** **

**UNITED STATESSECURITIES 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 endedSeptember 30, 2007**

 

**o****                    Transition Report Under Section13 or 15(d) of the Exchange Act**

 

**For the transition period from                           to                **

 

**Commission File Number  000-52096**

 

 

 

**SKAGIT STATE BANCORP,INC.**

(ExactName of Registrant as Specified in Its Charter)

 

 

| **WASHINGTON**                                       | ** ** | **20-5048602**         |
|------------------------------------------------------|------------|------------------------|
| (State or Other Jurisdiction of                      |       | (I.R.S. Employer       |
| Incorporation or Organization)                       |       | Identification Number) |
|                                                 |       |                   |
| **301 East Fairhaven Avenue**                        |
| **Burlington, Washington 98233**                     |
| (Address of Principal Executive Offices) (Zip  Code) |

 

**(360)755-0411**

(Registrant’sTelephone Number, Including Area Code)

 

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

Yes x    No o

 

Indicate by check markwhether the registrant is a large accelerated filer, an accelerate filer, or anon-accelerate.

| Large  accelerated filer o |   | Accelerated  filer o |   | Non-accelerated  filer x |   |
|---------------------------------|--------|----------------------|--------|--------------------------|--------|

 

                Indicate bycheck mark whether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act.

Yes o    No x

 

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

 

                Thenumber of shares of the issuer’s Common Stock outstanding at November 13 2007,was 670,872.

 

 

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**SKAGITSTATE BANCORP, INC.**

**TABLE OF CONTENTS**

 

 
| **PART I.**   | ** ** | **FINANCIAL INFORMATION** | ** ** | ** **                                                                                                                                      | ** ** |
|---------------|------------|---------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **    | ** ** | ** **                |       |                                                                                                                                            |       |   |   |
|          |       | Item 1.                   |       | Financial  Statements                                                                                                                           |       |   |   |
|          |       |                      |       |                                                                                                                                            |       |   |   |
|          |       |                      |       | Consolidated  Balance Sheet as of September 30, 2007 and December 31, 2006                                                                      |       |   |   |
|          |       |                      |       |                                                                                                                                            |       |   |   |
|          |       |                      |       | Consolidated  Statement of Income for the three and nine months ended September 30, 2007  and 2006                                              |       |   |   |
|          |       |                      |       |                                                                                                                                            |       |   |   |
|          |       |                      |       | Consolidated  Statement of Changes in Stockholders’ Equity and Comprehensive Income for the  nine months ended September 30, 2007 and 2006 |       |   |   |
|          |       |                      |       |                                                                                                                                            |       |   |   |
|          |       |                      |       | Consolidated  Statement of Cash Flows for the nine months ended September 30, 2007 and 2006                                                     |       |   |   |
|          |       |                      |       |                                                                                                                                            |       |   |   |
|          |       |                      |       | Notes to  Consolidated Financial Statements                                                                                                     |       |   |   |
|          |       |                      |       |                                                                                                                                            |       |   |   |
|          |       | Item 2.                   |       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                                     |       |   |   |
|          |       |                      |       |                                                                                                                                            |       |   |   |
|          |       | Item 3.                   |       | Quantitative  and Qualitative Disclosures About Market Risk                                                                                     |       |   |   |
|          |       |                      |       |                                                                                                                                            |       |   |   |
|          |       | Item 4.                   |       | Controls and  Procedures                                                                                                                        |       |   |   |
|          |       |                      |       |                                                                                                                                            |       |   |   |
| **PART  II.** | ** ** | **OTHER INFORMATION**     |       |                                                                                                                                            |       |
|          |       |                      |       |                                                                                                                                            |       |   |   |
|          |       | Item 1.                   |       | Legal Proceedings                                                                                                                               |       |   |   |
|          |       |                      |       |                                                                                                                                            |       |   |   |
|          |       | Item  1 A.                |       | Risk  Factors                                                                                                                                   |       |   |   |
|          |       |                      |       |                                                                                                                                            |       |   |   |
|          |       | Item 2.                   |       | Unregistered  Sales of Equity Securities and Use of Proceeds                                                                                    |       |   |   |
|          |       |                      |       |                                                                                                                                            |       |   |   |
|          |       | Item 3.                   |       | Defaults Upon  Senior Securities                                                                                                                |       |   |   |
|          |       |                      |       |                                                                                                                                            |       |   |   |
|          |       | Item 4.                   |       | Submission of  Matters to a Vote of Security Holders                                                                                            |       |   |   |
|          |       |                      |       |                                                                                                                                            |       |   |   |
|          |       | Item 5.                   |       | Other Information                                                                                                                               |       |   |   |
|          |       |                      |       |                                                                                                                                            |       |   |   |
|          |       | Item  6.                  |       | Exhibits                                                                                                                                        |       |   |   |
|          |       |                      |       |                                                                                                                                            |       |   |   |
|          |       |                      |       | Signatures                                                                                                                                      |       |   |   |

 

** **

 

2

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**Item1. ****FinancialStatements**

 

**SKAGIT STATE BANCORP, INC. ANDSUBSIDIARY**

**CONSOLIDATED BALANCE SHEET(Unaudited)**

 

 

 

 
| **(dollars in thousands except share data)**                                                                                                                          | ** ** | **September 30, 2007** | ** ** | **December 31, 2006** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| **ASSETS**                                                                                                                                                            | ** ** |
| **ASSETS**                                                                                                                                                            | ** ** | ** **             | ** ** | ** **            | ** ** |
| Cash and due  from banks                                                                                                                                              |       | $                      | 14,606     |                  | $          | 21,535 |   |
| Federal funds  sold                                                                                                                                                   |       | 43,630                 |       | 25,700                |       |
| Investment  securities                                                                                                                                                |       |                   |       |                  |       |
| Available-for-sale,  at fair value                                                                                                                                    |       | 119,008                |       | 113,941               |       |
| Held-to-maturity,  at amortized cost                                                                                                                                  |       | 38,667                 |       | 35,034                |       |
| Loans                                                                                                                                                                 |       | 348,279                |       | 325,744               |       |
| Allowance for  loan losses                                                                                                                                            |       | (4,805                 | )          | (5,176                | )          |
| Net loans                                                                                                                                                             |       | 343,474                |       | 320,568               |       |
| Bank premises  and equipment, net                                                                                                                                     |       | 11,156                 |       | 11,289                |       |
| Accrued interest  receivable                                                                                                                                          |       | 3,768                  |       | 3,414                 |       |
| Other assets                                                                                                                                                          |       | 2,692                  |       | 1,307                 |       |
| **TOTAL  ASSETS**                                                                                                                                                     |       | $                      | 577,001    |                  | $          | 532,788 |   |
| ** **                                                                                                                                                            | ** ** |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                        | ** ** |
| ** **                                                                                                                                                            | ** ** |
| **LIABILITIES**                                                                                                                                                       | ** ** | ** **             | ** ** | ** **            | ** ** |
| Deposits                                                                                                                                                              |       |                   |       |                  |       |
| Interest-bearing                                                                                                                                                      |       | $                      | 414,857    |                  | $          | 368,093 |   |
| Non-interest-bearing                                                                                                                                                  |       | 71,067                 |       | 81,250                |       |
| Total deposits                                                                                                                                                        |       | 485,924                |       | 449,343               |       |
| Securities sold  under agreements to repurchase                                                                                                                       |       | 16,730                 |       | 14,102                |       |
| Other  liabilities                                                                                                                                                    |       | 3,227                  |       | 2,799                 |       |
| Total  liabilities                                                                                                                                                    |       | 505,881                |       | 466,244               |       |
|                                                                                                                                                                  |       |                   |       |                  |       |
| **STOCKHOLDERS’  EQUITY**                                                                                                                                        | ** ** | ** **             | ** ** | ** **            | ** ** |
| Common stock, no  par value, 5,000,000 shares authorized 670,762 and 673,532 shares issued and  outstanding at September 30, 2007 and December 31, 2006, respectively |       | 13,526                 |       | 13,935                |       |
| Retained  earnings                                                                                                                                                    |       | 57,683                 |       | 52,878                |       |
| Accumulated  other comprehensive loss, net of tax                                                                                                                     |       | (89                    | )          | (269                  | )          |
| Total  stockholders’ equity                                                                                                                                      |       | 71,120                 |       | 66,544                |       |
| **TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                  |       | $                      | 577,001    |                  | $          | 532,788 |   |

 

*See accompanying notes to theseconsolidated financial statements*

 

3

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**SKAGIT STATEBANCORP, INC. AND SUBSIDIARY**

**CONSOLIDATED STATEMENT OF INCOME(Unaudited)**

 
| ** **                                      | ** ** | **Three months ended Sept. 30,** | ** ** | **Nine months ended Sept. 30,** | ** ** |
|-------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| **(dollars in thousands except share data)**    | ** ** | **2007**                         | ** ** | **2006**                        | ** ** | **2007** | ** ** | **2006** | ** ** |
| **INTEREST  INCOME**                            | ** ** | ** **                       | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest and  fees on loans                     |       | $                                | 7,050      |                            | $          | 6,534 |   | $ | 21,126 |   | $ | 18,774 |   |
| Investment  securities                          |       |                             |       |                            |       |   |   |   |   |
| Taxable                                         |       | 1,421                            |       | 1,113                           |       | 4,027 |   | 2,972 |   |
| Exempt from  federal income tax                 |       | 281                              |       | 210                             |       | 757 |   | 586 |   |
| Federal funds  sold                             |       | 431                              |       | 587                             |       | 1,393 |   | 2,205 |   |
| Total interest  income                          |       | 9,183                            |       | 8,444                           |       | 27,303 |   | 24,537 |   |
| **INTEREST  EXPENSE**                           | ** ** | ** **                       | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Deposits                                        |       | 3,327                            |       | 2,448                           |       | 9,296 |   | 6,855 |   |
| Securities sold  under agreements to repurchase |       | 168                              |       | 120                             |       | 453 |   | 340 |   |
| Total interest  expense                         |       | 3,495                            |       | 2,568                           |       | 9,749 |   | 7,195 |   |
| **NET  INTEREST INCOME**                        |       | 5,688                            |       | 5,876                           |       | 17,554 |   | 17,342 |   |
| Provision  (benefit) for loan losses            |       | —                           |       | —                          |       | (150 | ) | — |   |
| **NET  INTEREST INCOME AFTER**                  | ** ** | ** **                       | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| **PROVISION  (BENEFIT) FOR LOAN LOSSES**        |       | 5,688                            |       | 5,876                           |       | 17,704 |   | 17,342 |   |
| **NON-INTEREST  INCOME**                        | ** ** | ** **                       | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Service charges  on deposits                    |       | 765                              |       | 555                             |       | 1,943 |   | 1,622 |   |
| Other                                           |       | 352                              |       | 263                             |       | 788 |   | 669 |   |
| Total  non-interest income                      |       | 1,117                            |       | 818                             |       | 2,731 |   | 2,291 |   |
| **NON-INTEREST  EXPENSES**                      | ** ** | ** **                       | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Salaries                                        |       | 1,950                            |       | 1,820                           |       | 5,628 |   | 5,165 |   |
| Payroll taxes  and employee benefits            |       | 443                              |       | 415                             |       | 1,369 |   | 1,211 |   |
| Bank premises  and equipment                    |       | 322                              |       | 326                             |       | 971 |   | 945 |   |
| Occupancy                                       |       | 153                              |       | 169                             |       | 508 |   | 504 |   |
| State business  taxes                           |       | 146                              |       | 111                             |       | 376 |   | 335 |   |
| Advertising                                     |       | 261                              |       | 195                             |       | 678 |   | 521 |   |
| Loss on sale of  assets                         |       | 81                               |       | —                          |       | 81 |   | — |   |
| Other                                           |       | 810                              |       | 756                             |       | 2,547 |   | 2,177 |   |
| Total  non-interest expenses                    |       | 4,166                            |       | 3,792                           |       | 12,158 |   | 10,858 |   |
| **INCOME  BEFORE PROVISION**                    | ** ** | ** **                       | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| **FOR  INCOME TAX**                             |       | 2,639                            |       | 2,902                           |       | 8,277 |   | 8,775 |   |
| **PROVISION  FOR INCOME TAX**                   | ** ** | ** **                       | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Current                                         |       | 698                              |       | 760                             |       | 2,033 |   | 2,316 |   |
| Deferred                                        |       | (78                              | )          | —                          |       | (78 | ) | 51 |   |
| Total provision  for income tax                 |       | 620                              |       | 760                             |       | 1,955 |   | 2,367 |   |
| **NET  INCOME**                                 |       | $                                | 2,019      |                            | $          | 2,142 |   | $ | 6,322 |   | $ | 6,408 |   |
| **BASIC  EARNINGS PER SHARE**                   |       | $                                | 3.00       |                            | $          | 3.17 |   | $ | 9.40 |   | $ | 9.31 |   |
| **DILUTED  EARNINGS PER SHARE**                 |       | $                                | 3.00       |                            | $          | 3.17 |   | $ | 9.38 |   | $ | 9.30 |   |
| **DIVIDENDS  DECLARED PER SHARE**               |       | $                                | 0.00       |                            | $          | 0.00 |   | $ | 2.25 |   | $ | 1.25 |   |

 

 

*See accompanying notes to theseconsolidated financial statements*

 

4

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**SKAGIT STATE BANCORP, INC. ANDSUBSIDIARY**

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

 

 
| **(dollars in thousands except share and per**                                | ** ** | **Common Stock** | ** ** | **Retained** | ** ** | **Accum. Other  Comprehensive** | ** ** | **Total  Stockholders’** | ** ** | **Comprehensive** | ** ** |
|-------------------------------------------------------------------------------|------------|------------------|------------|--------------|------------|---------------------------------|------------|-------------------------------|------------|-------------------|------------|
| **share amounts)**                                                            | ** ** | **Shares**       | ** ** | **Amount**   | ** ** | **Earnings**                    | ** ** | **Income (Loss)**             | ** ** | **Equity**        | ** ** | **Income** | ** ** |
|                                                                          |       |             |       |         |       |                            |       |                          |       |              |       |   |   |
| **BALANCE,**January 1, 2006                                                   |       | 707,237          |       | $            | 14,604     |                            | $          | 51,139                        |       | $                 | (370       | ) | $ | 65,373 |   |   |   |
| Comprehensive  income:                                                        |       |             |       |         |       |                            |       |                          |       |              |       |   |   |
| Net income                                                                    |       | —           |       | —       |       | 6,408                           |       | —                        |       | 6,408             |       | $ | 6,408 |   |
| Other  comprehensive income:                                                  |       |             |       |         |       |                            |       |                          |       |              |       |   |   |
| Unrealized gains  on available-for-sale securities, net of taxes of $306      |       | —           |       | —       |       | —                          |       | 594                           |       | 594               |       | 594 |   |
| Unrealized loss  on available-for-sale securities, net of tax benefit of $340 |       | —           |       | —       |       | —                          |       | (659                          | )          | (659              | )          | (659 | ) |
| Total other  comprehensive loss                                               |       |             |       |         |       |                            |       |                          |       |              |       | (65 | ) |
| Comprehensive  income                                                         |       |             |       |         |       |                            |       |                          |       |              |       | $ | 6,343 |   |
| Cash dividend  declared, $1.25 per share                                      |       | —           |       | —       |       | (849                            | )          | —                        |       | (849              | )          |   |   |
| Common stock  redemption                                                      |       | (33,568          | )          | (664         | )          | (4,920                          | )          | —                        |       | (5,584            | )          |   |   |
| Common stock  issued                                                          |       | 100              |       | 15           |       | —                          |       | —                        |       | 15                |       |   |   |
| **BALANCE,**September 30,  2006                                               |       | 673,769          |       | $            | 13,955     |                            | $          | 51,778                        |       | $                 | (435       | ) | $ | 65,298 |   |   |   |
|                                                                          |       |             |       |         |       |                            |       |                          |       |              |       |   |   |
| **BALANCE,**January 1, 2007                                                   |       | 673,532          |       | $            | 13,935     |                            | $          | 52,878                        |       | $                 | (269       | ) | $ | 66,544 |   |   |   |
| Comprehensive  income:                                                        |       |             |       |         |       |                            |       |                          |       |              |       |   |   |
| Net income                                                                    |       | —           |       | —       |       | 6,322                           |       | —                        |       | 6,322             |       | $ | 6,322 |   |
| Other  comprehensive income:                                                  |       |             |       |         |       |                            |       |                          |       |              |       |   |   |
| Unrealized gains  on available-for-sale securities, net of taxes of $591      |       | —           |       | —       |       | —                          |       | 1,147                         |       | 1,147             |       | 1,147 |   |
| Unrealized loss  on available-for-sale securities, net of tax benefit of $498 |       | —           |       | —       |       | —                          |       | (967                          | )          | (967              | )          | (967 | ) |
| Total other  comprehensive income                                             |       |             |       |         |       |                            |       |                          |       |              |       | 180 |   |
| Comprehensive  income                                                         |       |             |       |         |       |                            |       |                          |       |              |       | $ | 6,502 |   |
| Cash dividend  declared, $2.25 per share                                      |       | —           |       | —       |       | (1,517                          | )          | —                        |       | (1,517            | )          |   |   |
| Common stock  redemption                                                      |       | (2,870           | )          | (510         | )          | —                          |       | —                        |       | (510              | )          |   |   |
| Common stock  issued                                                          |       | 100              |       | 101          |       | —                          |       | —                        |       | 101               |       |   |   |
| **BALANCE,**September 30,  2007                                               |       | 670,762          |       | $            | 13,526     |                            | $          | 57,683                        |       | $                 | (89        | ) | $ | 71,120 |   |   |   |

 

*See accompanying notes to these consolidatedfinancial statements*

 

5

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**SKAGIT STATE BANCORP, INC. ANDSUBSIDIARY**

**STATEMENTOF CASH FLOWS (Unaudited**)

 

 

 
| **(dollars in thousands)**                                                                                   | ** ** | ** ** | ** ** | ** ** | ** ** |
|--------------------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| **Nine months ended September 30,**                                                                          | ** ** | **2007**   | ** ** | **2006**   | ** ** |
| **CASH  FLOWS FROM OPERATING ACTIVITIES**                                                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income                                                                                                   |       | $          | 6,322      |       | $          | 6,408 |   |
| *Adjustments  to reconcile net income to net cash flows from operating activities*                           | * *   | * *   | * *   | * *   | * *   |
| Benefit for loan  losses                                                                                     |       | (150       | )          | —     |       |
| Depreciation                                                                                                 |       | 654        |       | 629        |       |
| Loss (gain) on  sale of assets                                                                               |       | 81         |       | (22        | )          |
| Gains on sale of  other real estate owned                                                                    |       | (6         | )          | —     |       |
| Gains on sale of  loans                                                                                      |       | (9         | )          | —     |       |
| Amortization of  investment security premiums and discounts, net                                             |       | (146       | )          | (42        | )          |
| Provision for  deferred income taxes                                                                         |       | (78        | )          | 51         |       |
| Stock  compensation for employee services                                                                    |       | 101        |       | 15         |       |
| *Changes  in operating assets and liabilities*                                                               | * *   | * *   | * *   | * *   | * *   |
| Decrease in  loans held for sale                                                                             |       | 9          |       | —     |       |
| Increase in interest  receivable                                                                             |       | (354       | )          | (805       | )          |
| Increase in  other assets                                                                                    |       | (1,400     | )          | (2,674     | )          |
| Decrease in  other liabilities                                                                               |       | 428        |       | 628        |       |
| Net cash flows  from operating activities                                                                    |       | 5,452      |       | 4,188      |       |
| **CASH  FLOWS FROM INVESTING ACTIVITIES**                                                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Proceeds from  maturities, calls, and principal payments of investment securities —  available-for-sale |       | 31,789     |       | 18,500     |       |
| Purchases of  investment securities — available-for-sale                                                |       | (36,437    | )          | (44,954    | )          |
| Proceeds from  maturities and principal payments of investment securities — held-to-maturity            |       | 3,172      |       | 5,765      |       |
| Purchases of  investment securities — held-to-maturity                                                  |       | (6,805     | )          | (10,146    | )          |
| Net decrease  (increase) in federal funds sold                                                               |       | (17,930    | )          | 45,955     |       |
| Net increase in  loans                                                                                       |       | (22,756    | )          | (11,327    | )          |
| Purchase of  premises and equipment                                                                          |       | (602       | )          | (881       | )          |
| Proceeds from  sale of assets                                                                                |       | 6          |       | 22         |       |
| Net cash flows  from investing activities                                                                    |       | (49,563    | )          | 2,934      |       |
| **CASH  FLOWS FROM FINANCING ACTIVITIES**                                                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net decrease in  demand deposits, money market, NOW and savings accounts                                     |       | (6,229     | )          | (23,487    | )          |
| Net increase in  time deposits                                                                               |       | 42,810     |       | 16,187     |       |
| Net increase in  securities sold under agreements to repurchase                                              |       | 2,628      |       | 2,203      |       |
| Amount paid for  redemption of common stock                                                                  |       | (510       | )          | (5,584     | )          |
| Cash dividends                                                                                               |       | (1,517     | )          | (849       | )          |
| Net cash flows  from financing activities                                                                    |       | 37,182     |       | (11,530    | )          |
| **NET  CHANGE IN CASH AND DUE FROM BANKS**                                                                   |       | (6,929     | )          | (4,408     | )          |
| **CASH  AND DUE FROM BANKS,**beginning of year                                                               |       | 21,535     |       | 24,975     |       |
| **CASH  AND DUE FROM BANKS,**end of period                                                                   |       | $          | 14,606     |       | $          | 20,567 |   |
| **SUPPLEMENTAL  DISCLOSURES OF CASH FLOW INFORMATION**                                                       | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash paid during  the year for income taxes                                                                  |       | $          | 2,387      |       | $          | 2,478 |   |
| Cash paid during  the year for interest                                                                      |       | 9,595      |       | 7,120      |       |
| **NONCASH  FINANCING AND INVESTING TRANSACTIONS**                                                            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net unrealized  loss (gain) on available-for-sale securities                                                 |       | (180       | )          | 65         |       |
|                                                                                                              |            |            |            |            |            |  |  |  |

 

* See accompanying notes to these consolidatedfinancial statements*

 

6

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** **

**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

 

**Note 1:   BASIS OF PRESENTATION**

The accompanying consolidated financial statementsinclude the accounts of Skagit State Bancorp, Inc. and its subsidiary SkagitState Bank, (collectively, “Company” or “Bancorp). All significantinter-company accounts and transactions have been eliminated. The consolidatedfinancial statements have been prepared in conformity with accountingprinciples generally accepted in the United States of America for interimfinancial information and with instructions to Form 10-Q. Accordingly they donot include all of the information and footnotes required by accountingprinciples generally accepted in the United States of America for completefinancial statements. In the opinion of management, all adjustments (consistingof normal recurring accruals) considered necessary for a fair presentation havebeen included. Operating results for the nine months ended September 30, 2007,are not necessarily indicative of the results anticipated for the year endingDecember 31, 2007. For additional information, refer to the audited financialstatements and footnotes for the most recent annual period ended December 31,2006 contained in the Annual Report on Form 10-K.

 

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

 

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

Inpreparing the financial statements, management is required to make estimatesand assumptions that affect the reported amounts of revenues and expenses forthe periods presented, and assets and liabilities as of the date of the balancesheet. Material estimates that are particularly susceptible to significantchange in the near term relate to the determination of the allowance for loanlosses, the valuation of real estate acquired in connection with foreclosuresor in satisfaction of loans and deferred income taxes. Uncertainties withrespect to such estimates and assumptions are inherent in the preparation ofBancorp’s financial statements. Accordingly, it is possible that actual resultscould differ from these estimates or assumptions, which could have a materialeffect on the reported amounts of the consolidated financial position andresults of operation. These policies aredescribed in more detail in the Annual Report on Form 10-K for the year endedDecember 31, 2006.

 

**Note 3:   RECLASSIFICATIONS**

Certain reclassifications have been made to the 2006financial statements to conform to the 2007 presentation. Such classificationshave no affect on net income.

 

**Note 4:   EARNINGSPER SHARE**

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

 
| ** **                                                     | ** ** | **Three months ended Sept. 30,** | ** ** | **Nine months ended Sept. 30,** | ** ** |
|----------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| **(dollars in thousands except  share and per share amounts)** | ** ** | **2007**                         | ** ** | **2006**                        | ** ** | **2007** | ** ** | **2006** | ** ** |
| Numerator:                                                     |       |                             |       |                            |       |   |   |   |   |
| Net income                                                     |       | $                                | 2,019      |                            | $          | 2,142 |   | $ | 6,322 |   | $ | 6,408 |   |
| Denominator:                                                   |       |                             |       |                            |       |   |   |   |   |
| Denominator for basic earnings per share -                     |       |                             |       |                            |       |   |   |   |   |
| Weighted average shares outstanding                            |       | 671,085                          |       | 675,372                         |       | 672,298 |   | 688,339 |   |
| Effect of diluted earnings per share-                          |       |                             |       |                            |       |   |   |   |   |
| Stock options and restricted stock grants                      |       | 1,333                            |       | 337                             |       | 1,434 |   | 379 |   |
| Denominator for diluted earnings per share -                   |       |                             |       |                            |       |   |   |   |   |
| Weighted average shares outstanding                            |       | 672,418                          |       | 675,709                         |       | 673,732 |   | 688,718 |   |
| Basic earnings per share                                       |       | $                                | 3.00       |                            | $          | 3.17 |   | $ | 9.40 |   | $ | 9.31 |   |
| Diluted earnings per share                                     |       | $                                | 3.00       |                            | $          | 3.17 |   | $ | 9.38 |   | $ | 9.30 |   |

 

 

7

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** **

 

**Note 5:   ALLOWANCE FOR LOAN LOSSES**

The allowance for loan losses is maintained at a level deemed adequateto provide for estimated future losses. Bancorp has a systematic methodologyfor evaluating the adequacy of the allowance for loan losses which is evaluatedon a quarterly basis. The allowance consists of specific, general andunallocated components.  The allowance isbased upon Bancorp’s evaluation of the pertinent factors underlying the qualityof the loan portfolio, including changes in size and composition of the loanportfolio, levels and trends in losses and delinquencies, actual loan lossexperience, current economic conditions, specific industry conditions, and loanconcentrations.  Additionally, the Bankconducts a detailed analysis of individual loans for which full collectibilitymay not be assured which includes the determination, the existence, and therealizable value of the collateral securing the loans. The general allowance isthen calculated, by applying a historical loss percentage factor to thedifferent loan types and the different risk gradings.  In addition, as part of the process, aspecific allowance is determined based on Bancorp’s review of classified ornon-performing loans for specific weaknesses and evaluation of those loans forimpairment and loss exposure. The unallocated component of the allowancereflects the margin of imprecision inherent in the underlying assumptions usedin the methodologies for estimated specific and general losses in the loanportfolio.

 

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

**Note 6:   STOCK-BASEDCOMPENSATION**

Bancorphas a stock-based equity compensation plan. Under this plan, Bancorp is authorized to grant options or restrictedstock up to 100,000 shares.  No grants ofoptions or restricted stock were awarded for the nine months ended September30, 2007. For additional information on thestock-based equity compensation plan, refer to Bancorp’s audited financialstatements and footnotes for the most recent annual period ended December 31,2006 contained in the Annual Report on Form 10-K.

 

**Note 7:   INCOMETAXES**

In 2006, the FASB issued FASB Interpretation48, “Accounting for Uncertainty in Income Taxes — an interpretation of FASBStatement No. 109”.  FIN 48 seeks toreduce the diversity in practice associated with certain aspects of measurementand recognition 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.  Bancorp adopted FIN 48 onJanuary 1, 2007. As a result of the implementation of FIN 48, Bancorprecognized no material adjustments for unrecognized income tax benefits, all ofwhich would affect Bancorp’s effective income tax rate if recognized.  Our accounting policy with respect tointerest and penalties arising from income tax settlements is to recognize themas non-interest expense.

 

Bancorp is no longer subject to U.S. federalincome tax examinations by tax authorities for tax years before 2003.  The State of Washington recently examinedBancorp’s business and occupation tax returns for 2003, 2004, 2005 and 2006 andno significant adjustments were identified.

 

**Note 8:   FINANCIALINSTRUMENTS**

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

 

8

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The following is a summary of the off-balance-sheet financialinstruments or contracts outstanding as of September 30, 2007: (dollars inthousands)

 
| Unfunded commitments to extend credit  |   | $     | 76,450 |   |
|----------------------------------------|--------|-------|--------|--------|
| Credit card arrangements               |   | 7,647 |   |
| Commitments to fund municipal warrants |   | 1,673 |   |
| Standby letters of credit              |   | 2,087 |   |

 

**Note 9:   NEW ACCOUNTINGPRONOUNCEMENTS**

In September 2006, the FASB issued SFAS No.157, “Fair Value Measures”. This statement defines fair value, establishes aframework for measuring fair value in generally accepted accounting principlesand expands disclosures about fair value measurements.  SFAS No. 157 is effective for financialstatements issued for fiscal years beginning after November 15, 2007 andinterim periods within those fiscal years. Bancorp does not anticipate the adoption of SFAS No. 157 will havea material impact on its consolidated financial statements.

 

In September 2006, the FASB issued SFAS No.158, “Employers’ Accounting for Defined Benefit Pension and OtherPostretirement Plans”, an amendment of SFAS No. 87, 88, 106 and 132(R).  This statement requires an employer torecognize the over-funded or under-funded status of a defined benefitpostretirement plan as an asset or liability in its statement of financialposition and to recognize changes in that funded status in the year in whichthe changes occur through comprehensive income. This statement also requires an employer to measure the funded status ofa plan as of the date of its year-end statement of financial position. Thisstatement is effective for Bancorp as of January 1, 2008.  Bancorp does not anticipate the adoption ofSFAS No. 158 will have a material impact on its consolidated financialstatements.

 

In February 2007, the FASB issued SFAS No.159, “The Fair Value Option for Financial Assets and Financial Liabilities,including an amendment of SFAS No. 115”. This statement permits companies tochoose to measure selected financial instruments at fair value. Following theinitial fair value measurement date, ongoing unrealized gains and losses on itemsfor which fair value reporting has been elected are reported in earnings.  SFAS No. 159 is effective for financialstatements issued for fiscal years beginning after November 15, 2007. Earlyadoption of this statement was permitted only as allowed in paragraph 30 of thestatement. Bancorp did not elect early adoption of this standard and does notanticipate the adoption of SFAS No. 159 on its effective date will have amaterial impact on its consolidated financial statements.

 

**Item 2.****          ****MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTSOF 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, 2006 in the Annual Report on Form10-K.*

 

**FORWARDLOOKING STATEMENTS**

In addition to historicalinformation, this report contains certain “forward looking statements” withinthe meaning of the Private Securities Litigation Reform Act of 1995(PSLRA).  This statement is included forthe express purpose of availing Bancorp of the protections of the safe harborprovision of the PSLRA.  Theforward-looking statements contained in this report are subject to factors,risk, and uncertainties that may cause actual results to differ materially fromthose projected.  Important factors thatmight cause such a material difference include, but are not limited to, thosediscussed in this section of the report. In addition, the following items are among the factors that could causeactual results to differ materially from the forward looking statements in thisreport: general economic conditions, including the effects of recent worldevents; business conditions in the banking industry; the regulatoryenvironment; new legislation; vendor quality and efficiency; employee retentionfactors; rapidly changing technology and evolving banking industry standards;competitive factors, including increased competition with community, regional,and national financial institutions; fluctuating interest rate environments;and similar matters.  Readers arecautioned not to place undue reliance on these forward-looking statements, whichreflect management’s analysis only as of the date of the statement.  Bancorp undertakes no obligation to publiclyreview or update these forward-looking statements to reflect events orcircumstances that arise after the date of this report.  Readers should carefully review any riskfactors described in this and other documents we file from time to time withthe Securities and Exchange Commission.

 

9

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**OVERVIEW**

SkagitState Bank, a wholly-owned subsidiary of Skagit State Bancorp, Inc., began operationsin 1958 and is headquartered in Burlington (Skagit County), Washington.  The Bank provides a full range of bankingservices and products to both businesses and individuals through 13 fullservice banking offices located in Skagit, Snohomish and Whatcom counties.

Netincome was $2.0 million and $2.1 million for the quarters ended September 30,2007 and 2006 with basic earnings per share at $3.00 and $3.17, respectively.Net income was $6.3 million and $6.4 million for the nine months endedSeptember 30, 2007 and 2006 with basic earnings per share at $9.40 and $9.31,respectively. The decreases in net income was primarily attributable toincreases in non-interest and interest expenses in 2007, which were partiallyoffset by increases in interest income resulting from an increase in theaverage balance of interest-earning assets in 2007. Net income, for the ninemonths ended September 30, 2007 was favorable impacted by a $495,000 interestrecovery on one loan relationship and a $150,000 benefit for loan lossescompared to no provision or benefit for loan losses in 2006.

Annualized return on average assets was 1.43percent and 1.53 percent for the quarter and nine months ending September 30,2007 compared to 1.68 percent and 1.65 percent during the same time periods in2006.  Annualized return on averageequity was 11.58 percent and 12.26 percent for the quarter and nine monthsending September 30, 2007 compared to 13.34 percent and 13.19 percent, for thesame time periods in 2006.

 

Total assets increased to $577.0 million atSeptember 30, 2007 compared to $532.8 million at December 31, 2006.  The increase was primarily due to a $36.6million increase in total deposits. Net loans increased by $22.9 million to$343.5 million compared to $320.6 million at December 31, 2006.

 

**RESULTS OF OPERATIONS**

Bancorp’s results of operations are dependentto a large degree on net interest income, operating efficiency and the level ofthe provision for loan losses. Bancorp’s operations are sensitive to interestrate changes and the resulting impact on net interest income.   Bancorp generates non-interest incomeprimarily through service charges and fees. Bancorp’s non-interest expenses consist primarily of salaries andemployee benefits expense, bank premises and equipment expense and advertisingexpense.

 

**NETINTEREST INCOME     **Net interestincome is Bancorp’s principal source of revenue and is comprised of interestincome on earnings assets (loans and investment securities) less interestexpense on interest-bearing liabilities (deposits and borrowings). Interestincome and expense are affected significantly by general economic conditions,particularly changes in market interest rates, and by government policies andthe actions of regulatory authorities.

Net interest income was $5.7 million and$17.6 million for the quarter and nine months ended September 30, 2007 comparedto $5.9 million and $17.3 million for the like periods in 2006.  The decrease for the third quarter of 2007compared to the same quarter in 2006 was primarily due to the decrease in theinterest-earning asset yield and an increase in the cost of funds on and theaverage balance of interest-bearing liabilities. The increase for the ninemonths ended September 30, 2007 compared to 2006 was primarily due to increasesin the balance of average interest-earning assets which was partially offset byan increase in the cost of funds on interest-bearing liabilities and anincrease in the average balance of interest-bearing liabilities.  In addition, for the nine months endedSeptember 30, 2007, Bancorp recorded a $495,000 interest recovery on one loanrelationship.

 

Thenet interest margin is net interest income expressed as a percent of averageinterest-earning assets. Net interest margin is influenced by the level andrelative mix of interest-earning assets and interest-bearing liabilities aswell as levels of non-interest bearing liabilities.  Starting in 2006, the Federal Reserveincreased its targeted federal funds rate by 100 basis points to 5.25 percent,where it remained until September 18, 2007 when the rate was decreased by 50basis points to 4.75 percent. Bancorp’s prime rate moves in conjunction withthe federal funds rate.  In 2007, Bancorpexperienced compression in the net interest margin compared to 2006.  For the quarter and nine months endedSeptember 30, 2007, the net interest margin decreased to 4.24 percent and 4.55percent from 4.91 percent and 4.85 percent for the like periods in 2006.  These decreases were primarily a result ofthe more rapid increase in the cost of funds than the yield on interest-earningassets. For the quarter and nine months ended September 30, 2007 compared tothe like periods in 2006, cost of funds increased 53 basis points and 63 basispoints while the interest-earning asset yield decreased 21 basis points andincreased 21 basis points, respectively.

 

10

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*Interest-earning assets*

The largest component of interest income isinterest earned on loans.  Total interestincome earned from loans increased by $516,000 and $2.4 million, respectivelyfor the quarter and nine months ended September 30, 2007 compared to the likeperiods in 2006.  For the currentquarter, this increase was primarily a result of a $38.7 million increase inthe average balance which was partially offset by a decrease in the yield onloans by 38 basis points from 8.59 percent to 8.21 percent. The increase forthe nine months ended September 30, 2007 compared to the like period in 2006was primarily a result of a $35.1 million increase in the average balance and a$495,000 interest recovery on one loan relationship which was partially offsetby a decrease in the yield on loans, without the interest recovery, by 15 basispoints from 8.49 percent to 8.34 percent.

 

Interest earned on investments and federalfunds sold increased $223,000 and $414,000 for the quarter and nine monthsended September 30, 2007 compared to the like quarters in 2006.  Within the total, interest on federal fundsdecreased $156,000 for the current quarter and $812,000 for the nine monthsended September 30, 2007. For the current quarter, this decrease was primarilya result of a 53 basis point decrease in yield and an $8.1 million decrease inthe average balance and for the nine months ended September 30, 2007, thisdecrease was primarily a result of the $24.6 million decrease in the averagebalance. Interest earned on investments increased by $379,000 and $1.2 millionfor the quarter and nine months ended September 30, 2007, primarily due to a $27.0million and a $27.2 million increase in the average balance.  The yield on investments increased from 4.09percent to 4.35 percent for the current quarter compared to the 2006 quarterand from 3.93 percent to 4.31 percent for the nine months ended September 30,2007 compared to the like period in 2006.

 

*Interest- bearing liabilities*

Interest expense increased $927,000 and $2.6million for the quarter and nine months ended September 30, 2007 compared tothe like periods in 2006.  For thecurrent quarter, the increase was the result of a $53.1 million increase in theaverage balance of total interest-bearing liabilities and a 53 basis pointincrease in the rates paid on interest-bearing liabilities from 2.75 percent to3.28 percent. For the nine months ended September 30, 2007, the increase wasdue to a $32.5 million increase in the average balance of interest-bearingliabilities and a 63 basis point increase in rates paid on interest-bearingliabilities from 2.57 percent to 3.20 percent.

 

 

11

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The following tables present informationregarding average balances of assets and liabilities  as well as the total amounts of interestincome from average interest-earning assets and interest expense on averageinterest-bearing liabilities, resulting yield and cost ratios, interest ratespread and net interest margin. Tax exempt securities, included in investmentsecurities below are stated at their contractual interest rate. Loan fees of$240,000 and $773,000 for the quarter and nine months ended September 30, 2007,and $301,000 and $879,000 for the quarter and nine months ended September 30,2006 are included in interest earned on loans.

 

**Condensed Average Balance Sheets**

** **

(dollars in thousands exceptshare data)
| ** **                                        | ** ** | **2007**    | ** ** | **2006**     | ** ** |
|---------------------------------------------------|------------|-------------|------------|--------------|------------|
| ** **                                        | ** ** | **Average** | ** ** | ** **   | ** ** | **Yield** | ** ** | **Average** | ** ** | ** ** | ** ** | **Yield** | ** ** |
| **Three months ended Sept. 30,**                  | ** ** | **Balance** | ** ** | **Interest** | ** ** | **/Cost** | ** ** | **Balance** | ** ** | **Interest** | ** ** | **/Cost** | ** ** |
| **Assets**                                        | ** ** | ** **  | ** ** | ** **   | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Federal funds sold                                |       | $           | 36,015     |         | $          | 431 |   | 4.75 | % | $ |  44,144 |   | $ |  587 |   | 5.28 | % |
| Taxable investment securities                     |       | 109,825     |       | 1,421        |       | 5.13 |   | 91,951 |   | 1,113 |   | 4.80 |   |
| Tax exempt securities                             |       | 45,429      |       | 281          |       | 2.45 |   | 36,292 |   | 210 |   | 2.30 |   |
| Loans                                             |       | 340,631     |       | 7,050        |       | 8.21 |   | 301,944 |   | 6,534 |   | 8.59 |   |
| Total interest-earning assets                     |       | 531,900     |       | 9,183        |       | 6.85 | % | 474,331 |   | 8,444 |   | 7.06 | % |
| Non-interest earning assets                       |       | 34,826      |       |         |       |   |   | 36,986 |   |   |   |   |   |
|                                              |       |        |       |         |       |   |   |   |   |   |   |   |   |
| Total assets                                      |       | $           | 566,726    |         |       |   |   |   | $ |  511,317 |   |   |   |   |   |
|                                              |       |        |       |         |       |   |   |   |   |   |   |   |   |
| **Liabilities and Stockholders’ Equity**     |       |        |       |         |       |   |   |   |   |   |   |   |   |
| Interest-bearing demand                           |       | $           | 88,008     |         | $          | 283 |   | 1.28 | % | $ | 84,434 |   | $ |  274 |   | 1.29 | % |
| Savings and money market                          |       | 139,951     |       | 762          |       | 2.16 |   | 141,196 |   | 741 |   | 2.08 |   |
| Certificates of deposit                           |       | 178,724     |       | 2,282        |       | 5.07 |   | 131,679 |   | 1,433 |   | 4.32 |   |
| Total interest-bearing deposits                   |       | 406,683     |       | 3,327        |       | 3.25 |   | 357,309 |   | 2,448 |   | 2.72 |   |
| Securities sold under agreement to repurchase     |       | 16,400      |       | 168          |       | 4.06 |   | 12,662 |   | 120 |   | 3.76 |   |
| Total interest-bearing deposits & liabilities |       | 423,083     |       | 3,495        |       | 3.28 | % | 369,971 |   | 2,568 |   | 2.75 | % |
| Non interest-bearing demand deposits              |       | 70,428      |       |         |       |   |   | 74,004 |   |   |   |   |   |
| Other non-interest-bearing liabilities            |       | 3,457       |       |         |       |   |   | 3,118 |   |   |   |   |   |
| Total liabilities                                 |       | 496,968     |       |         |       |   |   | 447,093 |   |   |   |   |   |
| Stockholders’ equity                         |       | 69,758      |       |         |       |   |   | 64,224 |   |   |   |   |   |
| Total liabilities and stockholders’ equity   |       | $           | 566,726    |         |       |   |   |   | $ | 511,317 |   |   |   |   |   |
| Net interest income                               |       |        |       | $            | 5,688      |   |   |   |   |   | $ | 5,876 |   |   |   |
| Interest rate spread                              |       |        |       |         |       | 3.57 | % |   |   |   |   | 4.31 | % |
| Net interest margin                               |       |        |       |         |       | 4.24 | % |   |   |   |   | 4.91 | % |
|                                                   |            |             |            |              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

 

12

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**CondensedAverage Balance Sheets**

** **

(dollars in thousands except share data)
| ** **                                        | ** ** | **2007**    | ** ** | **2006**     | ** ** |       |
|---------------------------------------------------|------------|-------------|------------|--------------|------------|------------|
| ** **                                        | ** ** | **Average** | ** ** | ** **   | ** ** | **Yield**  | ** ** | **Average** | ** ** | ** ** | ** ** | **Yield** | ** ** |   |
| **Nine months ended Sept. 30,**                   | ** ** | **Balance** | ** ** | **Interest** | ** ** | **/Cost**  | ** ** | **Balance** | ** ** | **Interest** | ** ** | **/Cost** | ** ** |   |
| **Assets**                                        | ** ** | ** **  | ** ** | ** **   | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |   |
| Federal funds sold                                |       | $           | 37,048     |         | $          | 1,393      |   | 5.03 | % | $ | 61,674 |   | $ | 2,205 |   | 4.78 | % |   |
| Taxable investment securities                     |       | 105,661     |       | 4,027        |       | 5.10       |   | 86,330 |   | 2,972 |   | 4.60 |   |   |
| Tax exempt securities                             |       | 42,628      |       | 757          |       | 2.37       |   | 34,736 |   | 586 |   | 2.26 |   |   |
| Loans                                             |       | 330,693     |       | 21,126       |       | 8.54       |   | 295,608 |   | 18,774 |   | 8.49 |   |   |
| Total interest-earning assets                     |       | 516,030     |       | 27,303       |       | 7.07       | % | 478,348 |   | 24,537 |   | 6.86 | % |   |
| Non-interest earning assets                       |       | 34,875      |       |         |       |       |   | 37,926 |   |   |   |   |   |   |
| Total assets                                      |       | $           | 550,905    |         |       |       |   |   | $ | 516,274 |   |   |   |   |   |
|                                              |       |        |       |         |       |       |   |   |   |   |   |   |   |   |
| **Liabilities and Stockholders’ Equity**     |       |        |       |         |       |       |   |   |   |   |   |   |   |   |
| Interest-bearing demand                           |       | $           | 85,187     |         | $          | 823        |   | 1.29 | % | $ | 87,653 |   | $ | 847 |   | 1.29 | % |
| Savings and money market                          |       | 140,530     |       | 2,295        |       | 2.18       |   | 148,198 |   | 2,246 |   | 2.03 |   |
| Certificates of deposit                           |       | 166,109     |       | 6,178        |       | 4.97       |   | 125,702 |   | 3,762 |   | 4.00 |   |
| Total interest-bearing deposits                   |       | 391,826     |       | 9,296        |       | 3.17       |   | 361,553 |   | 6,855 |   | 2.53 |   |
| Securities sold under agreement to repurchase     |       | 15,214      |       | 453          |       | 3.98       |   | 13,001 |   | 340 |   | 3.50 |   |
| Total interest-bearing deposits & liabilities |       | 407,040     |       | 9,749        |       | 3.20       | % | 374,554 |   | 7,195 |   | 2.57 | % |
| Non interest-bearing demand deposits              |       | 71,589      |       |         |       |       |   | 73,931 |   |   |   |   |   |
| Other non-interest-bearing liabilities            |       | 3,506       |       |         |       |       |   | 2,991 |   |   |   |   |   |
| Total liabilities                                 |       | 482,135     |       |         |       |       |   | 451,476 |   |   |   |   |   |
| Stockholders’ equity                         |       | 68,770      |       |         |       |       |   | 64,798 |   |   |   |   |   |
| Total liabilities and stockholders’ equity   |       | $           | 550,905    |         |       |       |   |   | $ | 516,274 |   |   |   |   |   |
| Net interest income                               |       |        |       | $            | 17,554     |       |   |   |   |   | $ | 17,342 |   |   |   |
| Interest rate spread                              |       |        |       |         |       | 3.87       | % |   |   |   |   | 4.29 | % |
| Net interest margin                               |       |        |       |         |       | 4.55       | % |   |   |   |   | 4.85 | % |
|                                                   |            |             |            |              |            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

 

13

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The following table sets forth information onchanges in net interest income which are attributable to changes in interestrates and changes in volume for the periods indicated.  Non-accruing loans have been included in thecomputation of average loans. Changes attributable to the combined effect ofvolume and interest rates have been allocated proportionately.

 

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

 

(dollars in thousands except per shareamounts)
| ** **                                            | ** ** | **Three months ended Sept. 30,** | ** ** | **Nine months ended Sept. 30,** | ** ** |
|-------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                            | ** ** | **2007 vs. 2006**                | ** ** | **2007 vs. 2006**               | ** ** |
| ** **                                            | ** ** | **Increase (Decrease) Due to**   | ** ** | **Increase (Decrease) Due to**  | ** ** |
| ** **                                            | ** ** | **Rate**                         | ** ** | **Volume**                      | ** ** | **Total** | ** ** | **Rate** | ** ** | **Volume** | ** ** | **Total** | ** ** |
| **Interest-Earning Assets**                           | ** ** | ** **                       | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Federal funds sold                                    |       | $                                | (55        | )                               | $          | (101 | ) | $ | (156 | ) | $ | 177 |   | $ | (989 | ) | $ | (812 | ) |
| Investment securities                                 |       | 96                               |       | 283                             |       | 379 |   | 373 |   | 853 |   | 1,226 |   |
| Loans                                                 |       | (1,555                           | )          | 2,071                           |       | 516 |   | 111 |   | 2,241 |   | 2,352 |   |
| Total net change in income on Interest-earning assets |       | (1,514                           | )          | 2,253                           |       | 739 |   | 661 |   | 2,105 |   | 2,766 |   |
| **Interest-Bearing Liabilities**                      | ** ** | ** **                       | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Deposits                                              |       | 296                              |       | 583                             |       | 879 |   | 1,219 |   | 1,222 |   | 2,441 |   |
| Securities sold under agreements to repurchase        |       | 10                               |       | 38                              |       | 48 |   | 51 |   | 62 |   | 113 |   |
| Total net change in expense on                        |       |                             |       |                            |       |   |   |   |   |   |   |   |   |
| Interest-bearing liabilities                          |       | 306                              |       | 621                             |       | 927 |   | 1,270 |   | 1,284 |   | 2,554 |   |
| Net change in net interest income                     |       | $                                | (1,820     | )                               | $          | 1,632 |   | $ | (188 | ) | $ | (609 | ) | $ | 821 |   | $ | 212 |   |
|                                                       |            |                                  |            |                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**NON-INTEREST INCOME     **Non-interestincome, which consists primarily of fees and service charges on deposits andother income, was $1.1 million and $2.7 million for the quarter and nine monthsended September 30, 2007 compared to $818,000 and $2.3 million for the sameperiods in 2006. In July 2007, Bancorp began offering a new overdraftprotection product to its checking account customers and due primarily to thisnew product overdraft and non-sufficient fund fees increased $191,000 for thethird quarter of 2007 compared to 2006. In addition, during May 2007, Bancorp expanded its residential lendingdepartment and as a result brokered loan fees and processing fees increased$48,000 and $115,000 for the quarter and nine months ended September 30, 2007compared to the same periods in 2006. Partially offsetting these increases wasa $72,000 and $76,000 decrease in late charges collected on non-performingloans for the quarter and nine months ended September 30, 2007.

 

**NON-INTERESTEXPENSE     **Non-interestexpense was $4.2 million and $12.2 million for the quarter and nine monthsended September 30, 2007 compared to $3.8 million and $10.9 million in the likeperiods in 2006. These increases were primarily attributable to increases of$130,000 and $463,000 in salary expenses, $28,000 and $158,000 in payroll taxesand employee benefit expenses, $66,000 and $157,000 in advertising costs and$43,000 and $274,000 in consulting expenses for the quarter and nine months in2007, respectively. The increase in salary expense from 2006 to 2007 wasprimarily attributable to higher salaries, overall growth in employment andequity compensation expenses.  In 2007,Bancorp continued its efforts to increase and enhance its Retail Banking andConsumer and Commercial Lending staff in addition to increasing staff withinthe Residential Lending department.  Theincrease in consulting fees was primarily attributable to the professional feesassociated with a profit enhancement review and professional fees associatedwith management’s evaluation and assessment of internal controls as requiredunder Sarbanes-Oxley Act Section 404.

The efficiency ratio is computed by dividingtotal operating expenses by non-interest income and net interest income afterprovision for loan losses.  An increasein the efficiency ratio indicates that more resources are being utilized togenerate the same or greater volume of income. The efficiency ratio for thequarter and nine months ended September 30, 2007 was 61.2 percent and 59.5percent compared to 56.6 percent and 55.3 percent in the same time periods in2006. These increases from 2006 were primarily due to increases in non-interestexpenses.

 

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**INCOME TAX EXPENSE     **Income taxexpense for the quarter and nine months ended September 30, 2007 was $620,000and $2.0 million compared to $760,000 and $2.4 million for the quarter and ninemonths ended September 30, 2006. Bancorp’s effective tax rates were 23.6percent and 27.0 percent for the nine months ended September 30, 2007 and 2006,respectively. The effective tax rate is lower than the federal statutory ratedue to tax credits from tax-exempt bonds and tax-exempt interest from municipalbonds and loans.  As of September 30,2007, Bancorp had $47.7 million in tax-exempt securities compared to $37.5million as of September 30, 2006.

** **

**REVIEW OF FINANCIAL CONDITION**

Assets totaled $577.0 million at September 30, 2007,compared to $532.8 million at December 31, 2006.  This increase was primarily due to anincrease of $36.6 million in deposits.

** **

**INVESTMENT SECURITIES AND FEDERALFUNDS SOLD     **Total investment securitiesincreased $8.7 million to $157.7 million at September 30, 2007 compared to$149.0 million at December 31, 2006. Bancorp continues to adjust the portfoliomix to include additional mortgage-backed securities and municipalsecurities.  Security purchases were$43.2 million in the first 3 quarters, which was offset by maturities, securitycalls and principal pay downs of $35.0 million. Federal funds sold increased to $43.6 million at September 30, 2007compared to $25.7 million at December 31, 2006.

 

Certaininvestment securities included in the table below currently have fair valuesless than amortized cost and, therefore, contain unrealized losses.  Bancorp has evaluated these securities andbelieves that the decline in value is temporary and is related to the changesin market interest rates since purchase, with no permanent sector or issuercredit concerns or impairments.  Bancorpanticipates full recovery of amortized cost with respect to these securities atmaturity or sooner in the event of a more favorable market interest rateenvironment.

 

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

 

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

** **

**Investment Securities Composition**
| (dollars in thousands)           | ** ** | **September 30, 2007** | ** **    | **December 31, 2006** | ** ** |
|----------------------------------|------------|------------------------|---------------|-----------------------|------------|
| **Held-to-maturity**             | ** ** | ** **             | ** **    | ** **            | ** ** |
| State and political subdivisions |       | $                      |  38,667  |                  | $          |  35,034 |   |
| Total                            |       | $                      |  38,667  |                  | $          |  35,034 |   |
| **Available-for-sale**           | ** ** | ** **             | ** **    | ** **            | ** ** |
| U.S. government agencies         |       | $                      |  78,335  |                  | $          |  90,520 |   |
| Mortgage-backed-securities       |       | 31,648                 |          | 19,777                |       |
| State and political subdivisions |       | 9,025                  |          | 3,644                 |       |
| Total                            |       | $                      |  119,008 |                  | $          |  113,941 |   |

 

**LOANS     **Net loans were$343.5 million at September 30, 2007 compared to $320.6 million at December 31,2006.  Loan growth has been focused inreal estate and consumer lending.  Duringthe year, real estate commercial and residential loans increased $23.6 millionand consumer loans increased $4.2 million. These increases were partially offset by decreases of $1.9 million and$3.5 million in commercial loans and real estate construction loans.

 

Bancorp concentrates on five areas of lending: loans to individuals forbusiness purposes, loans for small and medium-sized businesses, agriculturalloans, loans to commercial enterprises for real estate transactions andconsumer purpose loans.  Bancorp’sprimary lending activities include commercial real estate loans, commercialloans which include agriculture production loans and consumer purpose loans.

Mostof Bancorp’s business activity is with customers located within Skagit,Snohomish and Whatcom Counties. Bancorp originates commercial, real estate andconsumer loans. Generally, loans are secured by accounts receivable, inventory,deposit accounts, personal property or real estate. Rights to collateral varyand are legally documented to the extent practicable.

 

Real estate loans comprise the largestcategory of loans with a total of $247.1 million or 70.6 percent and $227.0million or 69.3 percent as of September 30, 2007 and December 31, 2006,respectively. Bancorp is committed to 

 

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providingcompetitive commercial real estate lending within our primary marketareas.  Our real estate portfolioconsists of commercial and residential loans. These loans are secured by property such as office buildings, retailbuildings, owner occupied commercial business properties, farm land, timberland, residential land development properties and residential properties. WhileBancorp has significant balances secured by real estate, Bancorp believes thatits lending policies and concentration policies are sufficient to minimizerisks.

Residentialmortgage loans are offered primarily through Bancorp’s residential lendingdepartment. During 2007, Bancorp expanded its residential lendingdepartment.  Loans originated areprimarily for the purchase or refinance of residential properties.  Bancorp brokers a majority of these loansthrough Countrywide Mortgage and Washington Mutual. In 2007, Bancorp brokeredor sold $12.5 million for the nine months ended September 30, 2007 compared to$8.7 million for the nine months ended September 30, 2006.

Commercialloans were $70.1 million as of September 30, 2007 and $72.0 million as ofDecember 31, 2006.    Commercial loans,secured and unsecured, are made primarily to small and medium-sized businessesincluding farms 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.

Consumerloans were $32.6 million at September, 2007 and $28.4 million at December 31,2006. Bancorp makes secured and unsecured consumer loans including loans toindividuals, primarily customers of Bancorp, for various purposes, includinghome equity loans, purchases of automobiles, mobile homes, boats and otherrecreational vehicles, home improvement loans and loans for education andpersonal investments.

TheBoard of Directors has approved specific lending policies and procedures forBancorp and management is responsible for implementation of the policies.  The lending policies and procedures includeguidelines for concentrations of credit, loan terms, loan-to-value ratios, collateralappraisals and interest rates.  The loanpolicies also vest varying levels of loan authority in management, Bancorp’sloan officers and the Board of Directors.

The following tablepresents the composition of loans for Bancorp as of the dates indicated.

**Loan Composition**

(dollars in thousands)
| ** **                                    | ** ** | **September 30, 2007** | ** **    | **December 31, 2006** | ** ** |
|-----------------------------------------------|------------|------------------------|---------------|-----------------------|------------|
| ** **                                    | ** ** | **Amount**             | ** **    | **%**                 | ** ** | **Amount** | ** ** | **%** | ** ** |
| Real estate—residential & commercial |       | $                      |  218,625 |                  | 62.5       | % | $ | 194,989 |   | 59.5 | % |
| Real estate construction                      |       | 28,491                 |          | 8.1                   | %          | 32,031 |   | 9.8 | % |
| Commercial, industrial & agricultural     |       | 70,093                 |          | 20.0                  | %          | 72,033 |   | 22.0 | % |
| Consumer                                      |       | 32,585                 |          | 9.4                   | %          | 28,385 |   | 8.7 | % |
| Total loans                                   |       | 349,794                |          | 100                   | %          | 327,438 |   | 100 | % |
| Less:                                         |       |                   |          |                  |       |   |   |   |   |
| Allowance for loan losses                     |       | 4,805                  |          |                  |       | 5,176 |   |   |   |
| Deferred loan fees                            |       | 1,515                  |          |                  |       | 1,694 |   |   |   |
| Net loans                                     |       | $                      |  343,474 |                  |       |   | $ | 320,568 |   |   |   |

 

*Concentrations*

As shown in the table above, Bancorp has aconcentration in commercial and residential real estate.  Although management believes that loanswithin the real estate area have no more than the normal risk of collectibility,a substantial decline in the performance of the economy, in general, or adecline in real estate values in our market areas, in particular, could have anadverse impact on collectibility, increase the level of real estatenon-performing loans or have other adverse effects which alone or in aggregatecould have a material adverse effect on our business, financial condition,results of operation and cash flows.

** **

**PROVISION AND ALLOWANCE FOR LOANLOSSES     **The allowancefor loan losses was $4.8 million as of September 30, 2007 compared to $5.2million at December 31, 2006. When available information confirms that specificloans or portions thereof, are uncollectible, those amounts are charged-offagainst the allowance for loan losses. Net charges-offs for the three months and nine months ended September30, 2007 were $61,000 and $221,000 compared to $108,000 and $466,000 for thethree and nine months ended September 30, 2006.

 

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For the quarter and nine months ended September30, 2007, Bancorp reported no provision and a $150,000 benefit for loan losses,respectively, compared to no provision or benefit for loan losses in 2006. Thiswas primarily related to the changes in risk grading of loans and minimal netcharge-offs. In the future, normal growth of the loan portfolio may require anincrease in the allowance for loan losses.

 

The allowance for loan losses is maintained at a level deemed adequateto provide for estimated future losses. Bancorp has a systematic methodologyfor evaluating the adequacy of the allowance for loan losses and the allowanceis evaluated on a quarterly basis. The allowance consists of specific, generaland unallocated components.  Theallowance is based upon Bancorp’s periodic evaluation of the pertinent factorsunderlying the quality of the loan portfolio, including changes in size andcomposition of the loan portfolio, levels and trends in losses anddelinquencies, actual loan loss experience, current economic conditions,specific industry conditions, loan concentrations, detailed analysis ofindividual loans for which full collectibility may not be assured and thedetermination of the existence and the realizable value of the collateralsecuring the loans. The general allowance is then calculated, by applying ahistorical loss percentage factor to the different loan types and the differentrisk gradings.  In addition, as part ofthe process, a specific allowance is determined based on Bancorp’s review ofclassified or non-performing loans for specific weaknesses, and evaluation ofthose loans for impairment and loss exposure. The unallocated component of theallowance reflects the margin of imprecision inherent in the underlyingassumptions used in the methodologies for estimated specific and general lossesin the loan portfolio.   See Note 5 ofNotes to the Consolidated Financial Statements for more information on theallowance for loan losses.

 

Bancorpcurrently monitors its loan portfolio for potential risk of loss according toan internal risk-grading system. Management monitors Bancorp’s credit qualityto identify potential problem credits and any loss exposure in a timelymanner.  Additionally, loans are subjectto examinations by regulators, who, based upon their judgment, may requireBancorp to make additional provisions or adjustments to its allowance for loanlosses.  Bancorp has assessed and willcontinue to assess on an on-going basis, the impact of the economy on thecredit risk in the loan portfolio. Currently, management is not aware of any unusually large loanconcentrations in industries negatively impacted by the current economy.

The following table presents the activity inthe allowance for loan losses for the dates indicated.

** **

**Allowance for Loan Loss Activity**

(dollars in thousands)
| ** **                                                                | ** ** | **Three months ended Sept. 30,** | ** **  | **Nine months ended Sept. 30,** | ** ** |
|---------------------------------------------------------------------------|------------|----------------------------------|-------------|---------------------------------|------------|
| ** **                                                                | ** ** | **2007**                         | ** **  | **2006**                        | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                                                      |       |                             |        |                            |       |   |   |   |   |
| Allowance as of beginning of period                                       |       | $                                |  4,866 |                            | $          |  4,820 |   | $ | 5,176 |   | $ |  5,178 |   |
| Provision (benefit) for loan losses                                       |       | —                           |        | —                          |       | (150 | ) | — |   |
| Charge-offs                                                               |       | (105                             | )           | (328                            | )          | (436 | ) | (1,251 | ) |
| Recoveries                                                                |       | 44                               |        | 220                             |       | 215 |   | 785 |   |
| Net charge-offs                                                           |       | (61                              | )           | (108                            | )          | (221 | ) | (466 | ) |
| Balance at end of period                                                  |       | $                                |  4,805 |                            | $          |  4,712 |   | $ |  4,805 |   | $ |  4,712 |   |
| Ratio of net charge-offs (annualized) to average loans during the  period |       | 0.07                             | %           | 0.14                            | %          | 0.09 | % | 0.21 | % |
| Ratio of allowance to net loans at end of period                          |       | 1.40                             | %           | 1.54                            | %          | 1.40 | % | 1.54 | % |
|                                                                           |            |                                  |             |                                 |            |  |  |  |  |  |  |  |  |  |

 

**NON-PERFORMING ASSETS     **Non-performingassets include non-accrual loans, loans 90 days or more delinquent and otherreal estate owned and at September 30, 2007 decreased to $4.7 million comparedto $5.7 million as of December 31, 2006. At September 30, 2007, other realestate owned was zero and non-accrual loans were $4.7 million with onerelationship comprising $3.5 million of the balance. Generally, these loans arewell collateralized though loss of principal on certain types of these loanswill remain in question until the loans are paid or collateral isliquidated.  It is Bancorp’s plan toaggressively continue its collection efforts and liquidation of collateral, ifnecessary, to recover as large a portion of the non-accrual assets as possible.Loans are generally placed on non-accrual status when they become 90 days ormore past due or at such earlier time as management determines 

 

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timely recognition of interest to be in doubt.  At September 30, 2007, impaired loans were$8.9 million and included in the allowance for loan losses was a $1.1 millionspecific allocation relating to two credit relationships.

The following table presents non-performingasset information related to loans accounted for on a non-accrual basis,accruing loans 90 days or more past due and other real estate owned for thedates indicated.

** **

**Non-Performing Assets**

(dollars in thousands)
|                                                     | ** ** | **September 30, 2007** | ** **  | **December 31, 2006** | ** ** |
|----------------------------------------------------------|------------|------------------------|-------------|-----------------------|------------|
| Non-accrual loans                                        |       | $                      |  4,650 |                  | $          |  5,734 |   |
| Loans past due 90 days or more, still accruing           |       | —                 |        | —                |       |
| Total non-performing loans                               |       | 4,650                  |        | 5,734                 |       |
| Other real estate owned                                  |       | —                 |        | —                |       |
| Total non-performing assets                              |       | $                      |  4,650 |                  | $          |  5,734 |   |
| Total non-performing loans to net loans                  |       | 1.35                   | %           | 1.79                  | %          |
| Total non-performing loans to total assets               |       | 0.81                   | %           | 1.08                  | %          |
| Total non-performing assets to total assets              |       | 0.81                   | %           | 1.08                  | %          |
| Total non-performing assets to allowance for loan losses |       | 96.77                  | %           | 110.78                | %          |

 

**DEPOSITS     **Bancorp offersa full range of deposit services including checking accounts, savings accounts,money market accounts and various types of certificates of deposit.  Transaction accounts and certificates ofdeposit are tailored to Bancorp’s primary market area at rates competitive withthose offered in the area.  At September30, 2007, total deposits were $485.9 million compared to $449.3 million atDecember 31, 2006.  Within the total,time deposits increased $42.8 million while core deposits decreased $6.2million. Time deposits increased to 38.5 percent of deposits at September 30,2007 compared to 32.1 percent of deposits at December 31, 2006.

The following table presents the balance andpercent of total deposits in the various categories of deposits offered byBancorp as of the dates indicated.

** **

**DepositComposition**
| ** **                  | ** ** | **September 30, 2007** | ** **    | **December 31, 2006** | ** ** |
|-----------------------------|------------|------------------------|---------------|-----------------------|------------|
| **(dollars in thousands)**  | ** ** | **Amount**             | ** **    | **% of Total**        | ** ** | **Amount** | ** ** | **% of Total** | ** ** |
| Non-interest bearing demand |       | $                      |  71,067  |                  | 14.6       | % | $ |  81,250 |   | 18.1 | % |
| Interest bearing demand     |       | 88,362                 |          | 18.2                  | %          | 83,602 |   | 18.6 | % |
| Money market                |       | 62,238                 |          | 12.8                  | %          | 59,855 |   | 13.3 | % |
| Savings                     |       | 77,245                 |          | 15.9                  | %          | 80,434 |   | 17.9 | % |
| Time                        |       | 187,012                |          | 38.5                  | %          | 144,202 |   | 32.1 | % |
| Total deposits              |       | $                      |  485,924 |                  | 100.0      | % | $ |  449,343 |   | 100.0 | % |

** **

**SECURITIES SOLD UNDER AGREEMENTSTO REPURCHASE     **As of September30, 2007 and December 31, 2006, securities sold under agreements to repurchasewere $16.7 million and $14.1 million, respectively. These borrowings decrease orincrease primarily based on the availability of funds and current competitiveinterest rates offered.  These borrowingsare collateralized by securities with an estimated fair value exceeding theface value of the borrowings.

 

**CAPITAL RESOURCES     **Stockholders’equity increased to $71.1 million at September 30, 2007 from $66.5 million atDecember 31, 2006.  This increase wasprimarily due to net income of $6.3 million which was partially offset by stockrepurchases of $510,000 and payment of cash dividends of $1.5 million. Bookvalue per share at September 30, 2007 was $106.03 compared to a book value of$98.80 at December 31, 2006.

 

Bancorp has only oneclass of stock, which is common stock. Bancorp’s stock is not actively traded or quoted and no broker currentlymakes a market in the stock. However, sales and transfers of the stock dooccur.  Skagit State Bank acts astransfer agent for Bancorp stock.  Tofacilitate trading, the Bank maintains a list of persons interested (known tothe Bank) in either purchasing or selling Bancorp stock.  Purchasers and sellers then negotiate theirown transactions with the Bank acting as transfer agent for those transactions.From time to time, Bancorp repurchases shares of its common stock. The number of shares of stock that will berepurchased and the price that will be paid is the result of many factorsincluding market and economic conditions, the number of shares available,Bancorp’s liquidity and capital needs and 

 

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regulatoryrequirements.  For the nine months endedSeptember 30, 2007, Bancorp repurchased 2,870 shares of stock for an averageprice of $178 per share.

 

Banking regulations require bank holdingcompanies and banks to maintain certain minimum capital levels.  As the following table indicates as ofSeptember 30, 2007 and December 31, 2006, Skagit State Bancorp, Inc. and SkagitState Bank both exceeded the well-capitalized requirements.
| ** **                                | ** ** | **Actual** | ** ** | **For Capital  Adequacy Purposes** | ** ** | **To Be Well  Capitalized Under  Prompt Corrective  Action Provisions** | ** ** |
|-------------------------------------------|------------|------------|------------|------------------------------------|------------|-------------------------------------------------------------------------|------------|
| **(dollars in thousands)**                | ** ** | **Amount** | ** ** | **Ratio**                          | ** ** | **Amount**                                                              | ** ** | ** ** | ** ** | **Minimu** | ** ** | **Amount** | ** ** | ** ** | ** ** | **Ratio** | ** ** |
| As of September 30, 2007                  |       |       |       |                               |       |                                                                    |       |   |   |   |   |   |   |   |   |   |   |
| Total Capital  (to Risk-Weighted Assets)  |       |       |       |                               |       |                                                                    |       |   |   |   |   |   |   |   |   |   |   |
| Skagit State Bank                         |       | $          | 75,758     |                               | 17.27      | %                                                                       | $          | 35,096 |   | >  |   | 8.00 | % | $ | 43,870 |   | >  |   | 10.00 | % |
| Skagit State Bancorp, Inc.                |       | $          | 76,014     |                               | 17.33      | %                                                                       | $          | 35,097 |   | >  |   | 8.00 | % | $ | 43,871 |   | >  |   | 10.00 | % |
| Tier I Capital  (to Risk-Weighted Assets) |       |       |       |                               |       |                                                                    |       |   |   |   |   |   |   |   |   |   |   |
| Skagit State Bank                         |       | $          | 70,953     |                               | 16.17      | %                                                                       | $          | 17,548 |   | >  |   | 4.00 | % | $ | 26,322 |   | >  |   | 6.00 | % |
| Skagit State Bancorp, Inc.                |       | $          | 71,209     |                               | 16.23      | %                                                                       | $          | 17,548 |   | >  |   | 4.00 | % | $ | 26,323 |   | >  |   | 6.00 | % |
| Tier I Capital  (to Average Assets)       |       |       |       |                               |       |                                                                    |       |   |   |   |   |   |   |   |   |   |   |
| Skagit State Bank                         |       | $          | 70,953     |                               | 12.56      | %                                                                       | $          | 22,594 |   | >  |   | 4.00 | % | $ | 28,243 |   | >  |   | 5.00 | % |
| Skagit State Bancorp, Inc.                |       | $          | 71,209     |                               | 12.61      | %                                                                       | $          | 22,594 |   | >  |   | 4.00 | % | $ | 28,243 |   | >  |   | 5.00 | % |
|                                      |       |       |       |                               |       |                                                                    |       |   |   |   |   |   |   |   |   |   |   |
| As of December 31, 2006                   |       |       |       |                               |       |                                                                    |       |   |   |   |   |   |   |   |   |   |   |
| Total Capital  (to Risk-Weighted Assets)  |       |       |       |                               |       |                                                                    |       |   |   |   |   |   |   |   |   |   |   |
| Skagit State Bank                         |       | $          | 71,548     |                               | 17.96      | %                                                                       | $          | 31,878 |   | >  |   | 8.00 | % | $ | 39,847 |   | >  |   | 10.00 | % |
| Skagit State Bancorp, Inc.                |       | $          | 71,796     |                               | 18.02      | %                                                                       | $          | 31,878 |   | >  |   | 8.00 | % | $ | 39,847 |   | >  |   | 10.00 | % |
| Tier I Capital  (to Risk-Weighted Assets) |       |       |       |                               |       |                                                                    |       |   |   |   |   |   |   |   |   |   |   |
| Skagit State Bank                         |       | $          | 66,565     |                               | 16.71      | %                                                                       | $          | 15,939 |   | >  |   | 4.00 | % | $ | 23,908 |   | >  |   | 6.00 | % |
| Skagit State Bancorp, Inc.                |       | $          | 66,813     |                               | 16.77      | %                                                                       | $          | 15,939 |   | >  |   | 4.00 | % | $ | 23,908 |   | >  |   | 6.00 | % |
| Tier I Capital  (to Average Assets)       |       |       |       |                               |       |                                                                    |       |   |   |   |   |   |   |   |   |   |   |
| Skagit State Bank                         |       | $          | 65,565     |                               | 12.66      | %                                                                       | $          | 21,031 |   | >  |   | 4.00 | % | $ | 26,289 |   | >  |   | 5.00 | % |
| Skagit State Bancorp, Inc.                |       | $          | 66,813     |                               | 12.71      | %                                                                       | $          | 21,031 |   | >  |   | 4.00 | % | $ | 26,289 |   | >  |   | 5.00 | % |
|                                           |            |            |            |                                    |            |                                                                         |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**LIQUIDITY**

Liquiditymanagement focuses on the need to meet both short-term funding requirements andlong-term strategies and goals.  Theobjective of liquidity management is to ensure Bancorp has adequate liquidityto accommodate fluctuations in deposit levels, fund operations, and provide forcustomer credit needs and to meet other obligations and commitments on a timelybasis. Bancorp’s long term growth objectives are to attract and retain businesscustomer and consumer relationships with a focus on transaction accounts andcommercial and consumer lending.  Bancorpstructures the balance sheet to meet those objectives. The majority of Bancorp’sfunding comes from customer deposits within its market area.

Bancorp has generally been a net seller offederal funds.  At September 30, 2007 andDecember 31, 2006, Bancorp’s federal funds sold were $43.6 million and $25.7million, respectively. Other sources of potential liquidity include loanrepayments, investment securities repayments and borrowing through pre-approvedcredit lines. Liquidity is also obtained by maintaining assets that are readilyconvertible to cash through maturities and sales.  As of September 30, 2007, Bancorp had $35.0million in approved credit lines from various financial institutions.

 

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Theanalysis of liquidity also includes a review of the statement of cashflows.  The cash flows detail the Bancorp’soperating, investing and financing activities. Cash flows from operationscontribute to liquidity as well as proceeds from the maturities of securities,loan repayments and increasing customer deposits. As indicated in the statementof cash flows, net cash from operating activities contributed $5.5 million toliquidity for the nine months ended September 30, 2007 and $4.2 million for thenine months ended September 30, 2006.

SkagitState Bancorp, Inc. is a separate legal entity from the Bank and must providefor its own liquidity.  Substantially allof Bancorp’s revenues are obtained from dividends declared and paid by theBank. 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**

Theresults of operations for financial institutions are largely dependent upon thefinancial institution’s ability to manage market risks which includes interestrate risk.  Interest rate risk refers tothe exposure of earnings and capital arising from changes in interest rates.

Bancorpmaintains an asset/liability management program which is the responsibility ofthe Asset/Liability Committee.  Theobjective of asset/liability management is to maximize long-term stockholderreturns and to manage, protect and stabilize Bancorp’s net interest income fromundue interest rate risk through various interest rate cycles within theconstraints of credit quality, interest rate risk policies, levels of capitaland adequate levels of liquidity.  Thecommittee meets to monitor the composition of the balance, to review projectedearnings trends, and to formulate strategies consistent with these objectivesfor liquidity, interest rate risk, and capital adequacy.

Bancorp believes that there have not been anymaterial changes about Bancorp’s market risk from the information that wasprovided in the Form 10-K for the year ended December 31, 2006.

** **

# **Item4.**     CONTROLS AND PROCEDURES

Evaluationof Disclosure Controls and Procedures

Bancorp’s ChiefExecutive Officer 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 this quarterlyreport.  Based on that evaluation, theChief Executive Officer and Chief Financial Officer have concluded that Bancorp’scurrent disclosure controls and procedures are effective and timely, providingthem with material information relating to Bancorp required to be disclosed inthe reports we file or submit under the Exchange Act.

 

Changesin Internal Controls

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

** **

**PART II -      OTHER INFORMATION**

 

**Item 1.     LegalProceedings**

From time to time, Bancorp may be a plaintiffand/or defendant in certain claims and legal actions arising in the ordinarycourse of commercial banking involving real estate lending transactions andother ordinary routine litigation incidental to the business of Bancorp.  Bancorp is not a party to any pending legalproceedings that Bancorp believes would have a material adverse effect on thefinancial condition of Bancorp.

 

**Item 1A.     RiskFactors**

There have been no material changes inBancorp’s risk factors from those disclosed in the 2006 Annual Report on Form10-K.  For information regarding riskfactors, refer to Bancorp’s 2006 Annual Report on Form 10-K.

 

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** **

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

For the quarter and nine monthsended September 30, 2007, Bancorp repurchased 782 and 2,870 shares of stock foran average price of $181 and $178 per share, respectively.

  
| ** **             | ** ** | **Total Number of Shares** | ** ** | **Average Price Paid per** | ** ** |
|------------------------|------------|----------------------------|------------|----------------------------|------------|
| **Period**             | ** ** | **Purchase**               | ** ** | **Share**                  | ** ** |
| July 1 - 31, 2007      |       | —                     |       | —                     |       |
|                   |       |                       |       |                       |       |
| August 1 - 31, 2007    |       | 712                        |       | $                          | 181.00     |   |
|                   |       |                       |       |                       |       |
| September 1 - 30, 2007 |       | 70                         |       | $                          | 181.00     |   |

 

Bancorp has not adopted anofficial repurchase plan or adapted a maximum shares that may be repurchased,however all stock repurchases are approved by the Board of Directors.

**Item 3.     DefaultsUpon Senior Securities**

**            **None

** **

# **Item4.**     Submission of Matters to a Vote ofSecurity Holders

             None

** **

**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 the requirements of the Securities ExchangeAct of 1934, the registrant has duly caused this report to be signed on itsbehalf by the undersigned thereunto duly authorized.

 

 
|   |              | SKAGIT STATE BANCORP, INC. |
|--------|-------------------|----------------------------|
|   |              | (Registrant)               |
|   |              |                       |
|   |              |                       |
|   |              |                       |
| Dated: | November 13, 2007 |                       | /s/Cheryl R. Bishop |
|   |              | Cheryl R. Bishop           |
|   |              | Chief Executive Officer    |
|   |              |                       |
|   |              |                       |
| Dated: | November 13, 2007 |                       | /s/Carla F. Tucker |
|   |              | Carla F. Tucker            |
|   |              | Senior Vice-President      |
|   |              | Chief Financial Officer    |

 

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