses inherent in the loanportfolio that may not have been contemplated in the general and specificcomponents of the allowance. The unallocated amount is reviewed periodicallybased on trends in credit losses, the results of credit reviews and overalleconomic trends. At March 31, 2010 and December 31, 2009, the generalallocated reserve was $4.9 million and $5.0 million, respectively. At March 31,2010 and December 31, 2009, $1.2 million related to loans for which therewas a specific reserve. The increase in the unallocated portion of theallowance for possible loan losses during 2010 is reflective of continuedrecessionary economic conditions and the impact to credit quality. While  we strive to carefully monitor credit qualityand to identify loans that may become nonperforming, at any time there areloans in the portfolio that could result in losses, but that have not beenidentified as nonperforming or potential problem loans.

 

While Bancorp believesthat it uses the best information available to determine the allowance for loanlosses, unforeseen market conditions could result in adjustments to theallowance for loan losses, and net income could be significantly affected ifcircumstances differ substantially from the assumptions used in making thefinal determination.  The growth of theloan portfolio and a further decline in the performance of the economy, ingeneral, or a further decline in real estate values in our market areas, in particular,could have an adverse impact on collectability, increase the level ofnon-performing loans or have other adverse effects which alone or in aggregatecould have a material adverse effect on our business, financial condition,results of operation and cash flows which may require additional provisions toour allowance for loan losses. The ultimate recovery of loans is susceptible tofuture market factors beyond Bancorp’s control. Additionally, loans are subjectto examinations by regulators, who, based upon their judgment, may require Bancorpto make additional provisions or adjustments to its allowance for loan losses.

 

The following tablepresents Bancorp’s allocation of the allowance for loan losses by loan categoryas of the dates indicated.  (dollars inthousands)

 
| ** **                                      | ** ** | **March 31, 2010** | ** ** | **December 31, 2009** | ** ** |
|-------------------------------------------------|------------|-------------------------|------------|----------------------------|------------|
| Commercial,  industrial & agricultural |       | $                       | 1,439      |                       | $          | 1,456 |   |
| Real  estate-residential & commercial  |       | 4,039                   |       | 4,013                      |       |
| Consumer                                        |       | 659                     |       | 683                        |       |
| Unallocated                                     |       | 1,143                   |       | 731                        |       |
| Total                                           |       | $                       | 7,280      |                       | $          | 6,883 |   |

 

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

 

**Allowance for Loan LossesActivity**

(dollarsin thousands)

 
| **For  the three months ended March 31,**               | ** ** | **2010** | ** ** | **2009** | ** ** |
|--------------------------------------------------------------|------------|----------|------------|----------|------------|
| Allowance  as of beginning of year                           |       | $        | 6,883      |     | $          | 5,450 |   |
| Provision  for loan losses                                   |       | 550      |       | 450      |       |
| Charge-offs                                                  |       | (188     | )          | (314     | )          |
| Recoveries                                                   |       | 35       |       | 51       |       |
| Net  (charge-offs) recoveries                                |       | (153     | )          | (263     | )          |
| Balance  at end of period                                    |       | $        | 7,280      |     | $          | 5,637 |   |
| Ratio  of net charge-offs to average loans during the period |       | 0.16     | %          | 0.27     | %          |
| Ratio  of allowance to net loans at end of period            |       | 1.90     | %          | 1.47     | %          |
| Ratio  of non-performing loans to allowance                  |       | 139.22   | %          | 95.23    | %          |

 

***ASSETQUALITY*****     **Non-performing assets consist of nonaccrual loans,accruing loans past due 90 days or more, and other real estate owned. At March 31,2010, non-performing assets increased to $17.5 million or 2.61 percent of totalassets compared to $17.0 million or 2.63 percent as of December 31, 2009.

 

*Non-accrual*- It is Bancorp’spolicy to discontinue the accrual of interest on all loans that are 90 days ormore past due or when there are otherwise serious doubts about thecollectability of principal or interest within the existing terms of the loanand place them on non-accrual.  When aloan is placed on non-accrual status, any accrued but unpaid interest on thatdate is removed from interest income.  Non-accruingloans decreased to $10.1 million as of March 31, 2010 compared to $10.7million as of December 31, 2009 with $1.4 million of the December balancetransferring into other real estate owned during 2010. Raw land, construction,and land development loans are the primary components of non-performing loansrepresenting $6.9 million or 68.3% of non-performing loans as of March 31,2010.

 

*Restructuredloans* — Loans areconsidered restructured on loans for which concessions, including the reductionof interest rates below a rate otherwise available to that borrower or thedeferral or forgiveness, of interest or principal, have been granted due to theborrower’s weakened financial condition. Restructured loans included in impaired loans were $1.2 million as of March 31,2010, of which, $791,000 was included in non-accrual loans.   Restructured loans included in impaired loanswere $945,000 as of December 31, 2009, of which, $555,000 was included innon-accrual loans.

 

*Other real estate owned* —  Other real estate owned increased to $7.3 million at March 31, 2010from $6.3 million at December 31, 2009. During 2010, Bancorp foreclosed on a non-accrual credit relationships of$1.4 million. In addition, Bancorp transferred the former Boulevard branch witha balance of $339,000 from other real estate owned back into bank premises foruse as the bank’s consumer loan administrative facility. As of March 31,2010, Bancorp held seven properties which represent four separate landdevelopment projects consisting of finished lots with a carrying balance of$4.7 million, two commercial real estate properties with a carrying balance of$2.5 million, and a $136,000 raw land property.

 

Valuation of the propertyoccurs when it is foreclosed upon and annually thereafter. Based on currentappraisals received during the quarter ended March 31, 2010, and thedecrease in fair market values of these real estate properties, Bancorprecorded a write-down on other real estate owned of $20,000 for the quarter.Bancorp plans to continue its collection efforts and liquidation of collateral,as necessary, to recover as large a portion of the non-accrual assets or otherreal estate owned as possible.

 

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

 

**Non-Performing Assets**

 
| **(dollars  in thousands)**                  | ** ** | **March 31, 2010** | ** ** | **December 31, 2009** | ** ** |
|----------------------------------------------|------------|-------------------------|------------|----------------------------|------------|
| Non-accrual  loans                           |       | $                       | 10,135     |                       | $          | 10,742 |   |
| Loans  past due 90 days or more              |       | —                  |       | —                     |       |
| Total  non-performing loans                  |       | 10,135                  |       | 10,742                     |       |
| Other  real estate owned                     |       | 7,344                   |       | 6,284                      |       |
| Total  non-performing assets                 |       | $                       | 17,479     |                       | $          | 17,026 |   |
| Total  non-performing loans to net loans     |       | 2.65                    | %          | 2.78                       | %          |
| Total  non-performing loans to total assets  |       | 1.51                    | %          | 1.66                       | %          |
| Total  non-performing assets to total assets |       | 2.61                    | %          | 2.63                       | %          |

 

*Impaired loans -*At March 31, 2010, impaired loansdecreased to $22.4 million compared to $24.4 million at December 31,2009.  Six credit relationships of $14.9million, accounted for 66.0 percent of impaired loans as of March 31,2010. All material loan restructurings have been included in impaired loans.

 

A loan is consideredimpaired when management determines that it is probable that Bancorp will beunable to collect all amounts of principal and interest according tocontractual terms. Factors considered by management in determining impairmentinclude payment status, and the probability of collecting scheduled principaland interest payments when due. Impaired loans include loans in nonaccrualstatus, troubled debt restructures and other loans that management considers tobe impaired. Other loans include loans that management has reviewed forimpairment and has determined to be impaired even though the loan may becurrent and performing in accordance with the contractual loan terms.   As a result, these other impaired loanscontinue to remain on accrual status and are not considered non-performingassets.  Loans that experienceinsignificant payment delays and payment shortfalls generally are notclassified as impaired.

 

*Potential problem loans* —  Potential problem loans consist of loans that are currently performing,are not on nonaccrual status, restructured or impaired, but for whichmanagement have identified as having a well defined weakness or weaknesses andwhich there are sufficient doubts as to the borrower’s future ability to complywith repayment terms.  These loans areidentified through our internal risk grading processes and management monitorsthese loans closely and reviews their performance on a regular basis. As of March 31,2010 and December 31, 2009, Bancorp had classified $10.8 million and $8.8million, respectively, as other potential problem loans.

 

**DEPOSITS**          Bancorpoffers a full range of deposit services including checking accounts, savingsaccounts, money market accounts and various types of certificates ofdeposit.  The transaction accounts andcertificates of deposit are tailored to Bancorp’s primary market area at ratescompetitive with those offered in the area. Bancorp offers both interest andnon-interest bearing checking accounts. In December 2008, Bancorpinitiated service through the Certificate of Deposit Account Registry Service(CDARS), which allows us to assist customers in maximizing their FDICinsurance.

 

Total deposits increasedto $567.9 million at March 31, 2010 compared to $545.4 million at December 31,2009.  Within the total, core depositsincreased $13.9 million and time deposits increased $8.5 million.  Core deposits, which consist of non-interestand interest bearing demand accounts, money market accounts, and savingaccounts, represented 62.1% of total deposits at March 31, 2010 and December 31,2009, respectively.

 

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

 

**Deposit Composition**

 
| ** **                   | ** ** | **March 31, 2010** | ** ** | **December 31, 2009** | ** ** |
|------------------------------|------------|-------------------------|------------|----------------------------|------------|
| **(dollars  in thousands)**  | ** ** | **Amount**              | ** ** | **% of Total**             | ** ** | **Amount** | ** ** | **% of Total** | ** ** |
| Non-interest  bearing demand |       | $                       | 71,763     |                       | 12.6       | % | $ | 73,839 |   | 13.5 | % |
| Interest  bearing demand     |       | 104,906                 |       | 18.5                       | %          | 101,504 |   | 18.6 | % |
| Money  market                |       | 84,548                  |       | 14.9                       | %          | 77,288 |   | 14.2 | % |
| Savings                      |       | 91,668                  |       | 16.1                       | %          | 86,370 |   | 15.8 | % |
| Time                         |       | 190,780                 |       | 33.6                       | %          | 182,441 |   | 33.4 | % |
| Brokered  time deposits      |       | 24,197                  |       | 4.3                        | %          | 23,994 |   | 4.5 | % |
| Total  deposits              |       | $                       | 567,862    |                       | 100.0      | % | $ | 545,436 |   | 100.0 | % |

 

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**OTHER BORROWINGS          **Borrowings consist of federal fundspurchased which include discount window borrowings from the Federal ReserveBank of San Francisco and securities sold under agreements to repurchase.

 

Securities sold underagreement to repurchase decreased to $35.2 million at March 31, 2010compared to $38.1 million as of December 31, 2009.  These borrowings decrease or increaseprimarily based on the availability of funds and the current competitiveinterest rate offered.  These borrowingsare collateralized by securities with an estimated fair value exceeding theface value of the borrowings. Investment securities with a carrying amount of$45.7 million, consisting of U.S. government agency debt securities and U.S.government agency mortgage-backed securities were pledged as collateral forsecurities sold under agreement to repurchase at March 31, 2010.  Periodically, Bancorp uses federal fundspurchased and Federal Reserve borrowings as a funding source. Bancorp had noFederal Reserve borrowings or federal funds purchased at March 31, 2010 orDecember 31, 2009. Both securities sold under repurchase and federal fundspurchased are overnight funds or borrowings that typically mature within oneyear.

 

For securities sold underagreements to repurchase, the Bancorp may transfer legal control over theunderlying securities but still retain effective control through an agreementthat both entitles and obligates Bancorp to repurchase the underlyingsecurities.  As a result, securities soldunder agreement to repurchase are accounted for as collateralized financingarrangements and not as a sale and subsequent repurchase of securities.

 

**CAPITAL RESOURCES**          Stockholders’equity increased to $64.7 million at March 31, 2010 from $62.9 million at December 31,2009.  Book value per share at March 31,2010 was $110.15 compared to a book value of $107.10 at December 31, 2009.

 

Bancorp has only oneclass of stock, which is common stock and at March 31, 2010, there were778 shareholders of record.  Bancorp’sstock is not actively traded or quoted and no broker currently makes a marketin the stock. However, sales and transfers of the stock do occur.  Skagit State Bank acts as transfer agent forBancorp stock.  To facilitate trading,the Bank maintains a list of persons interested (known to the Bank) in eitherpurchasing or selling Bancorp stock. Purchasers and sellers then negotiate their own transactions with theBank acting as transfer agent for those transactions. From time to time, Bancorprepurchases shares of its common stock. The number of shares of stock that willbe repurchased and the price that will be paid is the result of many factorsincluding market and economic conditions, the number of shares available,Bancorp’s liquidity and capital needs and regulatory requirements. Bancorprepurchased no shares of stock in 2010 or 2009.

 

On October 3,2008, Congress approved and the President signed the Emergency EconomicStabilization Act of 2008 (the “Act”). The Troubled Assets Relief Program (“TARP”) is the heart of the Act andprovides the Secretary of the Treasury the authority to purchase troubledassets from eligible financial institutions in an aggregate amount of up to$700 billion.  Under the Act, the Treasurycreated the Capital Purchase Program (“CPP”) that enables the federalgovernment to purchase equity in participating financial institutions to helprestore credit markets.  In November 2008,Bancorp applied to participate under this program.  In January 2009, Bancorp receivedpreliminary approval from the U.S. Department of Treasury for approximately $14million under the program.  After carefulconsideration by Executive Management and our Board of Directors, we determinednot to accept any of the TARP proceeds. In reaching this decision, the Board also considered the uncertaintiesand constraints (including dividend and stock repurchase restrictions)associated with the TARP.

 

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Banking regulationsrequire bank holding companies and banks to maintain certain minimum capitallevels.  As the following table indicatesas of March 31, 2010 and December 31, 2009, Skagit State Bancorp, Inc.and Skagit State Bank both exceeded the well-capitalized requirements.

 
|                             |       |       |       |                               |       |                                                                    |       |      |             |       |       |      |       |             |   |   |
|----------------------------------|------------|------------|------------|------------------------------------|------------|-------------------------------------------------------------------------|------------|-----------|------------------|------------|------------|-----------|------------|------------------|--------|--------|
| ** **                       | ** ** | **Actual** | ** ** | **For Capital  Adequacy Purposes** | ** ** | **To Be Well  Capitalized Under  Prompt Corrective  Action Provisions** | ** ** |
| **(dollars  in thousands)**      | ** ** | **Amount** | ** ** | **Ratio**                          | ** ** | **Amount**                                                              | ** ** | **Ratio** | ** **       | **Amount** | ** ** | **Ratio** | ** ** |
| As  of March 31, 2010       |       |       |       |                               |       |                                                                    |       |      |             |       |       |      |       |
| Total  Capital                   |       |       |       |                               |       |                                                                    |       |      |             |       |       |      |       |
| (to  Risk-Weighted Assets)       |       |       |       |                               |       |                                                                    |       |      |             |       |       |      |       |
| Skagit  State Bank               |       | $          | 67,618     |                               | 15.12      | %                                                                       | $          | 35,784    |   > | 8.00       | %          | $         | 44,730     |   > | 10.00  | %      |
| Skagit  State Bancorp, Inc. |       | $          | 67,873     |                               | 15.16      | %                                                                       | $          | 35,806    |   > | 8.00       | %          | $         | 44,757     |   > | 10.00  | %      |
| Tier  I Capital                  |       |       |       |                               |       |                                                                    |       |      |             |       |       |      |       |
| (to  Risk-Weighted Assets)       |       |       |       |                               |       |                                                                    |       |      |             |       |       |      |       |
| Skagit  State Bank               |       | $          | 62,006     |                               | 13.86      | %                                                                       | $          | 17,892    |   > | 4.00       | %          | $         | 26,838     |   > | 6.00   | %      |
| Skagit  State Bancorp, Inc. |       | $          | 62,258     |                               | 13.91      | %                                                                       | $          | 17,903    |   > | 4.00       | %          | $         | 26,854     |   > | 6.00   | %      |
| Tier  I Capital                  |       |       |       |                               |       |                                                                    |       |      |             |       |       |      |       |
| (to  Average Assets)             |       |       |       |                               |       |                                                                    |       |      |             |       |       |      |       |
| Skagit  State Bank               |       | $          | 62,006     |                               | 9.50       | %                                                                       | $          | 26,096    |   > | 4.00       | %          | $         | 32,620     |   > | 5.00   | %      |
| Skagit  State Bancorp, Inc. |       | $          | 62,258     |                               | 9.54       | %                                                                       | $          | 26,096    |  >       | 4.00       | %          | $         | 32,620     |   > | 5.00   | %      |
|                             |       |       |       |                               |       |                                                                    |       |      |             |       |       |      |       |
| As  of December 31, 2009    |       |       |       |                               |       |                                                                    |       |      |             |       |       |      |       |
| Total  Capital                   |       |       |       |                               |       |                                                                    |       |      |             |       |       |      |       |
| (to  Risk-Weighted Assets)       |       |       |       |                               |       |                                                                    |       |      |             |       |       |      |       |
| Skagit  State Bank               |       | $          | 66,563     |                               | 14.39      | %                                                                       | $          | 37,002    |   > | 8.00       | %          | $         | 46,252     |   > | 10.00  | %      |
| Skagit  State Bancorp, Inc. |       | $          | 66,783     |                               | 14.43      | %                                                                       | $          | 37,021    |   > | 8.00       | %          | $         | 46,276     |   > | 10.00  | %      |
| Tier  I Capital                  |       |       |       |                               |       |                                                                    |       |      |             |       |       |      |       |
| (to  Risk-Weighted Assets)       |       |       |       |                               |       |                                                                    |       |      |             |       |       |      |       |
| Skagit  State Bank               |       | $          | 60,768     |                               | 13.14      | %                                                                       | $          | 18,501    |   > | 4.00       | %          | $         | 27,751     |   > | 6.00   | %      |
| Skagit  State Bancorp, Inc. |       | $          | 60,985     |                               | 13.18      | %                                                                       | $          | 18,510    |   > | 4.00       | %          | $         | 27,765     |   > | 6.00   | %      |
| Tier  I Capital                  |       |       |       |                               |       |                                                                    |       |      |             |       |       |      |       |
| (to  Average Assets)             |       |       |       |                               |       |                                                                    |       |      |             |       |       |      |       |
| Skagit  State Bank               |       | $          | 60,768     |                               | 9.74       | %                                                                       | $          | 24,959    |   > | 4.00       | %          | $         | 31,199     |   > | 5.00   | %      |
| Skagit  State Bancorp, Inc. |       | $          | 60,985     |                               | 9.77       | %                                                                       | $          | 24,959    |   > | 4.00       | %          | $         | 31,199     |   > | 5.00   | %      |

 

**LIQUIDITY**

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

 

Liquidity is generatedfrom both internal and external sources. The majority of funding comes fromcustomer deposits within the Bank’s market area. In addition, funding needs aremet through loan repayments, investment securities repayments, earnings andother borrowings through pre-approved credit lines. Liquidity may also beobtained by maintaining assets that can be converted to cash with little or norisk of loss.  However, in this turbulentmarket environment, assets may be more difficult to convert to cash with orwithout a loss.

 

As part of the Bank’sliquidity management, the Bank utilizes federal funds purchased to supplementthe primary source of funds, which are deposits.  As a result, there could be fluctuations inthese borrowing balances depending on short-term liquidity and longer-term financingneeds of the Bank.  As of March 31,2010 Bancorp had approximately $47.0 million in approved unsecured credit linesfrom various financial institutions and had securities with a market value of$45.9 million pledged as collateral for borrowing at the Federal ReserveDiscount Window.

 

Because the Bank’sprimary sources and uses of funds are deposits and loans, the relationshipbetween net loans and total deposits provides one measure of the Bank’sliquidity.  The Bank’s loan to depositratio decreased to 67.3 percent at March 31, 2010 compared to 70.9 percentat December 31, 2009, as a result of the increase in deposits and thedecrease in loans.

 

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The turmoil in the creditmarkets during the last few years did not have a direct impact on Bancorp’sliquidity management practices. Access to our correspondent banks and theFederal Reserve remained open. Management believes that Bancorp’s liquidityposition at March 31, 2010 was adequate to fund ongoing operations.

 

Skagit State Bancorp, Inc.is a separate legal entity from the Bank and must provide for its own liquidity.  Substantially all of Bancorp’s revenues areobtained from dividends declared and paid by the Bank. Skagit State Bank’sability to pay dividends is limited by its earnings, financial condition andcapital 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 rate cycles within the constraintsof credit quality, interest rate risk policies, levels of capital and adequatelevels of liquidity.  The committee meetsto monitor the composition of the balance sheet, to review projected earningstrends, 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 31,2009.

 

# **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 -****                                          ****OTHER INFORMATION**

 

**Item 1.****                                                          ****Legal Proceedings**

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

 

**Item 1A.****                                                 ****Risk Factors**

There are certain risksinherent to Bancorp’s business.  Thematerial risks and uncertainties that management believes affect Bancorp aredescribed below.  Although we have riskmanagement policies, procedures and verification procedures in place,additional risks and uncertainties that management is not aware of or focusedon or that management currently deems immaterial may also impair Bancorp’sbusiness operations.  If any of thefollowing risks actually occur, our financial condition and results ofoperations could be materially and adversely affected.

 

**We cannot accurately predict theeffect of the national economic situation on Bancorp’s future results ofoperations.**

 

The national economy andthe financial services sector in particular are currently facing challenges ofa scope unprecedented in recent history. The Company cannot accurately predict the severity or duration of thecurrent economic downturn, which has adversely impacted the markets weserve.  Any further deterioration in the 

 

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economies of the nationas a whole or in our markets would have an adverse effect, which could bematerial, on our business, financial condition, results of operations andprospects.  While it is impossible topredict how long these conditions may exist, the economic downturn couldcontinue to present risks for some time for the industry and our company.

 

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

 

Real estate relatedloans, including those loans that are collateralized by real estate, comprisethe largest category of loans, representing 76.5% of Bancorp’s totalloans.  Our real estate portfolioconsists of commercial and residential lending.  These loans are securedby property such as office buildings, commercial business properties,healthcare buildings, agricultural land, timber land and residentialproperties.  Commercial and commercial real estate loans generally areviewed as having more risk of default than residential real estate loans orcertain other types of loans or investments.  Typically, these types ofloans are larger than residential real estate loans and other loans. Because the loan portfolio contains a number of commercial real estate loanswith relatively large balances, the deterioration of one or a few of theseloans may cause a significant increase in nonperforming loans.  Anincrease in nonperforming loans could result in a loss of earnings from theseloans, an increase in the provision for loan losses or an increase in loancharge-offs, which could have an adverse impact on our results of operationsand financial condition.

 

Therehas been an economic downturn throughout the country, particularly in thehousing and commercial real estate sectors.  While the Pacific Northwesteconomy typically lags the national economy, the effects of the economicdownturn are now significantly impacting our market area.  Furtherdownturn in the market areas we serve may cause us to have lower earnings andcould increase our credit risk associated with our loan portfolio, as thecollateral securing those loans may decrease in value.  A continueddownturn in the local economy could have a material adverse effect on both theability of borrowers to repay loans, as well as the value of the real propertyheld as collateral.  Substantially all of our loans are to businesses andindividuals in Skagit, Snohomish or Whatcom Counties and any decline in theeconomy of this market area could impact us adversely.  As a lender, weare exposed to the risk that our customers will be unable to repay their loansin accordance with their terms, and that any collateral securing the payment oftheir loans may not be sufficient to assure repayment.

 

**Our allowance for loan losses maynot be adequate to cover actual loan losses, which could adversely affect ourearnings.**

 

Bancorp maintains anallowance for loan losses in an amount that we believe is adequate to providefor losses inherent in the portfolio.  While we strive to carefullymanage and monitor credit quality and to identify loans that may becomenonperforming, at any time there are loans included in the portfolio that willresult in losses, but that have not been identified as nonperforming orpotential problem loans.  By closely monitoring our credit quality,we attempt to identify deteriorating loans before they become nonperformingassets and adjust the loan loss reserve accordingly.  However,because future events are uncertain, and if the economy continues todeteriorate, there may be loans that deteriorate to a nonperforming status inan accelerated time frame.  As a result, future additions to theallowance may be necessary.  Because the loan portfolio contains anumber of loans with relatively large balances, the deterioration of one or afew of these loans may cause a significant increase in nonperforming loans,requiring an increase to the loan loss allowance.  As a result,future additions to the allowance at elevated levels may be required based onchanges in the mix of loans comprising the portfolio, changes in the financialcondition of borrowers, such as may result from changes in economic conditions,or as a result of incorrect assumptions by management in determining theallowance.  Additionally, banking regulators, as an integral part oftheir supervisory function, periodically review our loan portfolio and theadequacy of our allowance for loan losses.  These regulatory agenciesmay require us to recognize further loan loss provisions or charge-offs basedupon their judgments, which may be different from ours.  Any increasein the allowance for loan losses could have a negative effect on our financialcondition and results of operation.

 

**A continuedtightening of the credit markets may make it difficult to obtain adequatefunding for loan growth, which could adversely affect our earnings.**

 

Acontinued tightening of the credit markets and the inability to obtain orretain adequate funds for continued loan growth at an acceptable cost maynegatively affect our asset growth and liquidity position and, therefore, ourearnings capability.  In addition to core deposit growth, maturity ofinvestment securities and loan payments, Bancorp also relies on alternativefunding sources through correspondent banking, and borrowing lines with the 

 

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FederalReserve Bank to fund loans.  In the event the current economic downturncontinues, particularly in the housing market, these resources could benegatively affected, both as to price and availability, which would limit andor raise the cost of the funds available to Bancorp.

 

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

 

Bancorp’sprofitability and cash flows are dependent to a large extent upon net interestincome. Net interest income is the difference (or “spread”) between theinterest earned on loans, securities and other interest-earning assets andBancorp’s cost of funds, primarily interest expense on deposits and borrowings.Interest rates are highly sensitive to many factors that are beyond our controlincluding, but not limited to, general economic conditions, and policies ofvarious governmental and regulatory agencies. Changes in monetary policy,including changes in interest rates, impact the level of loans, deposits andinvestments, the credit profile of existing loans and the rates received onloans and investment securities and the rates paid on deposits and borrowings.If the interest paid on deposits increases at a faster rate than the interestreceived on loans and investment securities, Bancorp’s net interest income, andtherefore earnings could be adversely affected.  Earnings could also beadversely affected if interest received on loans and investments decreasefaster than interest paid on deposits.

 

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

 

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

 

**Weoperate in a highly regulated environment and we cannot predict the effect ofrecent and pending federal legislation.**

 

Bancorpis subject to extensive regulation, supervision and examination by federal andstate banking authorities.  In addition, as a publicly traded company,Bancorp is subject to regulation by the Securities and ExchangeCommission.  Any change in applicableregulations or federal, state or local legislation could have a substantialimpact on Bancorp and its operations.  Additional legislation andregulations that could significantly affect Bancorp’s powers, authority andoperations may be enacted or adopted in the future, which could have a materialadverse effect on Bancorp’s financial condition and results of operations. Further, regulators have significant discretion and authority to prevent orremedy unsafe or unsound practices or violations of laws or regulations byfinancial institutions and holding companies in the performance of theirsupervisory and enforcement duties.  Recently these powers have beenutilized more frequently due to the serious national, regional and localeconomic conditions Bancorp is facing.  The exercise of regulatoryauthority may have a negative impact on Bancorp’s financial condition andresults of operations.

 

Bancorpcannot predict the actual effects of recent legislation or the proposedregulatory reform measures and various governmental, regulatory, monetary andfiscal initiatives which have been and may be enacted on the financial markets,on Bancorp.  The terms and costs of these activities, or the failure ofthese actions to help stabilize the financial markets, asset prices, marketliquidity and a continuation or worsening of current financial market andeconomic conditions could materially and adversely affect our business,financial condition, results of operations, and the trading price of our commonstock.

 

**Our ability to access markets forfunding and acquire and retain customers could be adversely affected by thedeterioration of other financial institutions or to the extent the financialservice industry’s reputation is damaged.**

 

Reputationrisk is the risk to liquidity, earnings and capital arising from negativepublicity regarding the financial services industry.  The financialservices industry continues to be featured in negative headlines about theglobal and national credit crisis and the resulting stabilization legislationenacted by the U.S. federal government.  These reports can be damaging tothe industry’s image and potentially erode consumer confidence in insuredfinancial institutions, such as our banking subsidiary.  In addition, ourability to engage in routine funding and other transactions could be adverselyaffected by the actions and financial condition of other financialinstitutions. 

 

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Financialservices institutions are interrelated as a result of trading, clearing,counterparty or other relationships. As a result, defaults by, or even rumorsor questions about, one or more financial services institutions, or thefinancial services industry generally, could lead to market-wide liquidityproblems, losses of depositor, creditor and counterparty confidence and couldlead to losses or defaults by us or by other institutions. We could experiencematerial changes in the level of deposits as a direct or indirect result ofother banks’ difficulties or failure, which could affect the amount of capitalwe need.

 

**The FDIChas increased insurance premiums to restore and maintain the federal depositinsurance fund, and there may be additional future premium increases andspecial assessments.**

 

TheFDIC adopted a final rule revising its risk-based assessment system,effective April 1, 2009.  The changes to the assessment systeminvolve adjustments to the risk-based calculation of an institution’s unsecureddebt, secured liabilities and brokered deposits.  The potential increasein FDIC insurance premiums could have a significant impact on Bancorp.

 

TheFDIC also has recently required insured institutions to prepay estimatedquarterly risk-based assessments for the fourth quarter of 2009 and for 2010,2011 and 2012, and increased the regular assessment rate by three basis pointseffective January 1, 2011, as a means of replenishing the depositinsurance fund.  The prepayment was collected on December 30, 2009,and was accounted for as a prepaid expense amortized over the prepaymentperiod.

 

TheFDIC also recently imposed a special deposit insurance assessment of five basispoints on all insured institutions.  This emergency assessment wascalculated based on the insured institution’s assets at June 30, 2009, andcollected on September 30, 2009.  Based on our June 30, 2009assets subject to the FDIC assessment, the special assessment was approximately$260,000.  This special assessment was in addition to the regularquarterly risk-based assessment.

 

TheFDIC deposit insurance fund may suffer additional losses in the future due tobank failures.  There can be no assurance that there will not beadditional significant deposit insurance premium increases, special assessmentsor prepayments in order to restore the insurance fund’s reserve ratio.  Any significant premium increases, specialassessments or prepayment requirements could have a material adverse effect onour financial condition 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.  It is not knownwhether significant trading activity will take place for several years, if atall.  Accordingly, our shares should beconsidered as a long-term investment.

 

**There are restrictions on changes in control ofBancorp that could decrease our shareholders’ chance to realize a premium ontheir 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.

 
| **Item 2.** | **Unregistered Sales of Equity  Securities and Use of Proceeds**                                                                                              |
|-------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------|
|        | None                                                                                                                                                          |
|        |                                                                                                                                                          |   |
| **Item 3.** |                                                                                                                                                          | **Defaults Upon Senior Securities** |
|        | None                                                                                                                                                          |
|        |                                                                                                                                                          | ** ** |
| **Item 4.** |                                                                                                                                                          | **Removed and Reserved** |
| ** **  | None                                                                                                                                                          |
| ** **  |                                                                                                                                                          | ** ** |
| **Item 5.** |                                                                                                                                                          | **Other Information** |
| ** **  | None                                                                                                                                                          |
| ** **  |                                                                                                                                                          | ** ** |
| **Item 6.** |                                                                                                                                                          | **Exhibits** |
| ** **  | ** **                                                                                                                                                    |
| ** **  |                                                                                                                                                          | (a) | Exhibits. |
| ** **  |                                                                                                                                                          |
| 31.1        | Certification of CEO,  Pursuant to Exchange Act Rule 13a-14 (as adopted Pursuant to Section 302  of the Sarbanes-Oxley Act of 2002)                 |
| 31.2        | Certification Chief  Financial Officer Pursuant to Exchange Act Rule 13a-14 (as adopted  Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002) |
| 32          | Certifications Pursuant  to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of  the Sarbanes-Oxley Act of 2002                           |

 

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**SIGNATURES**

 

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: | May 11, 2010 |                                   | /s/ Cheryl R. Bishop |
|   |              | Cheryl R. Bishop                       |
|   |              | President and Chief  Executive Officer |
|   |              |                                   |
|   |              |                                   |
| Dated: | May 11, 2010 |                                   | /s/ Carla F. Tucker |
|   |              | Carla F. Tucker                        |
|   |              | Executive  Vice-President              |
|   |              | Chief Financial Officer                |

 

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