**Table ofContents**

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**UNITEDSTATES SECURITIES AND EXCHANGE COMMISSON**

**Washington D.C., 20549**

** **

**FORM 10-Q**

 

**x****     ****Quarterly Report Pursuant toSection 13 or 15(d) of the Securities Exchange Act of 1934**

** **

**For the quarterly period endedJune 30, 2009**

** **

**o****        ****Transition Report UnderSection 13 or 15(d) of the Exchange Act**

** **

**For the transition period from          to           **

** **

**Commission File Number  000-52096**

 

**SKAGIT STATE BANCORP, INC.**

(Exact Name of Registrant asSpecified in Its Charter)

 

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

 

**301 East Fairhaven Avenue**

**Burlington, Washington  98233**

(Address of Principal ExecutiveOffices) (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 the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days.   Yes x No o

 

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

 

| Large  accelerated filer  o |   | 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 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).   Yeso No o

 

**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 Stock outstanding at August 13,2009 was 588,469.

 

 

 

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Table of Contents

 

**SKAGIT STATE BANCORP, INC.**

**TABLE OF CONTENTS**

 
| **PART I.**  | **FINANCIAL INFORMATION** |                                                                                                                                           |   |
|-------------------|---------------------------|------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|              |                      |                                                                                                                                           |   |   |
|              | Item 1.                   | Financial Statements                                                                                                                           |   |   |
|              |                      |                                                                                                                                           |   |   |
|              |                      | Consolidated  Balance Sheet as of June 30, 2009 and December 31, 2008                                                                |   | Page 3 |
|              |                      |                                                                                                                                           |   |   |
|              |                      | Consolidated  Statement of Income for the three and six months ended June 30, 2009 and  2008                                              |   | Page 4 |
|              |                      |                                                                                                                                           |   |   |
|              |                      | Consolidated Statement of Changes in Stockholders’  Equity and Comprehensive Income for the six months ended June 30, 2009 and  2008 |   | Page 5 |
|              |                      |                                                                                                                                           |   |   |
|              |                      | Consolidated Statement of Cash Flows for the six  months ended June 30, 2009 and 2008                                                     |   | Page 6 |
|              |                      |                                                                                                                                           |   |   |
|              |                      | Notes to Consolidated Financial Statements                                                                                                     |   | Pages 7-13 |
|              |                      |                                                                                                                                           |   |   |
|              | Item 2.                   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                                    |   | Pages 14-27 |
|              |                      |                                                                                                                                           |   |   |
|              | 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 31 |
|              |                      |                                                                                                                                           |   |   |
|              | Item 3.                   | Defaults Upon Senior Securities                                                                                                                |   | Page 31 |
|              |                      |                                                                                                                                           |   |   |
|              | Item 4.                   | Submission of Matters to a Vote of Security Holders                                                                                            |   | Page 31 |
|              |                      |                                                                                                                                           |   |   |
|              | Item  5.                  | Other  Information                                                                                                                             |   | Page 31 |
|              |                      |                                                                                                                                           |   |   |
|              | Item 6.                   | Exhibits                                                                                                                                       |   | Page 31 |
|              |                      |                                                                                                                                           |   |   |
|              |                      | Signatures                                                                                                                                     |   | Page 32 |

 

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**Item 1.    FinancialStatements**

 

**SKAGIT STATEBANCORP, INC. AND SUBSIDIARY**

**CONSOLIDATED BALANCE SHEET(Unaudited)**

** **
| **(dollars in thousands except  share data)**                                                                                                                              | ** ** | **June 30, 2009** | ** ** | **December 31, 2008** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|----------------------------|------------|
| **ASSETS**                                                                                                                                                                 | ** ** |
| **ASSETS**                                                                                                                                                                 | ** ** | ** **             | ** ** | ** **                 | ** ** |
| Cash  and due from banks                                                                                                                                                   |       | $                      | 10,682     |                       | $          | 11,954 |   |
| Federal  funds sold and interest-bearing bank balances                                                                                                                     |       | 31,778                 |       | —                     |       |
| Investment  securities                                                                                                                                                     |       |                   |       |                       |       |
| Available-for-sale,  at fair value                                                                                                                                         |       | 98,423                 |       | 102,647                    |       |
| Held-to-maturity,  at amortized cost                                                                                                                                       |       | 36,407                 |       | 36,518                     |       |
| Loans  held for sale                                                                                                                                                       |       | 658                    |       | 350                        |       |
| Loans                                                                                                                                                                      |       | 390,275                |       | 399,225                    |       |
| Allowance  for loan losses                                                                                                                                                 |       | (5,629                 | )          | (5,450                     | )          |
| Net  loans                                                                                                                                                                 |       | 384,646                |       | 393,775                    |       |
| Bank  premises and equipment, net                                                                                                                                          |       | 10,823                 |       | 11,480                     |       |
| Other  real estate owned                                                                                                                                                   |       | 7,103                  |       | 5,667                      |       |
| Accrued  interest receivable                                                                                                                                               |       | 2,377                  |       | 2,430                      |       |
| Other  assets                                                                                                                                                              |       | 2,468                  |       | 2,055                      |       |
| **TOTAL ASSETS**                                                                                                                                                           |       | $                      | 585,365    |                       | $          | 566,876 |   |
| ** **                                                                                                                                                                 |       |                   |       |                       |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                             | ** ** |
| **LIABILITIES**                                                                                                                                                            |       |                   |       |                       |       |
| Deposits                                                                                                                                                                   |       |                   |       |                       |       |
| Interest-bearing                                                                                                                                                           |       | $                      | 439,618    |                       | $          | 394,422 |   |
| Non-interest-bearing                                                                                                                                                       |       | 64,558                 |       | 75,116                     |       |
| Total  deposits                                                                                                                                                            |       | 504,176                |       | 469,538                    |       |
| Other  borrowings                                                                                                                                                          |       | 16,731                 |       | 32,665                     |       |
| Other  liabilities                                                                                                                                                         |       | 2,263                  |       | 2,872                      |       |
| Total  liabilities                                                                                                                                                         |       | 523,170                |       | 505,075                    |       |
|                                                                                                                                                                       |       |                   |       |                       |       |
| **STOCKHOLDERS’ EQUITY**                                                                                                                                              |       |                   |       |                       |       |
| Common  stock no par value, 5,000,000 shares authorized, 586,595 and 586,285 shares  issued and outstanding at June 30, 2009 and December 31, 2008  respectively |       | 12,174                 |       | 12,042                     |       |
| Accumulated  other comprehensive income, net of tax                                                                                                                        |       | 1,825                  |       | 2,325                      |       |
| Retained  earnings                                                                                                                                                         |       | 48,196                 |       | 47,434                     |       |
| Total  stockholders’ equity                                                                                                                                           |       | 62,195                 |       | 61,801                     |       |
| **TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                        |       | $                      | 585,365    |                       | $          | 566,876 |   |

 

*See accompanying notes to theseconsolidated financial statements*

 

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**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

**CONSOLIDATED STATEMENT OF INCOME(Unaudited)**

 
| ** **                                                  | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|-------------------------------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| **(dollars in thousands except  share data)**               | ** ** | **2009**                             | ** ** | **2008**                           | ** ** | **2009** | ** ** | **2008** | ** ** |
| ** **                                                  |       |                                 |       |                               |       |   |   |   |   |
| **INTEREST INCOME**                                         |       |                                 |       |                               |       |   |   |   |   |
| Interest  and fees on loans                                 |       | $                                    | 5,760      |                               | $          | 6,230 |   | $ | 11,667 |   | $ | 12,671 |   |
| Investment  securities                                      |       |                                 |       |                               |       |   |   |   |   |
| Taxable                                                     |       | 1,044                                |       | 1,363                              |       | 2,114 |   | 2,869 |   |
| Exempt  from federal income tax                             |       | 281                                  |       | 309                                |       | 562 |   | 634 |   |
| Federal  funds sold                                         |       | 11                                   |       | 31                                 |       | 12 |   | 273 |   |
| Total  interest income                                      |       | 7,096                                |       | 7,933                              |       | 14,355 |   | 16,447 |   |
| **INTEREST EXPENSE**                                        |       |                                 |       |                               |       |   |   |   |   |
| Deposits                                                    |       | 1,743                                |       | 2,522                              |       | 3,477 |   | 5,423 |   |
| Other  borrowings                                           |       | 64                                   |       | 129                                |       | 153 |   | 253 |   |
| Total  interest expense                                     |       | 1,807                                |       | 2,651                              |       | 3,630 |   | 5,676 |   |
| **NET INTEREST INCOME**                                     |       | 5,289                                |       | 5,282                              |       | 10,725 |   | 10,771 |   |
| Provision  for loan losses                                  |       | 450                                  |       | —                             |       | 900 |   | — |   |
| **NET INTEREST INCOME AFTER****PROVISION FOR  LOAN LOSSES** |       | 4,839                                |       | 5,282                              |       | 9,825 |   | 10,771 |   |
| **NON-INTEREST INCOME**                                     |       |                                 |       |                               |       |   |   |   |   |
| Service  charges on deposits                                |       | 781                                  |       | 775                                |       | 1,489 |   | 1,525 |   |
| Other                                                       |       | 179                                  |       | 180                                |       | 379 |   | 380 |   |
| Gain  on sale of assets                                     |       | 67                                   |       | 65                                 |       | 119 |   | 128 |   |
| Total  non-interest income                                  |       | 1,027                                |       | 1,020                              |       | 1,987 |   | 2,033 |   |
| **NON-INTEREST EXPENSES**                                   |       |                                 |       |                               |       |   |   |   |   |
| Salaries                                                    |       | 1,891                                |       | 1,959                              |       | 3,872 |   | 3,880 |   |
| Payroll  taxes and employee benefits                        |       | 464                                  |       | 454                                |       | 979 |   | 955 |   |
| Write-down  of other real estate owned                      |       | 373                                  |       | —                             |       | 373 |   | — |   |
| Bank  premises and equipment                                |       | 242                                  |       | 254                                |       | 484 |   | 529 |   |
| Occupancy                                                   |       | 189                                  |       | 200                                |       | 413 |   | 386 |   |
| State  business taxes                                       |       | 94                                   |       | 105                                |       | 192 |   | 226 |   |
| Advertising                                                 |       | 224                                  |       | 219                                |       | 373 |   | 369 |   |
| Other                                                       |       | 1,461                                |       | 945                                |       | 2,790 |   | 1,854 |   |
| Total  non-interest expenses                                |       | 4,938                                |       | 4,136                              |       | 9,476 |   | 8,199 |   |
| **INCOME BEFORE PROVISION FOR INCOME TAX**                  |       | 928                                  |       | 2,166                              |       | 2,336 |   | 4,605 |   |
| **PROVISION FOR INCOME TAX**                                |       |                                 |       |                               |       |   |   |   |   |
| Provision  for Income Tax                                   |       | 40                                   |       | 455                                |       | 250 |   | 994 |   |
| **NET INCOME**                                              |       | $                                    | 888        |                               | $          | 1,711 |   | $ | 2,086 |   | $ | 3,611 |   |
| **BASIC EARNINGS PER SHARE**                                |       | $                                    | 1.51       |                               | $          | 2.92 |   | $ | 3.56 |   | $ | 5.77 |   |
| **DILUTED EARNINGS PER SHARE**                              |       | $                                    | 1.50       |                               | $          | 2.89 |   | $ | 3.53 |   | $ | 5.72 |   |
| **DIVIDENDS DECLARED PER SHARE**                            |       | $                                    | 2.25       |                               | $          | 2.25 |   | $ | 2.25 |   | $ | 2.25 |   |

 

*Seeaccompanying notes to these consolidated financial statements*

 

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**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

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

Six monthsended June 30, 2009 and 2008

 
| ** **                                                                      | ** ** | ** **        | ** ** | ** **        | ** ** | **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, 2008                                                |       | 670,997           |       | $                 | 13,564     |              | $          | 694                    |       | $                 | 58,425     |       | $          | 72,683 |   |   |   |
| Comprehensive  income:                                                          |       |              |       |              |       |              |       |                   |       |              |       |       |       |
| Net  income                                                                     |       | —            |       | —            |       | —            |       | 3,611                  |       | 3,611             |       | $          | 3,611      |   |
| Other  comprehensive income:                                                    |       |              |       |              |       |              |       |                   |       |              |       |       |       |
| Unrealized  losses on available-for-sale securities, net of tax benefit of $599 |       | —            |       | —            |       | (1,163            | )          | —                 |       | (1,163            | )          | (1,163     | )          |
| Total  other comprehensive loss                                                 |       |              |       |              |       |              |       |                   |       |              |       | (1,163     | )          |
| Comprehensive  income                                                           |       |              |       |              |       |              |       |                   |       |              |       | $          | 2,448      |   |
| Cash  dividend declared, $2.25 per share                                        |       | —            |       | —            |       | —            |       | (1,323                 | )          | (1,323            | )          |       |       |
| Common  stock redemption                                                        |       | (85,022           | )          | (1,721            | )          | —            |       | (13,583                | )          | (15,304           | )          |       |       |
| Stock  compensation expense                                                     |       | —            |       | 93                |       | —            |       | —                 |       | 93                |       |       |       |
| **BALANCE,**June 30, 2008                                                  |       | 585,975           |       | $                 | 11,936     |              | $          | (469                   | )          | $                 | 47,130     |       | $          | 58,597 |   |   |   |
|                                                                            |       |              |       |              |       |              |       |                   |       |              |       |       |       |
| **BALANCE,**January 1, 2009                                                |       | 586,285           |       | $                 | 12,042     |              | $          | 2,325                  |       | $                 | 47,434     |       | $          | 61,801 |   |   |   |
| Comprehensive  income:                                                          |       |              |       |              |       |              |       |                   |       |              |       |       |       |
| Net  income                                                                     |       | —            |       | —            |       | —            |       | 2,086                  |       | 2,086             |       | $          | 2,086      |   |
| Other  comprehensive income (loss):                                             |       |              |       |              |       |              |       |                   |       |              |       |       |       |
| Unrealized  loss on available-for-sale securities, net of tax benefit of $257   |       | —            |       | —            |       | (500              | )          | —                 |       | (500              | )          | (500       | )          |
| Total  other comprehensive loss                                                 |       |              |       |              |       |              |       |                   |       |              |       | (500       | )          |
| Comprehensive  income                                                           |       |              |       |              |       |              |       |                   |       |              |       | $          | 1,586      |   |
| Cash  dividend declared, $2.25 per share                                        |       | —            |       | —            |       | —            |       | (1,324                 | )          | (1,324            | )          |       |       |
| Stock  options exercised                                                        |       | 25                |       | 4                 |       | —            |       | —                 |       | 4                 |       |       |       |
| Stock  compensation expense and restricted stock awards                         |       | 285               |       | 128               |       | —            |       | —                 |       | 128               |       |       |       |
| **BALANCE,**June 30, 2009                                                  |       | 586,595           |       | $                 | 12,174     |              | $          | 1,825                  |       | $                 | 48,196     |       | $          | 62,195 |   |   |   |

 

*Seeaccompanying notes to these consolidated financial statements*

 

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**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

**CONSOLIDATED STATEMENT OF CASHFLOWS**

**(Unaudited**)

 
| **(dollars in thousands)  Six months ended June 30,**                               | ** ** | **2009**   | ** ** | **2008**   | ** ** |
|------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| **CASH FLOWS FROM OPERATING  ACTIVITIES**                                                |       |       |       |       |       |
| Net income                                                                               |       | $          | 2,086      |       | $          | 3,611 |   |
| *Adjustments to reconcile net  income to net**cash flows from operating activities*      |       |       |       |       |       |
| Provision for loan losses                                                                |       | 900        |       | —     |       |
| Write-down of other real estate owned                                                    |       | 373        |       | —     |       |
| Depreciation                                                                             |       | 430        |       | 445        |       |
| Loss on sale of premises and equipment                                                   |       | 8          |       | —     |       |
| Gains on sale of loans held-for-sale                                                     |       | (119       | )          | (128       | )          |
| Amortization of investment securitypremiums and discounts, net                           |       | (98        | )          | (134       | )          |
| Provision for deferred income taxes                                                      |       | —     |       | (7         | )          |
| Stock compensation for employee services                                                 |       | 128        |       | 93         |       |
| *Changes in operating assets and  liabilities*                                           |       |       |       |       |       |
| Originations of loans held for sale                                                      |       | (9,926     | )          | (10,889    | )          |
| Proceeds for sales of loans held for sale                                                |       | 9,737      |       | 10,254     |       |
| Decrease in interest receivable                                                          |       | 53         |       | 515        |       |
| Increase in other assets                                                                 |       | (155       | )          | (1,384     | )          |
| Decrease in other liabilities                                                            |       | (609       | )          | (778       | )          |
| Net cash flows from operating activities                                                 |       | 2,808      |       | 1,598      |       |
| **CASH FLOWS FROM INVESTING  ACTIVITIES**                                                |       |       |       |       |       |
| Proceeds from maturities of investmentsecurities –  available-for-sale              |       | 10,705     |       | 25,950     |       |
| Purchases of investment securities –  available-for-sale                            |       | (7,140     | )          | (20,135    | )          |
| Proceeds from maturities of investmentsecurities –  held-to-maturity                |       | 4,528      |       | 4,105      |       |
| Purchases of investment securities –  held-to-maturity                              |       | (4,417     | )          | —     |       |
| Net decrease (increase) in federal funds  sold & interest-bearing bank balances |       | (31,778    | )          | 41,195     |       |
| Net decrease (increase) in loans                                                         |       | 6,895      |       | (29,151    | )          |
| Purchase of premises and equipment                                                       |       | (121       | )          | (150       | )          |
| Capitalized expenditures for improvements to other  real estate owned                    |       | (136       | )          | (9         | )          |
| Net cash flows from investing activities                                                 |       | (21,464    | )          | 21,805     |       |
| **CASH FLOWS FROM FINANCING  ACTIVITIES**                                                |       |       |       |       |       |
| Net increase in demand deposits, money market, NOW  and savings accounts                 |       | 16,376     |       | (868       | )          |
| Net increase (decrease) in time deposits                                                 |       | 18,262     |       | (14,272    | )          |
| Amount paid for redemption of common stock                                               |       | —     |       | (15,304    | )          |
| Net increase (decrease) in other borrowings                                              |       | (15,934    | )          | 5,417      |       |
| Proceeds from exercise of stock options                                                  |       | 4          |       | —     |       |
| Cash dividends                                                                           |       | (1,324     | )          | (1,323     | )          |
| Net cash flows from financing activities                                                 |       | 17,384     |       | (26,350    | )          |
| **NET CHANGE IN CASH AND DUE FROM  BANKS**                                               |       | (1,272     | )          | (2,947     | )          |
| **CASH AND DUE FROM BANKS,**beginning of  period                                         |       | 11,954     |       | 16,641     |       |
| **CASH AND DUE FROM BANKS,** end of period                                               |       | $          | 10,682     |       | $          | 13,694 |   |
| **SUPPLEMENTAL DISCLOSURES OF CASH  FLOW INFORMATION**                                   | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash paid during the period for income taxes                                             |       | $          | 166        |       | $          | 947 |   |
| Cash paid during the period for interest                                                 |       | 3,600      |       | 5,857      |       |
| **NONCASH FINANCING AND INVESTING  TRANSACTIONS**                                        |       |       |       |       |       |
| Property taken in settlement of loans                                                    |       | 1,334      |       | 6,202      |       |

 

* See accompanying notes to these consolidatedfinancial statements*

 

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**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

**Note 1:   BASIS OF PRESENTATION**

 

The accompanyingconsolidated financial statements include the accounts of Skagit State Bancorp, Inc.and its subsidiary Skagit State Bank, (collectively, “Company” or “Bancorp”).All significant inter-company accounts and transactions have been eliminated.The consolidated financial statements have been prepared in conformity withaccounting principles generally accepted in the United States of America forinterim financial information and with instructions to Form 10-Q.Accordingly they do not include all of the information and footnotes 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 six months ended June 30,2009 are not necessarily indicative of the results anticipated for the yearending December 31, 2009. For additional information, refer to the auditedfinancial statements and footnotes for the most recent annual period ended December 31,2008 contained in the Annual Report on Form 10-K.  Bancorp has evaluated subsequent events forpotential recognition and/or disclosure through August 13, 2009, which isthe date the financial statements were issued.

 

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

 

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

 

Bancorp’s financialstatements are based upon the selection and application of significantaccounting policies which by their nature are inherently subject to estimationtechniques, valuation assumptions and other subjective assessments. Managementhas identified specific accounting policies that due to judgments, estimatesand assumptions and economic assumptions which may prove inaccurate or aresubject to variation that may significantly affect our reported results ofoperations and financial positions for the periods presented or in futureperiods.  These policies relate to thedetermination of the allowance for loan losses and the valuation of real estateowned. These policies and the judgments, estimates and assumptions aredescribed in the Annual Report on Form 10-K for the year ended December 31,2008.

 

**Note 3:   RECLASSIFICATIONS**

 

Certain reclassificationshave been made to the 2008 financial statements to conform to the 2009presentation. Such classifications have no affect on net income.

 

**Note 4:   EARNINGSPER SHARE**

 

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

 
| ** **                                                                         | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| **(dollars in thousands except  share and per share amounts)**                     | ** ** | **2009**                             | ** ** | **2008**                           | ** ** | **2009** | ** ** | **2008** | ** ** |
| Numerator:                                                                         |       |                                 |       |                               |       |   |   |   |   |
| Net  income                                                                        |       | $                                    | 888        |                               | $          | 1,711 |   | $ | 2,086 |   | $ | 3,611 |   |
| Denominator:                                                                       |       |                                 |       |                               |       |   |   |   |   |
| Denominator  for basic earnings per share - Weighted average shares outstanding    |       | 586,595                              |       | 585,975                            |       | 586,519 |   | 626,150 |   |
| Effect  of dilutive securities: Stock options and unvested restricted stock grants |       | 4,399                                |       | 5,175                              |       | 4,690 |   | 4,797 |   |
| Denominator  for diluted earning per share - Weighted average shares outstanding   |       | 590,994                              |       | 591,150                            |       | 591,209 |   | 630,947 |   |
| Basic  earnings per share                                                          |       | $                                    | 1.51       |                               | $          | 2.92 |   | $ | 3.56 |   | $ | 5.77 |   |
| Diluted  earnings per share                                                        |       | $                                    | 1.50       |                               | $          | 2.89 |   | $ | 3.53 |   | $ | 5.72 |   |

 

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**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

**Note 5:   CASH DIVIDENDS**

 

On May 19, 2009, Bancorp declared a semi-annual cash dividend of$2.25 per share, payable on June 5, 2009 to shareholders of record as ofthe close of business on May 27, 2009.

 

**Note 6:   ALLOWANCE FOR LOAN LOSSES**

 

The allowance for loan losses represents management’s best estimate andis maintained at a level deemed adequate to provide for estimated future lossesand is evaluated on a regular basis. Bancorp’s evaluation of the allowance forloan losses is inherently subjective as it requires estimates that aresusceptible to significant revision as more information becomes available. The ultimaterecovery of loans is susceptible to future market factors beyond Bancorp’scontrol. These factors may result in losses or recoveries differingsignificantly from those provided in Bancorp’s financial statements. In addition, regulatory agencies, as anintegralpart of theirexaminationprocess,periodically review the estimated losses on loans, and based upon theirjudgment, may require Bancorp to make additional provisions or adjustments toits allowance for loan losses

 

The allowance is basedupon Bancorp’s evaluation of the pertinent factors underlying the quality andcomposition of the loan portfolio, levels and trends in losses anddelinquencies, current economic conditions, specific industry conditions andthe estimated value of any underlying collateral. The allowance consists ofspecific, general and unallocated components. The general allowance iscalculated by applying a loss percentage factor to the different loan types andthe different risk gradings.  A specificallowance is calculated based on a review of classified or non-performing loansfor specific weaknesses and evaluation of those loans for impairment and lossexposure. The unallocated component of the allowance reflects the margin ofimprecision inherent in the underlying assumptions used in the methodologiesfor estimated specific and general losses in the loan portfolio. Theunallocated allowance provides for other credit losses inherent in our 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.

 

Additions to the allowance, in the form of provisions, are reflected incurrent operating results, while charge-offs to the allowance are made when aloss is determined to have occurred.

 

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

 

**Allowance for Loan LossesActivity**

** **
| ** **                                                   | ** ** | **Three months ended,** | ** ** | **Six months ended,** | ** ** |
|--------------------------------------------------------------|------------|-------------------------|------------|-----------------------|------------|
| **(dollars in thousands)**                                   | ** ** | **2009**                | ** ** | **2008**              | ** ** | **2009** | ** ** | **2008** | ** ** |
| Allowance  as of beginning of period                         |       | $                       | 5,637      |                  | $          | 4,098 |   | $ | 5,450 |   | $ | 4,535 |   |
| Provision  (benefit) for loan losses                         |       | 450                     |       | —                |       | 900 |   | — |   |
| Charge-offs                                                  |       | (496                    | )          | (94                   | )          | (810 | ) | (634 | ) |
| Recoveries                                                   |       | 38                      |       | 47                    |       | 89 |   | 150 |   |
| Net  charge-offs                                             |       | (458                    | )          | (47                   | )          | (721 | ) | (484 | ) |
| Balance  at end of period                                    |       | $                       | 5,629      |                  | $          | 4,051 |   | $ | 5,629 |   | $ | 4,051 |   |
| Ratio  of net charge-offs to average loans during the period |       | (0.48                   | )%         | (0.05                 | )%         | (0.37 | )% | (0.27 | )% |
| Ratio  of allowance to net loans at end of period            |       | 1.46                    | %          | 1.08                  | %          | 1.46 | % | 1.08 | % |
| Ratio  of non-performing loans to allowance                  |       | 162.96                  | %          | 50.80                 | %          | 162.96 | % | 50.80 | % |

 

**Note 7:   STOCK-BASEDCOMPENSATION**

 

Bancorp has one share-based payment plan, which is shareholderapproved, and permits the grant of share-based awards to its employees anddirectors up to 100,000 shares and at June 30, 2009, there were 68,710common shares available for grant. In addition to this share-based paymentplan, Bancorp has outstanding restricted stock awards granted pursuant to anemployment agreement with an executive officer.

 

Total equity compensation expense was $128,000 and $93,000 for the sixmonths ended June 30, 2009 and 2008, respectively.

 

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**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

 

**Stock Options**: All options granted during 2009 and 2008 wereIncentive Stock Options and were granted at a price equal to the market valueof the stock on the grant date, have a term of 10 years and vest over a fiveyear period.  Bancorp measures the fairvalue of each stock option at the date of the grant, using the Black Scholesoption valuation model.  The applicationof this valuation model involves assumptions that are judgmental and sensitivein the determination of compensation expense.

 

The following assumptions were used in arriving at the fair value ofoptions granted for the six months ended June 30, 2009:

 
| ** **                               | ** ** | **Employee options** | ** ** |
|------------------------------------------|------------|----------------------|------------|
| Expected  price volatility               |       | 18.41                | %          |
| Risk-free  interest rate                 |       | 2.05                 | %          |
| Dividend  yield on underlying stock      |       | 2.30                 | %          |
| Weighted-average  expected life in years |       | 7.00                 |       |

 

The following tablesummarizes the activity related to options outstanding during the six monthsended June 30, 2009. 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):

 
| **(dollars in thousands except  share and per share amounts)** | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise/Grant  Price** | ** ** | **Weighted   Average  Remaining  Contractual Terms** | ** ** | **Aggregate  Intrinsic Value** | ** ** |
|----------------------------------------------------------------|------------|------------|------------|----------------------------------------------|------------|------------------------------------------------------|------------|--------------------------------|------------|
| Outstanding  at January 1, 2009                           |       | 18,331     |       | $                                            | 170.48     |                                                 | 7.69       |                           | $          | 541 |   |
| Granted                                                        |       | 10,455     |       | 195.00                                       |       | 10.00                                                |       | —                         |       |
| Exercised                                                      |       | 25         |       | —                                       |       | —                                               |       | —                         |       |
| Forfeited                                                      |       | —     |       | —                                       |       | —                                               |       | —                         |       |
| Outstanding  at June 30, 2009                             |       | 28,761     |       | $                                            | 179.40     |                                                 | 8.08       |                           | $          | 449 |   |
| Exercisable  at June 30, 2009                             |       | 6,282      |       | $                                            | 167.54     |                                                 | 6.96       |                           | $          | 173 |   |

 

The unrecognized share-based compensation cost relating to stock optionexpense at June 30, 2009 is approximately $643,000, which will berecognized over the remaining vesting schedule through 2014. The weightedaverage grant date fair value of options granted during 2009 was $30.78 pershare.

 

**Stock Awards**: Recipients of restricted stock awards do not pay anycash consideration to Bancorp for the shares and receive all dividends withrespect to all such shares, whether or not shares have vested.  The awards vest over a five year period.  Bancorp measures the fair value of each stockaward at the date of the grant and recognizes compensation based on the amountthe market price of Bancorp’s common stock exceeds the exercise price.  The unrecognized share-based compensationcost relating to restricted stock awards expense at June 30, 2009 wasapproximately $198,000, which will be recognized over the remaining years ofthe original five year vesting period of the awards.  There were no awards granted for the sixmonths ended June 30, 2009.   Thetotal intrinsic value of stock awards exercised and vested during the sixmonths ended June 30, 2009 was $54,000.

 

The aggregate intrinsic value in the table above and followingrepresents the total pretax intrinsic value (amount by which the fair value ofthe underlying stock exceeds the exercise price of an option or award, timesthe number of shares).  The followingtable summarizes the activity relating to restricted stock awards outstandingfor the six months ended June 30, 2009.

 

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**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

 
| **(dollars in thousands except  share and per share amounts)** | ** ** | **Shares** | ** ** | **Weighted Average  Remaining  Contractual Terms (in  years)** | ** ** | **Aggregate  Intrinsic Value** | ** ** |
|----------------------------------------------------------------|------------|------------|------------|----------------------------------------------------------------|------------|--------------------------------|------------|
| Outstanding  at January 1, 2009                           |       | 2,159      |       | 3.61                                                           |       | $                              | 432        |   |
| Granted                                                        |       | —     |       | —                                                         |       | —                         |       |
| Vested                                                         |       | 285        |       | —                                                         |       | 54                             |       |
| Forfeited                                                      |       | —     |       | —                                                         |       | —                         |       |
| Outstanding  at June 30, 2009                             |       | 1,874      |       | 3.03                                                           |       | $                              | 365        |   |
| Exercisable  at June 30, 2009                             |       | —     |       | —                                                         |       | —                         |       |

 

For additionalinformation on the stock-based equity compensation plan, refer to Bancorp’saudited financial statements and footnotes for the most recent annual periodended December 31, 2008 contained in the Annual Report on Form 10-K.

 

**Note 8:   INCOMETAXES**

 

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

 

Bancorp adopted FIN 48,“Accounting for Uncertainty in Income Taxes — an interpretation of FASBStatement No. 109” on January 1, 2007. FIN 48 seeks to reduce thediversity in practice associated with certain aspects of measurement andrecognition in accounting for income taxes. FIN 48 provides guidance onde-recognition, classification, interest and penalties and accounting ininterim periods and requires expanded disclosure with respect to uncertainty inincome taxes.  Our accounting policy withrespect to interest and penalties arising from income tax settlements is torecognize them as non-interest expense.

 

**Note 9:   FINANCIALINSTRUMENTS**

 

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

 

The following is a summary of the off-balance-sheet financialinstruments or contracts outstanding as of June 30, 2009: (dollars in thousands)

 
| Unfunded  commitments to extend credit  |   | $      | 66,451 |   |
|-----------------------------------------|--------|--------|--------|--------|
| Credit  card arrangements               |   | 11,169 |   |
| Commitments  to fund municipal warrants |   | 4,834  |   |
| Standby letters of credit               |   | 2,170  |   |

 

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** **

**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

**Note 10:  FAIR VALUE**

 

SFAS No. 107-1, “Interim Disclosures About Fair Value of FinancialInstruments” requires disclosures of the fair value of financial asset andliabilities, including those financial assets and liabilities that are notmeasured and reported at fair value on a recurring basis or non-recurringbasis.  The estimated fair values havebeen determined 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 assumptions and/orestimation methodologies may have a material effect on the estimated fair valueamounts. In that regard, the fair value estimates cannot be substantiated bycomparison to independent markets and, in many cases, could not be realized inimmediate settlement on the instrument. Accordingly, the aggregate fair valueamounts presented do not represent the underlying value of Bancorp.

 

*Cash, Due FromBanks, Federal Funds Sold, Interest-bearing bank balances, Other Borrowings andAccrued Interest Receivable and Payable —*The carrying amount of these financial assets andliabilities approximates fair value.

 

*InvestmentSecurities —*The securities classified as available for sale arereported at fair value utilizing Level 2 inputs. The fair values of fixed rate warrants and qualifiedzone academy bonds, included in state and political subdivisions investmentsecurities, are estimated using discounted cash flow analysis using interestrates currently being offered for warrants of similar terms or the currentqualified zone academy bond interest rates.

 

*Loans —* The fair values for variable-rate loansthat reprice frequently are based on carrying values. The fair values offixed-rate commercial, real estate mortgage, installment, and other loans areestimated using discounted cash flow analysis, using interest rates currentlybeing offered for loans with similar terms to borrowers of similar creditquality.

 

*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-Sheet Instruments—*Commitments to extend credit and standby letters of credit represent theprincipal categories of off-balance financial instruments (See Note 9).  The fair value of these instruments is notconsidered material since they are for relatively short periods of time and aresubject to customary credit terms, which would not include terms that wouldexpose Bancorp to significant gains or losses.

 

The carrying amounts and estimated fair values of Bancorp’s financialinstruments at June 30, 2009 are as follows:

 
| ** **                                             | ** ** | **June 30, 2009** | ** ** |
|--------------------------------------------------------|------------|------------------------|------------|
| ** **                                             | ** ** | **Carrying**           | ** ** | ** ** | ** ** |
| **(dollars in thousands)**                             | ** ** | **Amount**             | ** ** | **Fair Value** | ** ** |
| *Financial Assets*                                     | * *   | * *               | * *   | * * | * * |
| Cash  and due from banks                               |       | $                      | 10,682     |   | $ | 10,682 |   |
| Federal  funds sold and Interest-bearing bank balances |       | 31,778                 |       | 31,778 |   |
| Investment  securities                                 |       | 134,830                |       | 133,216 |   |
| Net  loans                                             |       | 384,646                |       | 383,355 |   |
| Accrued  interest receivable                           |       | 2,377                  |       | 2,377 |   |
| *Financial Liabilities*                                |       |                   |       |   |   |
| Demand  and savings deposits                           |       | 324,777                |       | 324,777 |   |
| Time  deposits                                         |       | 179,399                |       | 180,865 |   |
| Other  borrowings                                      |       | 16,731                 |       | 16,731 |   |
| Accrued  interest payable                              |       | 371                    |       | 371 |   |
|                                                        |            |                        |            |  |  |  |  |

 

SFAS No. 157, “FairValue Measures” defines fair value, establishes a framework for measuring fairvalue and expands disclosures about fair value measurements and expandsdisclosures about fair value measurements.

 

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**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

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

 

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

 

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

 

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

 

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

 

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

 

Impaired Loans — Impairedloans are reported at the lower of the recorded amount of the loan or fairvalue of the underlying collateral if repayment is expected from thecollateral.

 

Other Real Estate Owned —Other real estate owned includes properties acquired through foreclosure.  These properties are recorded at the lower ofthe recorded amount of the loan, or estimated fair value less estimated coststo sell based on periodic evaluations using Level 3 inputs.  Valuation of the property occurs when it isforeclosed upon and at least annually thereafter.  Write-downs arising from the acquisition ofproperty, in full or partial satisfaction of loans, are charged to theallowance for loan losses.  Subsequentwrite-downs after acquisition, identified through management’s periodicvaluations, are written down through non-interest expenses.

 

The table below showsassets measured at fair value on a recurring basis as of June 30, 2009.

 
| **(dollars in thousands)**     | ** ** | ** ** | ** ** | **Quoted Prices  in Active  Markets for  Identical Assets** | ** ** | **Significant  Other  Observable  Inputs** | ** ** | **Significant  Unobservable  Inputs** | ** ** |
|--------------------------------|------------|------------|------------|-------------------------------------------------------------|------------|--------------------------------------------|------------|---------------------------------------|------------|
| **Description**                | ** ** | **Total**  | ** ** | **(Level 1)**                                               | ** ** | **(Level 2)**                              | ** ** | **(Level 3)**                         | ** ** |
| Available-for-sale  securities |       | $          | 98,423     |                                                        | $          | —                                     |       | $                                     | 98,423     |   | $ | — |   |
| Total                          |       | $          | 98,423     |                                                        | $          | —                                     |       | $                                     | 98,423     |   | $ | — |   |

 

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**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

The table below showsassets measured at fair value on a non-recurring basis as of June 30,2009.

 
| **(dollars in thousands)** | ** ** | ** ** | ** ** | **Quoted Prices  in Active  Markets for  Identical Assets** | ** ** | **Significant  Other   Observable   Inputs** | ** ** | **Significant  Unobservable  Inputs** | ** ** |
|----------------------------|------------|------------|------------|-------------------------------------------------------------|------------|----------------------------------------------|------------|---------------------------------------|------------|
| **Description**            | ** ** | **Total**  | ** ** | **(Level 1)**                                               | ** ** | **(Level 2)**                                | ** ** | **(Level 3)**                         | ** ** |
| Impaired  loans            |       | $          | 10,189     |                                                        | $          | —                                       |       | $                                     | —     |   | $ | 10,189 |   |
| Other  real estate owned   |       | $          | 7,103      |                                                        | $          | —                                       |       | $                                     | —     |   | $ | 7,103 |   |
| Total                      |       | $          | 17,292     |                                                        | $          | —                                       |       | $                                     | —     |   | $ | 17,292 |   |

 

Impaired loans with acarrying amount of $10.6 million were written down to their fair value of $10.2million, resulting in charge-downs and impairments of $420,000, which wasincluded in the allowance for loan losses for the six months ended June 30,2009.

 

Other real estate ownedwith a carrying amount of $7.5 million, were written down to their fair valueof $7.1 million, resulting in write-downs of $373,000, which was chargedagainst earnings for the six months ended June 30, 2009.

 

**Note 11:   NEW ACCOUNTING PRONOUNCEMENTS**

 

In May 2009, theFASB issued SFAS No. 165, “Subsequent Events”.  The statementestablished general standards of accounting for and disclosure of events thatoccur after the balance sheet date but prior to financial statements beingissued or available to be issued.  This statement is effective for interimand annual periods ending after June 15, 2009.  The implementation ofthis statement did not have a material impact on the consolidated financialstatements.

 

In April 2009, theFASB issued SFAS No. 107-1 and APB 28-1, “Interim Disclosures about FairValue of Financial Instruments”.  The disclosures require publically tradedcompanies to disclose the fair value of financial instruments in interimperiods previously required in annual financial statements.  These FASB’sare effective for interim and annual periods ending after June 15, 2009.The implementation of this statement did not have a material impact on theconsolidated financial statements.

 

In April 2009, theFASB issued SFAS No. 115-2 and 124-2, “Recognition and Presentation ofOther-Than-Temporary Impairments”.  This FASB amends theother-than-temporary impairment guidance in U.S. GAAP for debt securities tomake the guidance more operational and to improve the presentation anddisclosure of other-than-temporary impairments on debt and equity securities inthe financial statements.  These FASB’s are effective for interim andannual periods ending after June 15, 2009. The implementation of thisstatement did not have a material impact on the consolidated financialstatements.

 

In April 2009, theFASB issued FAS 157-4, “Determining Fair Value When the Volume and Level ofActivity for the Asset or Liability Have Significantly Decreased andIdentifying Transactions That Are Not Orderly”.  This FASB providesadditional guidance for estimating fair value in accordance with FASB StatementNo. 157, when the volume and level of activity for the asset or liabilityhave significantly decreased.  This FASB also includes guidance onidentifying circumstances that indicate a transaction in not orderly. These FASB’s are effective for interim and annual periods ending after June 15,2009.  The implementation of this statement did not have a material impacton the consolidated financial statements.

 

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

 

*The following discussion shouldbe read in conjunction with the consolidated financial statements and notesthereto presented elsewhere in this report. For additional information, refer to the financial statements andfootnotes for the year ended December 31, 2008 in the Annual Report on Form 10-K.*

** **

**FORWARD LOOKING 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 not historicalfacts, and other statements identified by words such as “expects,”“anticipates,” “intends,” “plans,” “believes,” “should,” “projects,” “seeks,”“estimates” or words of similar meaning. These forward-looking statements arebased on current beliefs and expectations of management and are inherentlysubject to significant business, economic and competitive uncertainties andcontingencies, many of which are beyond Bancorp’s control. In addition, theseforward-looking statements are subject to assumptions with respect to futurebusiness strategies and decisions that are subject to change. The followingfactors, among others, could cause actual results to differ materially from theanticipated results or other expectations in the forward-looking statements,including those set forth in this Form 10-Q, or the documents incorporatedby reference:

 

·                  the risks associated with lending and potentialadverse 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, investmentvalues, liquidity levels, and loan originations;

·                  changes in market interest rates, which couldadversely affect our net interest income and profitability;

·                  legislative or regulatory changes that adverselyaffect our business or our ability to complete pending or prospective futureacquisitions;

·                  reduced demand for banking products and services;

·                  competition from other financial services companies inour markets; and

·                  Bancorp’s success in managing risks involved in theforegoing.

 

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 located inSkagit, Snohomish and Whatcom counties.

 

**OVERVIEW**

 

Net income was $888,000and $1.7 million for the quarters ended June 30, 2009 and 2008 withdiluted earnings per share at $1.50 and $2.89, respectively. Net income was$2.1 million and $3.6 million for the six months ended June 30, 2009 and2008 with diluted earnings per share at $3.53 and $5.72, respectively.  The decreases in net income were primarilyattributable to increased FDIC insurance premiums, increased write-downs ofother real estate owned and increased provisions for loan losses reflective ofinternal downgrades of credit within the loan portfolio and increasedcharge-offs.

 

Annualized return onaverage assets was 0.61 percent and 0.73 percent for the quarter and six monthsending June 30, 2009 compared to 1.19 percent and 1.24 percent during thesame time periods in 2008.  Annualizedreturn on average equity was 5.60 percent and 6.62 percent for the quarter andsix months ending June 30, 2009 compared to 11.47 percent and 10.98percent, respectively, for the same time periods in 2008.

 

The provision for loanlosses was $450,000 and $900,000 for the quarter and six months ended June 30,2009 compared to no provision for loan losses for the like periods in 2008. Theincrease in provision is primarily attributable to the deteriorating economy,internal downgrades of credit within the loan portfolio, increased charge-offsand the growth in loans year over year.  The provisions increased Bancorp’s total allowance forloans to 1.46 percent of net loans at June 30, 2009 compared to 1.08percent at June 30, 2008.  Forthe quarter and six months ended June 30, 2009, respectively, netcharge-offs were $458,000 and $721,000 comparedto $47,000 and $484,000 for the like periods in 2008.

 

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Non-interest expense was$4.9 million and $9.5 million for the quarter and six months ended June 30,2009 compared to $4.1 million and $8.2 million in the like periods in2008.  For the 2009 quarter compared tothe 2008 quarter, the increase was primarily attributable to a $373,000write-down of other real estate owned, a $103,000 increase in other costsrelated to other real estate owned and a $454,000 increase in FDIC insurancepremium assessments including a $260,000 special assessment. For the six monthsended June 30, 2009 compared to the like period in 2008, the increase wasprimarily attributable to a $373,000 write-down of other real estate owned, a$202,000 increase in other costs related to other real estate owned and a$734,000 increase in FDIC insurance premium assessments including a $260,000special assessment. Increased FDIC insurance premium assessments are the resultof losses incurred by the Deposit Insurance Fund and not directly correlated toBancorp’s performance.

 

Total assets increased to$585.4 million at June 30, 2009, compared to $566.9 million at December 31,2008.  The increase was primarily due todeposit growth of $34.6 million.  Netloans decreased by $9.1 million or 2.3 percent to $384.6 million at June 30,2009, compared to $393.8 million at December 31, 2008.  This decrease was primarily in commercial andagricultural 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 service charges and other deposit relatedfees. Bancorp’s non-interest expenses consist primarily of salaries and employeebenefits expense, bank premises and equipment expenses and other operatingexpenses.

 

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

 

Net interest income was$5.3 million and $10.7 million for the quarter and six months ended June 30,2009 compared to $5.3 million and $10.8 million for the like periods in2008.  The net interest margin is netinterest income expressed as a percent of average interest-earning assets. Netinterest margin is influenced by the level and relative mix of interest-earningassets and interest-bearing liabilities as well as levels of non-interestbearing liabilities.  For the quarterended June 30, 2009, the net interest margin decreased to 3.88 percentfrom 3.97 percent for the like period in 2008. For the six months ended June 30, 2009, the net interest marginincreased to 3.99 percent from 3.98 percent for the like period in 2008.

 

*Interest-earning assets*

 

The largest component ofinterest income is interest earned on loans. Total interest income earned from loans was $5.8 million and $11.7million for the quarter and six months ended June 30, 2009 compared to$6.2 million and $12.7 for the like periods in 2008.  For the current quarter, this decrease wasprimarily a result of the current declining interest rate environment whichdecreased the loan yield from 6.84 percent to 5.99 percent.  Partially offsetting this yield decrease wasa $19.5 million increase in the average loan balance.  For the six months ended June 30, 2009,loan yields decreased to 6.03 percent from 7.09 percent compared to the likeperiod in 2008.  This was partiallyoffset by a $28.8 million increase in the average loan balance.

 

Interest earned oninvestments, interest-bearing bank balances and federal funds sold decreased$367,000 and $1.1 million for the quarter and six months ended June 30,2009 compared to the like periods in 2008. These decreases were the result ofboth decreases in yield and in average balances.

 

*Interest- bearing liabilities*

 

Interest expensedecreased to $1.8 million and $3.6 million from $2.7 million and $5.7 millionfor the quarter and six months ended June 30, 2009 and 2008. Thesedecreases were a result of an 80 basis point and a 95 basis point decrease inthe cost of funds for the quarter and six months ended June 30, 2009compared to 2008. The majority of our deposits are short term and re-pricewithin a twelve month period.

 

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The following tablespresent information regarding average balances of assets and liabilities aswell as the total amounts of interest income from average interest-earningassets and interest expense on average interest-bearing liabilities, resultingyield and cost ratios, interest rate spread and net interest margin. Tax exemptsecurities, included in investment securities below are stated at their contractualinterest rate.  Loan fees of $215,000 and$438,000 for the quarter and six months ended June 30, 2009, and $282,000and $543,000 for the quarter and six months ended June 30, 2008,respectively, are included in interest earned on loans. Non-accruing loans havebeen included in the computation of average loans.

 

**Condensed Average Balance Sheets**

(dollars inthousands except share data)

 
| ** **                                             | ** ** | **2009**    | ** ** | **2008**     | ** ** |
|--------------------------------------------------------|------------|-------------|------------|--------------|------------|
| ** **                                             | ** ** | **Average** | ** ** | ** **   | ** ** | **Yield** | ** ** | **Average** | ** ** | ** ** | ** ** | **Yield** | ** ** |
| **Three months ended  June 30,**                  | ** ** | **Balance** | ** ** | **Interest** | ** ** | **/Cost** | ** ** | **Balance** | ** ** | **Interest** | ** ** | **/Cost** | ** ** |
| **Assets**                                             |       |        |       |         |       |   |   |   |   |   |   |   |   |
| Federal funds sold and interest-bearing bank  balances |       | $           | 24,691     |         | $          | 11 |   | 0.18 | % | $ | 6,888 |   | $ | 31 |   | 1.81 | % |
| Taxable investment securities                          |       | 87,958      |       | 1,044        |       | 4.76 |   | 111,518 |   | 1,363 |   | 4.92 |   |
| Tax exempt securities                                  |       | 48,290      |       | 281          |       | 2.33 |   | 49,916 |   | 309 |   | 2.49 |   |
| Loans                                                  |       | 385,946     |       | 5,760        |       | 5.99 |   | 366,429 |   | 6,230 |   | 6.84 |   |
| Total interest-earning assets                          |       | 546,885     |       | 7,096        |       | 5.20 | % | 534,751 |   | 7,933 |   | 5.97 | % |
| Non-interest earning assets                            |       | 32,483      |       |         |       |   |   | 38,381 |   |   |   |   |   |
| Total assets                                           |       | $           | 579,368    |         |       |   |   |   | $ | 573,132 |   |   |   |   |   |
|                                                   |       |        |       |         |       |   |   |   |   |   |   |   |   |
| **Liabilities and Stockholders’  Equity**         |       |        |       |         |       |   |   |   |   |   |   |   |   |
| Interest-bearing demand                                |       | $           | 89,073     |         | $          | 78 |   | 0.35 | % | $ | 89,688 |   | $ | 116 |   | 0.52 | % |
| Savings and money market                               |       | 165,560     |       | 410          |       | 0.99 |   | 148,368 |   | 515 |   | 1.40 |   |
| Certificates of deposit                                |       | 175,346     |       | 1,255        |       | 2.87 |   | 181,450 |   | 1,891 |   | 4.19 |   |
| Total interest-bearing deposits                        |       | 429,979     |       | 1,743        |       | 1.63 |   | 419,506 |   | 2,522 |   | 2.42 |   |
| Other borrowings                                       |       | 15,074      |       | 64           |       | 1.70 |   | 19,385 |   | 129 |   | 2.68 |   |
| Total interest-bearing deposits & liabilities      |       | 445,053     |       | 1,807        |       | 1.63 | % | 438,891 |   | 2,651 |   | 2.43 | % |
| Non interest-bearing demand deposits                   |       | 69,043      |       |         |       |   |   | 71,623 |   |   |   |   |   |
| Other non-interest-bearing liabilities                 |       | 1,841       |       |         |       |   |   | 2,946 |   |   |   |   |   |
| Total liabilities                                      |       | 515,937     |       |         |       |   |   | 513,460 |   |   |   |   |   |
| Stockholders’ equity                              |       | 63,431      |       |         |       |   |   | 59,672 |   |   |   |   |   |
| Total liabilities and stockholders equity              |       | $           | 579,368    |         |       |   |   |   | $ | 573,132 |   |   |   |   |   |
| Net interest income                                    |       |        |       | $            | 5,289      |   |   |   |   |   | $ | 5,282 |   |   |   |
| Interest rate spread                                   |       |        |       |         |       | 3.58 | % |   |   |   |   | 3.54 | % |
| Net interest margin                                    |       |        |       |         |       | 3.88 | % |   |   |   |   | 3.97 | % |

 

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**Condensed Average Balance Sheets**

(dollars inthousands except share data)

 
| ** **                                             | ** ** | **2009**    | ** ** | **2008**     | ** ** |
|--------------------------------------------------------|------------|-------------|------------|--------------|------------|
| ** **                                             | ** ** | **Average** | ** ** | ** **   | ** ** | **Yield** | ** ** | **Average** | ** ** | ** ** | ** ** | **Yield** | ** ** |
| **Six months ended June 30,**                     | ** ** | **Balance** | ** ** | **Interest** | ** ** | **/Cost** | ** ** | **Balance** | ** ** | **Interest** | ** ** | **/Cost** | ** ** |
| **Assets**                                             |       |        |       |         |       |   |   |   |   |   |   |   |   |
| Federal funds sold and interest-bearing bank  balances |       | $           | 14,041     |         | $          | 12 |   | 0.17 | % | $ | 18,631 |   | $ | 273 |   | 2.95 | % |
| Taxable investment securities                          |       | 89,188      |       | 2,114        |       | 4.75 |   | 116,054 |   | 2,869 |   | 4.97 |   |
| Tax exempt securities                                  |       | 48,093      |       | 562          |       | 2.34 |   | 50,265 |   | 634 |   | 2.54 |   |
| Loans                                                  |       | 388,172     |       | 11,667       |       | 6.03 |   | 359,369 |   | 12,671 |   | 7.09 |   |
| Total interest-earning assets                          |       | 539,494     |       | 14,355       |       | 5.34 | % | 544,319 |   | 16,447 |   | 6.08 | % |
| Non-interest earning assets                            |       | 32,068      |       |         |       |   |   | 35,788 |   |   |   |   |   |
| Total assets                                           |       | $           | 571,562    |         |       |   |   |   | $ | 580,107 |   |   |   |   |   |
|                                                   |       |        |       |         |       |   |   |   |   |   |   |   |   |
| **Liabilities and Stockholders’  Equity**         |       |        |       |         |       |   |   |   |   |   |   |   |   |
| Interest-bearing demand                                |       | $           | 87,899     |         | $          | 149 |   | 0.34 | % | $ | 90,015 |   | $ | 253 |   | 0.57 | % |
| Savings and money market                               |       | 159,396     |       | 787          |       | 0.99 |   | 145,715 |   | 1,039 |   | 1.43 |   |
| Certificates of deposit                                |       | 170,891     |       | 2,541        |       | 2.98 |   | 185,040 |   | 4,131 |   | 4.49 |   |
| Total interest-bearing deposits                        |       | 418,186     |       | 3,477        |       | 1.67 |   | 420,770 |   | 5,423 |   | 2.61 |   |
| Other borrowings                                       |       | 19,804      |       | 153          |       | 1.55 |   | 17,381 |   | 253 |   | 2.93 |   |
| Total interest-bearing deposits & liabilities      |       | 437,990     |       | 3,630        |       | 1.66 | % | 438,151 |   | 5,676 |   | 2.61 | % |
| Non interest-bearing demand deposits                   |       | 69,065      |       |         |       |   |   | 73,079 |   |   |   |   |   |
| Other non-interest-bearing liabilities                 |       | 1,455       |       |         |       |   |   | 3,126 |   |   |   |   |   |
| Total liabilities                                      |       | 508,510     |       |         |       |   |   | 514,356 |   |   |   |   |   |
| Stockholders’ equity                              |       | 63,052      |       |         |       |   |   | 65,751 |   |   |   |   |   |
| Total liabilities and stockholders equity              |       | $           | 571,562    |         |       |   |   |   | $ | 580,107 |   |   |   |   |   |
| Net interest income                                    |       |        |       | $            | 10,725     |   |   |   |   |   | $ | 10,771 |   |   |   |
| Interest rate spread                                   |       |        |       |         |       | 3.67 | % |   |   |   |   | 3.47 | % |
| Net interest margin                                    |       |        |       |         |       | 3.99 | % |   |   |   |   | 3.98 | % |

 

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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**

** **
| ** **                                                   | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|--------------------------------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                                                   | ** ** | **2009 vs. 2008**                    | ** ** | **2009 vs. 2008**                  | ** ** |
| ** **                                                   | ** ** | **Increase (Decrease) Due to**       | ** ** | **Increase (Decrease) Due to**     | ** ** |
| **(dollars in thousands except  per share amounts)**         | ** ** | **Rate**                             | ** ** | **Volume**                         | ** ** | **Total** | ** ** | **Rate** | ** ** | **Volume** | ** ** | **Total** | ** ** |
| **Interest-Earning Assets**                                  | ** ** | ** **                           | ** ** | ** **                         | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Federal funds sold and interest-bearing bank  balances       |       | $                                    | (172       | )                                  | $          | 152 |   | $ | (20 | ) | $ | (207 | ) | $ | (54 | ) | $ | (261 | ) |
| Investment securities                                        |       | (59                                  | )          | (288                               | )          | (347 | ) | (166 | ) | (661 | ) | (827 | ) |
| Loans                                                        |       | (2,199                               | )          | 1,729                              |       | (470 | ) | (3,316 | ) | 2,312 |   | (1,004 | ) |
| Total net change in income on Interest-earning  assets       |       | (2,430                               | )          | 1,593                              |       | (837 | ) | (3,689 | ) | 1,597 |   | (2,092 | ) |
| **Interest-Bearing Liabilities**                             |       |                                 |       |                               |       |   |   |   |   |   |   |   |   |
| Deposits                                                     |       | (1,020                               | )          | 241                                |       | (779 | ) | (1,864 | ) | (82 | ) | (1,946 | ) |
| Other borrowings                                             |       | (40                                  | )          | (25                                | )          | (65 | ) | (187 | ) | 87 |   | (100 | ) |
| Total net change in expense on Interest-bearing  liabilities |       | (1,060                               | )          | 216                                |       | (844 | ) | (2,051 | ) | 5 |   | (2,046 | ) |
| Net change in net interest income                            |       | $                                    | (1,370     | )                                  | $          | 1,377 |   | $ | 7 |   | $ | (1,638 | ) | $ | 1,592 |   | $ | (46 | ) |

 

***PROVISIONFOR LOAN LOSSES*******The provision for loan losses was $450,000 and$900,000 for the quarter and six months ended June 30, 2009 compared to noprovision for loan losses for the like periods in 2008. The increase inprovision is primarily attributable to the deteriorating economy, internaldowngrades of credit within the loan portfolio, increased charge-offs and thegrowth in loans year over year.  For thequarter and six months ended June 30, 2009 respectively, net charge-offswere $458,000 and $721,000 compared to $47,000and $484,000 for the like periods in 2008.

 

The provision for loanlosses is highly dependent upon Bancorp’s ability to manage asset quality andcontrol the level of net charge-offs through prudent underwriting standards. Inthe future, continued growth of the loan portfolio may or further declines ineconomic conditions could increase future provisions for loan losses and impactBancorp’s net income. Additional discussion on loan quality and the allowancefor loan losses is provided under Allowance for Loan Losses and Asset Quality.

 

**NON-INTEREST INCOME               **Non-interest income, which consists primarily of feesand service charges on deposits and other income, remained unchanged at $1.0million and $2.0 million for the quarter and six months ended June 30,2009 and 2008.

 

**NON-INTEREST EXPENSE             **Non-interest expense was $4.9 million and $9.5 millionfor the quarter and six months ended June 30, 2009 compared to $4.1million and $8.2 million in the like periods in 2008.  For the 2009 quarter compared to the 2008quarter, the increase was primarily attributable to a $373,000 write-down ofother real estate owned, a $103,000 increase in other costs related to otherreal estate owned and a $454,000 increase FDIC insurance premium assessmentsincluding a $260,000 special assessment. For the six months ended June 30,2009 compared to the like period in 2008, the increase was primarilyattributable to a $373,0000 write-down of other real estate owned, a $202,000increase in other costs related to other real estate owned and a $734,000increase in FDIC insurance premium assessments including a $260,000 specialassessment. Increased FDIC insurance premium assessments are the result oflosses incurred by the Deposit Insurance Fund and not directly correlated toBancorp’s performance.

 

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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 and six months ended June 30,2009 was 78.2 percent and 74.5 percent compared to 65.6 percent and 64.0percent for the same time periods in 2008. The increase from 2008 was primarilydue to increased operating expenses as noted above.

 

**INCOMETAX EXPENSE                 **Income tax expense for the quarter andsix months ended June 30, 2009 was $40,000 and $250,000 compared to$455,000 and $994,000 for the quarter and six months ended June 30, 2008,respectively. Bancorp’s effective tax rates were 10.7 percent and 21.6 percentfor the six months ended June 30, 2009 and 2008, respectively. Theeffective tax rate is lower than the federal statutory rate due to tax creditsfrom tax-exempt bonds and tax-exempt interest from municipal bonds andloans.  As of June 30, 2009, Bancorphad $47.6 million in tax-exempt securities compared to $48.1 million as of June 30,2008.

 

**REVIEW OF FINANCIAL CONDITION**

 

Total assets increased to$585.4 million at June 30, 2009 compared to $566.9 million at December 31,2008.  This increase was primarily due toa $34.6 million increase in deposits to $504.2 million. Total loans decreased$9.1 million to $384.6 million during the same time period.

 

**INVESTMENTSECURITIES, INTEREST-BEARING BANK BALANCES AND FEDERAL FUNDS SOLD **Total investment securities, including federal fundssold and interest-bearing bank balances increased to $166.6 million at June 30,2009 compared to $139.2 million at December 31, 2008. Interest-bearingaccount balances at the Federal Reserve increased to $31.8 million at June 30,2009. This increase resulted primarily from the growth in deposits. Theavailable-for-sale investment portfolio is comprised of 60.8 percent GovernmentSponsored Agencies and Government Agencies mortgage-backed pass-throughsecurities, 11.3 percent of state and municipals and 27.9 percent of GovernmentSponsored Agencies and Government Agencies securities.  The held-to-maturity portfolio isconcentrated in municipal securities and Qualified Zone Academy Bonds. Securitypurchases for the quarter and six months ended June 30, 2009 respectively,were $10.2 million and $11.6 million. Security maturities, calls, and pay-downs were $12.3 million and 15.2million for the quarter and six months ended June 30, 2009, respectively.

 

The fair values forinvestment securities are based on quoted market prices, where available. Ifquoted market values are not available, fair values are based on quoted marketprices of comparable instruments. The fair values of fixed rate warrants andqualified zone academy bonds, included in state and political subdivisionsinvestment securities, are estimated using discounted cash flow analysis using interestrates currently being offered for warrants of similar terms or the currentqualified zone academy bond interest rates.

 

Management evaluatessecurities for other-than-temporary impairment on a quarterlybasis.  Consideration is given to: (1) the length of time andextent to which the fair value has been less than cost, (2) the financialcondition and near term prospects of the issuer and (3) our intent andability to retain a security for a period of time sufficient to allow for anyanticipated recovery in fair value.  Declines in the fair value ofavailable for sale and held to maturity securities below their cost that aredeemed to be other-than-temporary are reflected in earnings as realizedlosses.  At June 30, 2009, Bancorp held no securities in theavailable-for-sale portfolio and 1 security in the held-to-maturity portfoliothat had an unrealized loss for more than one year.

 

Bancorp has the abilityand intent to hold securities classified as held to maturity until they mature,at which time we expect to receive full value for the securities. Furthermore, management also has the ability and intent to hold the securitiesclassified as available for sale for a period of time sufficient for a recoveryof cost. The unrealized losses are largely due to increases in market interestrates.  The fair value is expected to recover as the bonds approach theirmaturity date or repricing date or if market yields for such investmentsdecline.  Bancorp believes that the decline in fair value is temporary,with no permanent sector or issuer credit concerns or impairments. Accordingly, Bancorp did not recognize any other-than-temporary impairmentlosses for the six months ended June 30, 2009.

 

Securitiesclassified as available-for-sale are reported at estimated fair value, withunrealized gains and losses (net of income taxes) reported in accumulated othercomprehensive income, as a separate component of stockholders’ equity.

 

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Thefollowing tables summarize the aggregate amortized cost and estimated fairvalue of investment securities as of the dates indicated.

 

**Investment Securities Composition**

**June 30, 2009**

** **
| ** **                        | ** ** | **Amortized** | ** ** | **Gross Unrealized** | ** ** | **Estimated** | ** ** |
|-----------------------------------|------------|---------------|------------|----------------------|------------|---------------|------------|
| **(dollars in thousands)**        | ** ** | **Cost**      | ** ** | **Gains**            | ** ** | **Losses**    | ** ** | **Fair Value** | ** ** |
| *Available-For-Sale Securities*   |       |          |       |                 |       |          |       |   |   |
| U.S.  government agencies         |       | $             | 26,993     |                 | $          | 455           |       | $ | 1 |   | $ | 27,447 |   |
| Mortgage-backed  securities       |       | 57,736        |       | 2,094                |       | —        |       | $ | 59,830 |   |
| State  and political subdivisions |       | 10,929        |       | 281                  |       | 64            |       | $ | 11,146 |   |
| Total  available-for-sale         |       | 95,658        |       | 2,830                |       | 65            |       | 98,423 |   |
| *Held-To-Maturity Securities*     |       |          |       |                 |       |          |       |   |   |
| State  and political subdivisions |       | 36,407        |       | 294                  |       | 1,908         |       | 34,793 |   |
| Total  held-to-maturity           |       | 36,407        |       | 294                  |       | 1,908         |       | 34,793 |   |
| Total  investment securities      |       | $             | 132,065    |                 | $          | 3,124         |       | $ | 1,973 |   | $ | 133,216 |   |

 

**December 31, 2008**

** **
| ** **                        | ** ** | **Amortized** | ** ** | **Gross Unrealized** | ** ** | **Estimated** | ** ** |
|-----------------------------------|------------|---------------|------------|----------------------|------------|---------------|------------|
| **(dollars in thousands)**        | ** ** | **Cost**      | ** ** | **Gains**            | ** ** | **Losses**    | ** ** | **Fair Value** | ** ** |
| *Available-For-Sale Securities*   |       |          |       |                 |       |          |       |   |   |
| U.S.  government agencies         |       | $             | 28,669     |                 | $          | 857           |       | $ | — |   | $ | 29,526 |   |
| Mortgage-backed  securities       |       | 59,316        |       | 2,525                |       | —        |       | 61,841 |   |
| State  and political subdivisions |       | 11,140        |       | 218                  |       | 78            |       | 11,280 |   |
| Total  available-for-sale         |       | 99,125        |       | 3,600                |       | 78            |       | 102,647 |   |
| *Held-To-Maturity Securities*     |       |          |       |                 |       |          |       |   |   |
| State  and political subdivisions |       | 36,518        |       | 167                  |       | 87            |       | 36,598 |   |
| Total  held-to-maturity           |       | 36,518        |       | 167                  |       | 87            |       | 36,598 |   |
| Total  investment securities      |       | $             | 135,643    |                 | $          | 3,767         |       | $ | 165 |   | $ | 139,245 |   |

 

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;

 

**June 30, 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         |       | $                       | 1,999      |                     | $          | 1              |       | $ | — |   | $ | — |   | $ | 1,999 |   | $ | 1 |   |
| State  and political subdivisions |       | $                       | 1,773      |                     | $          | 64             |       | $ | — |   | $ | — |   | $ | 1,773 |   | $ | 64 |   |
| Total  available-for-sale         |       | 3,772                   |       | 65                       |       | —         |       | — |   | 3,772 |   | 65 |   |
| *Held-To-Maturity Securities*     |       |                    |       |                     |       |           |       |   |   |   |   |   |   |
| State  and political subdivisions |       | 21,535                  |       | 1,888                    |       | 3,519          |       | 20 |   | 25,054 |   | 1,908 |   |
| Total  held-to-maturity           |       | 21,535                  |       | 1,888                    |       | 3,519          |       | 20 |   | 25,054 |   | 1,908 |   |
| Total  investment securities      |       | $                       | 25,307     |                     | $          | 1,953          |       | $ | 3,519 |   | $ | 20 |   | $ | 28,826 |   | $ | 1,973 |   |

 

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The amortized cost andestimated fair value of investment securities at June 30, 2009, bycontractual maturity, are show 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.

 
| ** **                   | ** ** | **Available-For-Sale** | ** ** | **Held-To-Maturity** | ** ** |
|------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                   | ** ** | **Amortized**          | ** ** | **Estimated**        | ** ** | **Amortized** | ** ** | **Estimated** | ** ** |
| **(dollars in thousands)**   | ** ** | **Cost**               | ** ** | **Fair Value**       | ** ** | **Cost** | ** ** | **Fair Value** | ** ** |
| 0-1  year                    |       | $                      | 4,804      |                 | $          | 4,838 |   | $ | 4,155 |   | $ | 4,137 |   |
| 1-5  years                   |       | 27,131                 |       | 27,739               |       | 11,287 |   | 11,073 |   |
| 5-10  years                  |       | 4,083                  |       | 4,162                |       | 8,770 |   | 8,234 |   |
| Over  10 years               |       | 1,904                  |       | 1,854                |       | 12,195 |   | 11,349 |   |
| *Mortgage-backed securities* |       | 57,736                 |       | 59,830               |       | — |   | — |   |
| Total  investment securities |       | $                      | 95,658     |                 | $          | 98,423 |   | $ | 36,407 |   | $ | 34,793 |   |

 

**LOANS        **Net loans decreased 2.3 percent to $384.6 million at June 30,2009 compared to $393.8 million at December 31, 2008.  This decrease was primarily in commercial andagricultural loans. Net loans represented 65.7 percent of total assets at June 30,2009.

 

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 agricultureproduction loans and consumer purpose loans. Most of Bancorp’s businessactivity is with customers located within Skagit, Snohomish and WhatcomCounties. Bancorp originates 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 loans compromised69.4% of total loans at June 30, 2009. The primary repayment source of these specific loan types are from thecash flows generated by the occupant business, occupant farm operation, or thesale of properties. While Bancorp has significant balances secured by realestate, Bancorp believes that its lending policies and concentration policiesare sufficient to minimize risks. However, economic conditions may affect a borrower’s ability to meet thestated repayment terms. Bancorp is committed to providing competitivecommercial real estate lending within our primary market areas.

 

*Commercial Loans*: Commercial loans, secured andunsecured, are made primarily to small and medium-sized businesses includingfarms operating within Skagit, Snohomish and Whatcom Counties.  These loans are available for generaloperating purposes, acquisition of fixed assets, purchases of equipment andmachinery, financing of inventory and accounts receivable, and other businesspurposes.  Bancorp originates SmallBusiness Administration (SBA) loans, including 504 and 7A loans.

 

*Consumer Loans:* Bancorp makessecured and unsecured consumer loans including loans to individuals, primarilycustomers of Bancorp, for various purposes, including home equity loans,purchases of automobiles, mobile homes, boats and other recreational vehicles,home improvement loans and loans for education and personal investments.

 

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

 

**Loan Composition**

** **
| ** **                                            | ** ** | **June 30, 2009** | ** ** | **December 31, 2008** | ** ** |
|-------------------------------------------------------|------------|------------------------|------------|----------------------------|------------|
| **(dollars in thousands)**                            | ** ** | **Amount**             | ** ** | **%**                      | ** ** | **Amount** | ** ** | **%** | ** ** |
| Real  estate – residential & commercial |       | $                      | 256,244    |                       | 65.5       | % | $ | 258,958 |   | 64.7 | % |
| Real  estate construction                             |       | 15,382                 |       | 3.9                        | %          | 17,470 |   | 4.4 | % |
| Commercial,  industrial & agricultural       |       | 68,209                 |       | 17.4                       | %          | 79,819 |   | 19.9 | % |
| Consumer                                              |       | 51,525                 |       | 13.2                       | %          | 44,224 |   | 11.0 | % |
| Total  loans                                          |       | 391,360                |       | 100                        | %          | 400,471 |   | 100 | % |
| Less:                                                 |       |                   |       |                       |       |   |   |   |   |
| Allowance  for loan losses                            |       | 5,629                  |       |                       |       | 5,450 |   |   |   |
| Deferred  loan fees                                   |       | 1,085                  |       |                       |       | 1,246 |   |   |   |
| Net  loans                                            |       | $                      | 384,646    |                       |       |   | $ | 393,775 |   |   |   |

 

*Concentrations*

 

As shown in the tableabove, a concentration of loans in commercial and residential real estateexisted as of June 30, 2009.  At June 30, 2009, Bancorp’s realestate portfolio included $168.1 million in non-farm non-residential realestate loans of which $102.2 million is owner occupied, $57.2 million in rawland, land development and construction loans and $56.4 million in one-to-fourfamily residential loans.  Further declines in the performance of theeconomy, in general, or further declines in real estate values in our marketareas, in particular, could have an adverse impact on collectability, increasethe level of non-performing loans or have other adverse effects which alone orin aggregate could have a material adverse effect on our business, financialcondition, results of operation and cash flows.

 

**ALLOWANCE FOR LOAN LOSSES**             Theallowance for loan losses was $5.6 million or 1.46 percent of net loans as of June 30,2009 compared to $5.5 million or 1.38 percent of net loans as of December 31,2008. Additions to the allowance, in the form of provisions, are reflected incurrent operating results, while charge-offs to the allowance are made when aloss is determined to have occurred.

 

The allowance for loanlosses represents management’s best estimate and is maintained at a leveldeemed adequate to provide for estimated future losses and is evaluated on aregular basis and reviewed by the Board of Directors. Bancorp’s evaluation ofthe allowance for loan losses is inherently subjective as it requires estimatesthat are susceptible to significant revision as more information becomesavailable.  The allowance is based uponBancorp’s evaluation of the pertinent factors underlying the quality andcomposition of the loan portfolio, levels and trends in losses anddelinquencies, current economic conditions, specific industry conditions andestimated value of any underlying collateral. The allowance consists of specific,general and unallocated components. The general allowance is calculated byapplying a loss percentage factor to the different loan types and the differentrisk gradings.  A specific allowance iscalculated based on a review of classified or non-performing loans for specificweaknesses and evaluation of those loans for impairment and loss exposure. Theunallocated component of the allowance reflects the margin of imprecisioninherent in the underlying assumptions used in the methodologies for estimatedspecific and general losses in the loan portfolio. The unallocated allowanceprovides for other credit losses inherent in our loan portfolio that may nothave been contemplated in the general and specific components of the allowance.The unallocated amount is reviewed periodically based on trends in creditlosses, the results of credit reviews and overall economic trends.  See discussion under “Loans” and“Concentrations” for details relating to real estate loan composition.

 

Bancorp has assessed andwill continue to assess on an on-going basis, the impact of the economy on thecredit risk in the loan portfolio. While Bancorp believes that it uses the bestinformation available to determine the allowance for loan losses, unforeseenmarket conditions could result in adjustments to the allowance for loan losses,and net income could be significantly affected if circumstances differsubstantially from the assumptions used in making the final determination.  These factors may result in losses orrecoveries differing significantly from those provided in Bancorp’s financialstatements. The growth of the loan portfolio and a further decline in theperformance of the economy, in general, or a further decline in real estatevalues in our market areas, in particular, could have an adverse impact oncollectability, increase the level of non-performing loans or have otheradverse effects which alone or in aggregate could have a material adverseeffect on our business, financial condition, results of operation and cashflows which may require additional provisions to our allowance for loan losses.The ultimate recovery of loans is susceptible to future market factors beyondBancorp’s control. Additionally, loans are subject to examinations byregulators, who, based upon their judgment, may require Bancorp to makeadditional provisions or adjustments to its allowance for loan losses.

 

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

 

**Allowance for Loan LossesActivity**

** **
| ** **                                                   | ** ** | **Three months ended,** | ** ** | **Six months ended,** | ** ** |
|--------------------------------------------------------------|------------|-------------------------|------------|-----------------------|------------|
| **(dollars in thousands)**                                   | ** ** | **2009**                | ** ** | **2008**              | ** ** | **2009** | ** ** | **2008** | ** ** |
| Allowance  as of beginning of period                         |       | $                       | 5,637      |                  | $          | 4,098 |   | $ | 5,450 |   | $ | 4,535 |   |
| Provision  (benefit) for loan losses                         |       | 450                     |       | —                |       | 900 |   | — |   |
| Charge-offs                                                  |       | (496                    | )          | (94                   | )          | (810 | ) | (634 | ) |
| Recoveries                                                   |       | 38                      |       | 47                    |       | 89 |   | 150 |   |
| Net  charge-offs                                             |       | (458                    | )          | (47                   | )          | (721 | ) | (484 | ) |
| Balance  at end of period                                    |       | $                       | 5,629      |                  | $          | 4,051 |   | $ | 5,629 |   | $ | 4,051 |   |
| Ratio  of net charge-offs to average loans during the period |       | (0.48                   | )%         | (0.05                 | )%         | (0.37 | )% | (0.27 | )% |
| Ratio  of allowance to net loans at end of period            |       | 1.46                    | %          | 1.08                  | %          | 1.46 | % | 1.08 | % |
| Ratio  of non-performing loans to allowance                  |       | 162.96                  | %          | 50.80                 | %          | 162.96 | % | 50.80 | % |

 

*Credit Risk Management*

 

Bancorp monitors its loanportfolio for potential risk of loss according to an internal risk-gradingsystem and monitors its credit quality to identify potential problem creditsand any loss exposure in a timely manner. Bancorp has assessed and will continue to assess on an on-going basis,the impact of the economy on the credit risk in the loan portfolio. The extensionof credit to individuals and businesses is a significant portion of Bancorp’sprincipal business activity and requires ongoing portfolio and creditmanagement.  As such, Bancorp hasestablished lending policies and procedures to manage and monitor risk. Theselending policies and procedures include guidelines for concentrations ofcredit, loan terms, loan-to-value ratios, collateral appraisals and loanapproval limits.

 

***ASSET QUALITY              ***Non-performing assets consist ofnonaccrual loans, accruing loans past due 90 days or more, and other realestate owned. At June 30, 2009, non-performing assets increased to $16.3million or 2.78 percent of total assets compared to $11.1 million or 1.96percent as of December 31, 2008.

 

*Non-accrualand impaired loans*- It is Bancorp’s policy to discontinue the accrual of interest on all loansthat are 90 days or more past due and place them on non-accrual.  When a loan is placed on non-accrual status,any accrued but unpaid interest on that date is removed from interest income.Non-accruing loans increased to $9.2 million as of June 30, 2009 comparedto $5.5 million as of December 31, 2008 with $1.4 million of the December balancetransfering into other real estate owned during 2009.  $5.4 million, representing 4 loan credit relationships,were put on non-accrual status during 2009.

 

Impaired loans increasedto $10.3 million at June 30, 2009 from $5.5 million at December 31,2008, and  $1.4 million in impaired loanswere transferred to other real estate owned during 2009. Five creditrelationships of $8.7 million, accounted for 84 percent of impaired loans as ofJune 30, 2009. A $140,000 specific allocation relating to two creditrelationships was included in the allowance for loan losses. All material loanrestructurings have been included in impaired loans.

 

*Otherreal estate owned*— Other real estate owned increased to $7.1 million at June 30, 2009 from$5.7 million at December 31, 2008. During 2009, Bancorp foreclosed on two non-accrual credit relationshipsof $1.4 million. In addition, Bancorp transferred the former Boulevard branchto other real estate owned.  As of June 30,2009, Bancorp held seven properties which represent four separate landdevelopment projects consisting of finished lots with a carrying balance of $5.4million, two commercial real estate property with a carrying balance of $1.5million,  and a $194,000 raw landproperty.

 

To prepare certainproperties for sell, the Bank capitalized $136,000 in property improvementsduring the six months ended June 30, 2009. Valuation of the property occurs when it is foreclosed upon and at leastannually thereafter.  Based on currentappraisal received on one of our properties during the 2009 quarter, Bancorprecorded a write-down on other real estate owned of $373,000 for the six monthsended June 30, 2009. Bancorp plans to continue its collection efforts andliquidation of collateral, as necessary, to recover as large a portion of thenon-accrual assets or other real estate owned as possible.

 

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*Potential problem loans* — Potential problem loans consist ofloans that are currently performing, but for which management have identifiedas having a well defined weakness or weaknesses. These weaknesses mayjeopardize the liquidation of the loan and are characterized by the distinctpossibility that Bancorp may sustain some loss if the deficiencies creating theweaknesses are not corrected. These loans are identified through our internalrisk grading processes and management monitors these loans closely and reviewstheir performance on a regular basis.  As of June 30, 2009, Bancorphad classified $9.5 million as potential problem loans.

 

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

 

**Non-Performing Assets**

** **
| **(dollars in thousands)**                   | ** ** | **June 30, 2009** | ** ** | **December 31, 2008** | ** ** |
|----------------------------------------------|------------|------------------------|------------|----------------------------|------------|
| Non-accrual  loans                           |       | $                      | 9,173      |                       | $          | 5,456 |   |
| Loans  past due 90 days or more              |       | —                 |       | —                     |       |
| Total  non-performing loans                  |       | 9,173                  |       | 5,456                      |       |
| Other  real estate owned                     |       | 7,103                  |       | 5,667                      |       |
| Total  non-performing assets                 |       | $                      | 16,276     |                       | $          | 11,123 |   |
| Total  non-performing loans to net loans     |       | 2.38                   | %          | 1.39                       | %          |
| Total  non-performing loans to total assets  |       | 1.57                   | %          | 0.96                       | %          |
| Total  non-performing assets to total assets |       | 2.78                   | %          | 1.96                       | %          |

 

**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 $504.2 million at June 30, 2009 compared to $469.5 million at December 31,2008.  Within the total, core depositsincreased $16.4 million and time deposits increased $18.3 million.  Core deposits, which consist of non-interestand interest bearing demand accounts, money market accounts, and savingaccounts, represented 64.4% and 65.6% of total deposits at June 30, 2009and December 31, 2008, 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**

** **
| ** **                   | ** ** | **June 30, 2009** | ** ** | **December 31, 2008** | ** ** |
|------------------------------|------------|------------------------|------------|----------------------------|------------|
| **(dollars in thousands)**   |       | **Amount**             |       | **% of Total**             |       | **Amount** |   | **% of Total** |   |
| Non-interest  bearing demand |       | $                      | 64,558     |                       | 12.8       | % | $ | 75,116 |   | 16.0 | % |
| Interest  bearing demand     |       | 94,074                 |       | 18.7                       | %          | 87,091 |   | 18.5 | % |
| Money  market                |       | 81,653                 |       | 16.2                       | %          | 69,548 |   | 14.8 | % |
| Savings                      |       | 84,492                 |       | 16.8                       | %          | 76,646 |   | 16.3 | % |
| Time                         |       | 169,761                |       | 33.7                       | %          | 157,127 |   | 33.5 | % |
| Brokered  time deposits      |       | 9,638                  |       | 1.8                        | %          | 4,010 |   | 0.9 | % |
| Total  deposits              |       | $                      | 504,176    |                       | 100.0      | % | $ | 469,538 |   | 100.0 | % |

** **

**OTHER BORROWINGS  **Borrowings consist of federal funds purchased whichinclude discount window borrowings from the Federal Reserve Bank of SanFrancisco and securities sold under agreements to repurchase.  Total borrowings decreased to $16.7 millionat June 30, 2009 compared to $32.7 million as of December 31,2008.  Bancorp’s deposit growth duringthe 2009 year contributed to the $13.4 million reduction in Federal Fundspurchased to zero as of June 30, 2009.

 

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

 

**CAPITAL RESOURCES**    Stockholders’equity increased to $62.2 million at June 30, 2009 from $61.8 million at December 31,2008.  Book value per share at June 30,2009 was $106.03 compared to a book value of $105.41 at December 31, 2008.

 

Bancorp has only oneclass of stock, which is common stock and at June 30, 2009, there were 767shareholders of record.  Bancorp’s stockis not actively traded or quoted and no broker currently makes a market in thestock. 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,Bancorp repurchases shares of its common stock. The number of shares of stockthat will be repurchased and the price that will be paid is the result of manyfactors including market and economic conditions, the number of sharesavailable, Bancorp’s liquidity and capital needs and regulatory requirements.For the three and six months ended June 30, 2009, Bancorp repurchased noshares of stock.

 

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, theTreasury created 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.

 

Banking regulationsrequire bank holding companies and banks to maintain certain minimum capitallevels.  As the following table indicatesas of June 30, 2009 and December 31, 2008, Skagit State Bancorp, Inc.and Skagit State Bank both exceeded the well-capitalized requirements.

 

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| ** **                       | ** ** | ** ** | ** ** | ** **            | ** ** | ** **            | ** ** | ** **            | ** ** | **To Be Well**        | ** ** |
|----------------------------------|------------|------------|------------|-----------------------|------------|-----------------------|------------|-----------------------|------------|-----------------------|------------|
| ** **                       | ** ** | ** ** | ** ** | ** **            | ** ** | ** **            | ** ** | ** **            | ** ** | **Capitalized Under** | ** ** |
| ** **                       | ** ** | ** ** | ** ** | ** **            | ** ** | **For Capital**       | ** ** | **Prompt Corrective** | ** ** |
| ** **                       | ** ** | **Actual** | ** ** | **Adequacy Purposes** | ** ** | **Action Provisions** | ** ** |
| **(dollars in thousands)**       | ** ** | **Amount** | ** ** | **Ratio**             | ** ** | **Amount**            | ** ** | **Ratio**             | ** ** | **Amount**            | ** ** | **Ratio** | ** ** |
| As  of June 30, 2009        |       |       |       |                  |       |                  |       |                  |       |                  |       |   |   |
| Total  Capital                   |       |       |       |                  |       |                  |       |                  |       |                  |       |   |   |
| (to  Risk-Weighted Assets)       |       |       |       |                  |       |                  |       |                  |       |                  |       |   |   |
| Skagit  State Bank               |       | $          | 65,767     |                  | 14.53      | %                     | $          | 36,211                |       | > 8.00             | %          | $ | 45,264 |   | > 10.00 | % |
| Skagit  State Bancorp, Inc. |       | $          | 65,999     |                  | 14.57      | %                     | $          | 36,266                |       | > 8.00             | %          | $ | 45,283 |   | > 10.00 | % |
| Tier  I Capital                  |       |       |       |                  |       |                  |       |                  |       |                  |       |   |   |
| (to  Risk-Weighted Assets)       |       |       |       |                  |       |                  |       |                  |       |                  |       |   |   |
| Skagit  State Bank               |       | $          | 60,138     |                  | 13.29      | %                     | $          | 18,106                |       | > 4.00             | %          | $ | 27,158 |   | >   6.00 | % |
| Skagit  State Bancorp, Inc. |       | $          | 60,370     |                  | 13.33      | %                     | $          | 18,113                |       | > 4.00             | %          | $ | 27,170 |   | >   6.00 | % |
| Tier  I Capital                  |       |       |       |                  |       |                  |       |                  |       |                  |       |   |   |
| (to  Average Assets)             |       |       |       |                  |       |                  |       |                  |       |                  |       |   |   |
| Skagit  State Bank               |       | $          | 60,138     |                  | 10.39      | %                     | $          | 23,163                |       | > 4.00             | %          | $ | 28,953 |   | >   5.00 | % |
| Skagit  State Bancorp, Inc. |       | $          | 60,370     |                  | 10.43      | %                     | $          | 23,163                |       | > 4.00             | %          | $ | 28,953 |   | >   5.00 | % |
|                             |       |       |       |                  |       |                  |       |                  |       |                  |       |   |   |
| As  of December 31, 2008    |       |       |       |                  |       |                  |       |                  |       |                  |       |   |   |
| Total  Capital                   |       |       |       |                  |       |                  |       |                  |       |                  |       |   |   |
| (to  Risk-Weighted Assets)       |       |       |       |                  |       |                  |       |                  |       |                  |       |   |   |
| Skagit  State Bank               |       | $          | 64,776     |                  | 14.04      | %                     | $          | 36,901                |       | > 8.00             | %          | $ | 46,127 |   | > 10.00 | % |
| Skagit  State Bancorp, Inc. |       | $          | 64,926     |                  | 14.07      | %                     | $          | 36,913                |       | > 8.00             | %          | $ | 46,141 |   | > 10.00 | % |
| Tier  I Capital                  |       |       |       |                  |       |                  |       |                  |       |                  |       |   |   |
| (to  Risk-Weighted Assets)       |       |       |       |                  |       |                  |       |                  |       |                  |       |   |   |
| Skagit  State Bank               |       | $          | 59,326     |                  | 12.86      | %                     | $          | 18,451                |       | > 4.00             | %          | $ | 27,676 |   | >   6.00 | % |
| Skagit  State Bancorp, Inc. |       | $          | 59,476     |                  | 12.89      | %                     | $          | 18,456                |       | > 4.00             | %          | $ | 27,684 |   | >   6.00 | % |
| Tier  I Capital                  |       |       |       |                  |       |                  |       |                  |       |                  |       |   |   |
| (to  Average Assets)             |       |       |       |                  |       |                  |       |                  |       |                  |       |   |   |
| Skagit  State Bank               |       | $          | 59,326     |                  | 10.50      | %                     | $          | 22,596                |       | > 4.00             | %          | $ | 28,245 |   | >   5.00 | % |
| Skagit  State Bancorp, Inc. |       | $          | 59,476     |                  | 10.53      | %                     | $          | 22,596                |       | > 4.00             | %          | $ | 28,245 |   | >   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 from customerdeposits within the Bank’s market area. In addition, funding needs are metthrough loan repayments, investment securities repayments, earnings and otherborrowings through pre-approved credit lines. Liquidity may also be obtained bymaintaining assets that can be converted to cash with little or no risk ofloss.  However, in this turbulent marketenvironment, assets may be more difficult to convert to cash with or without aloss.

 

As part of the Bank’sliquidity management, the Bank utilizes federal funds purchased to supplementthe primary source of funds, which are deposits.  As a result, there could be fluctuations inthese borrowing balances depending on short-term liquidity and longer-termfinancing needs of the Bank.  As of June 30,2009, Bancorp had approximately $47.0 million in approved unsecured creditlines from various financial institutions and had securities with a marketvalue of $54.8 million pledged as collateral for borrowing at the FederalReserve Discount Window.

 

Because the Bank’sprimary sources and uses of funds are deposits and loans, the relationshipbetween net loans and total deposits provides one measure of the Bank’sliquidity.  The Bank’s loan to depositratio decreased to 76.3 percent at June 30, 2009 compared to 83.9 percentat December 31, 2008, as a result of the increase in deposits and thedecrease in loans.

 

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The turmoil in the creditmarkets during the last year 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 June 30, 2009 was adequate to fund ongoing operations.

 

Skagit State Bancorp, Inc.is a separate legal entity from the Bank and must provide for its ownliquidity.  Substantially all ofBancorp’s revenues are obtained from dividends declared and paid by the Bank.Skagit State Bank’s ability to pay dividends is limited by its earnings,financial condition and capital requirements, as well as regulatoryrestrictions.

 

**Item 3.            QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

The results of operationsfor financial institutions are largely dependent upon the financialinstitution’s ability to manage market risks which includes interest raterisk.  Interest rate risk refers to theexposure of earnings and capital arising from changes in interest rates.

 

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

 

Bancorp believes thatthere have not been any material changes about Bancorp’s market risk from theinformation that was provided in the Form 10-K for the year ended December 31,2008.

 

**Item 4T.         CONTROLSAND PROCEDURES**

# ** **

Evaluation of DisclosureControls and Procedures

 

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

 

Changes in InternalControls

 

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

 

**PART II -       OTHERINFORMATION**

 

**Item 1.            LegalProceedings**

 

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

 

**Item 1A.         RiskFactors**

 

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

 

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

 

Bancorp’s profitabilityis dependent to a large extent upon net interest income. Earnings and cashflows are largely dependent upon our net interest income.  Net interest income is the difference (or“spread”) between the interest earned on loans, securities and otherinterest-earning assets and Bancorp’s cost of funds, primarily interest expenseon deposits and borrowings. Interest rates are highly sensitive to many factorsthat are beyond our control including, but not limited to, general economicconditions, and policies of various governmental and regulatory agencies.Changes in monetary policy, including changes in interest rates, impact thelevel of loans, deposits and investments, the credit profile of existing loansand the rates received on loans and investment securities and the rates paid ondeposits and borrowings. If the interest paid on deposits increases at a fasterrate than the interest received on loans and investment securities, Bancorp’snet interest income, and therefore earnings could be adversely affected.  Earnings could also be adversely affected ifinterest received on loans and investments decrease faster than interest paidon deposits.

 

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

 

Real estate loanscomprise the largest category of loans and represent 69.5 percent of Bancorp’stotal loans.  Our real estate portfolioconsists of commercial and residential lending. These loans are secured by property such as office buildings, commercialbusiness properties, healthcare buildings, agricultural land, timber land andresidential properties.  Commercial andcommercial real estate loans generally are viewed as having more risk ofdefault than residential real estate loans or certain other types of loans orinvestments.  Typically, these types ofloans are larger than residential real estate loans and other loans.  Because the loan portfolio contains a numberof commercial real estate loans with relatively large balances, thedeterioration of one or a few of these loans may cause a significant increasein nonperforming loans.  An increase innonperforming loans could result in a loss of earnings from these loans, anincrease in the provision for loan losses or an increase in loan charge-offs,which could have an adverse impact on our results of operations and financialcondition.

 

**There hasbeen an economic downturn throughout the country, particularly in the housingand commercial real estate sectors. While the Pacific Northwest economy typically lags the national economy,the effects of the economic downturn are now significantly impacting our marketarea.  Further downturn in the marketareas we serve may cause us to have lower earnings and could increase ourcredit risk associated with our loan portfolio, as the collateral securingthose loans may decrease in value.  Acontinued downturn in the local economy could have a material adverse effect onboth the ability of borrowers to repay loans, as well as the value of the realproperty held as collateral. **Substantially all ofour loans are to businesses and individuals in Skagit, Snohomish or WhatcomCounties and any decline in the economy of this market area could impact usadversely.  As a lender, we are exposedto the risk that our customers will be unable to repay their loans inaccordance with their terms, and that any collateral securing the payment oftheir loans may not be sufficient to assure repayment.

** **

**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 managing our credit quality, we attemptto identify deteriorating loans before they become nonperforming assets andadjust the loan loss reserve accordingly.  However, because futureevents are uncertain, and if the economy continues to deteriorate, there may beloans that deteriorate to a nonperforming status in an accelerated timeframe.  As a result, future additions to the allowance may benecessary.  Because the loan portfolio contains a number of loanswith relatively large balances, the deterioration of one or a few of theseloans may cause a significant increase in nonperforming loans, requiring anincrease to the loan loss allowance.  Additionally, future significantadditions to the allowance may be required based on changes in the mix of loanscomprising the portfolio, changes in the financial condition of borrowers, suchas may result from changes in economic conditions, or as a result of incorrectassumptions 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.

 

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** **

**Acontinued tightening of the credit markets may make it difficult to obtainadequate funding for loan growth, which could adversely affect our earnings.**

 

A continued tightening ofthe credit market and the inability to obtain or retain adequate money to fundcontinued loan growth may negatively affect our asset growth and liquidityposition and, therefore, our earnings capability.  In addition tocore deposit growth, maturity of investment securities and loan payments,Bancorp also relies on alternative funding sources through correspondentbanking, and borrowing lines with the Federal Reserve 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.

 

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

 

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

 

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

 

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

 

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

 

Weare subject to extensive regulation, supervision and examination by federal andstate banking authorities.  Any change inapplicable regulations or federal, state or local legislation could have asubstantial impact on us and our operations. Additional legislation and regulations that could significantly affectour powers, authority and operations may be enacted or adopted in the future,which could have a material adverse effect on our financial condition andresults of operations.  In that regard,proposals for legislation restructuring the regulation of the financialservices industry are currently under consideration.  Adoption of such proposals could, among otherthings, increase the overall costs of regulatory compliance.  Further, regulators have significantdiscretion and authority to prevent or remedy unsafe or unsound practices orviolations of laws or regulations by financial institutions and holdingcompanies in the performance of their supervisory and enforcement duties.  These powers recently have been utilized morefrequently due to the serious national, regional and local economic conditionswe are facing.  The exercise ofregulatory authority may have a negative impact on our financial condition andresults of operations.

 

On October 3, 2008,Congress enacted the Emergency Economic Stabilization Act of 2008 (“EESA”),which provides the United States Treasury Department (“Treasury”) with broadauthority to implement action intended to help restore stability and liquidityto the US financial markets.  The EESAalso increased the amount of deposit account insurance coverage from $100,000to $250,000 effective until December 31, 2009, which was recently extendedto December 31, 2013 under the Helping Families Save Their Homes Act of2009.

 

Inearly 2009, the Treasury also announced the Financial Stability Plan which,among other things, provides a new capital program called the CapitalAssistance Program, which establishes a public-private investment fund for thepurchase of troubled assets, and expands the Term Asset-Backed Securities LoanFacility.  The full effect of this broadlegislation on the national economy and financial institutions, particularly onmid-sized institutions like the Company, cannot now be predicted.  In addition, the American Recovery andReinvestment Act of 2009, or ARRA, was signed into law on February 17,2009, and includes, among other things, extensive new restrictions on thecompensation and governance arrangements of financial institutionsparticipating in the Treasury’s Troubled Asset Relief Program.  The SEC recently has proposed expanding someof the reforms in ARRA to apply to all public companies.

 

Numerous actions have beentaken by the Federal Reserve, the U.S. Congress, the Treasury, the FDIC, theSEC and others to address the liquidity and credit crisis.  In addition, the Secretary of the Treasuryproposed fundamental changes to the regulation of financial institutions,markets and products on June 17, 2009.

 

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We cannot predict the actualeffects of EESA, the ARRA, the proposed regulatory reform measures and variousgovernmental, regulatory, monetary and fiscal initiatives which have been andmay be enacted on the financial markets, on Bancorp. The terms and costs ofthese activities, or the failure of these actions to help stabilize thefinancial markets, asset prices, market liquidity and a continuation orworsening of current financial market and economic conditions could materiallyand adversely affect our business, financial condition, results of operations,and the trading price of our common stock.

 

**Our ability to access markets forfunding and acquire and retain customers could be adversely affected by thedeterioration of either the financial condition of other financial institutionsor the overall reputation of the financial service industry.**

 

The financial servicesindustry continues to be featured in negative headlines about the global andnational credit crisis and the resulting stabilization legislation enacted bythe U.S. federal government.  Thesereports can be damaging to the industry’s image and potentially erode consumerconfidence in insured financial institutions, such as our bankingsubsidiary.  In addition, our ability toengage in routine funding and other transactions could be adversely affected bythe actions and financial condition of other financial institutions. 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 rebuild and maintain the federal depositinsurance fund and we may separately incur state statutory assessments in thefuture.**

 

The FDIC recently adopted a final rule revisingits risk-based assessment system, effective April 1, 2009.  The changes to the assessment system involveadjustments to the risk-based calculation of an institution’s unsecured debt,secured liabilities and brokered deposits. The revisions effectively result in a range of possible assessmentsunder the risk-based system of 7 to 77.5 basis points.  The potential increase in FDIC insurancepremiums will add to our cost of operations and could have a significant impacton the Company.  Depending on any futurelosses that the FDIC insurance fund may suffer due to failed institutions,there can be no assurance that there will not be additional significant premiumincreases in order to replenish the fund.

 

The FDIC has imposed a special Deposit Insuranceassessment of 5 basis points on all insured institutions.  This emergency assessment will be calculatedbased on the insured institution’s assets at June 30, 2009, and collectedon September 30, 2009.  Based on ourJune 30, 2009 assets subject to the FDIC assessment, the Company accruedapproximately $260,000 for the special assessment.  The FDIC has announced that an additionalspecial assessment in 2009 of up to 5 basis points is probable.

 

Further,under Washington state laws, Bancorp may incur additional costs if one or moreWashington state banks that hold public deposits fail, since, as a publicdepositary, we are subject to Washington statutory pro-rata assessments tocover any net losses in public deposits not otherwise covered by federaldeposit insurance or other means.

 

**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.

 

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**Item 2.****                                                     ****Unregistered Sales of EquitySecurities and Use of Proceeds**

 

None

 

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

 

None

 

**Item 4.****                                                     ****Submission of Matters to a Voteof Security Holders**

 

(a)          Skagit State Bancorp’s, Inc. Annual ShareholderMeeting was held on April 21, 2009.

 

(b)         Not Applicable

 

(c)          A brief description of each matter voted upon at theAnnual Meeting and number of votes cast for, or withheld, including a separatetabulation with respect to each nominee to serve on the Board is presentedbelow:

 

(1)          Election of three (3) directors for termsexpiring in 2012 or until their successor is nominated and has qualified.

 
| Directors:             |   |    |   |
|------------------------|--------|---------|--------|
| Gerald  W. Christensen |   |    |   |
| Votes  For:            |   | 495,452 |   |
| Votes  Withheld:       |   | 1,267   |   |
| Michael  F. Janicki    |   |    |   |
| Votes  For:            |   | 495,452 |   |
| Votes  Withheld:       |   | 1,267   |   |
| Richard  N. Nelson     |   |    |   |
| Votes  For:            |   | 495,452 |   |
| Votes Withheld:        |   | 1,267   |   |

 

**Item 5.                  OtherInformation**

 

None

 

**Item 6.                  Exhibits**

 

(a)                                  Exhibits.

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

 

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**SIGNATURES**

 

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

 

 
|   | SKAGIT STATE BANCORP,  INC. |
|--------|-----------------------------|
|   | (Registrant)                |
|   |                        |
|   |                        |
| Dated: | August 13, 2009        |   | /s/ Cheryl R. Bishop |
|   | Cheryl R. Bishop            |
|   | Chief Executive Officer     |
|   |                        |
|   |                        |
| Dated: | August 13, 2009        |   | /s/ Carla F. Tucker |
|   | Carla F. Tucker             |
|   | Executive  Vice-President   |
|   | Chief Financial Officer     |

 

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