Table of Contents

 

 

 

**UNITED STATES SECURITIES ANDEXCHANGE COMMISSION**

**Washington D.C., 20549**

 

**FORM 10-Q**

 

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

 

**For thequarterly period ended September 30, 2010**

 

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

 

**For thetransition period from                            to                            **

 

**CommissionFile Number  000-52096**

 

**SKAGIT STATE BANCORP, INC.**

(Exact Name of Registrant asSpecified in Its Charter)

 

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

 

**301 East Fairhaven Avenue**

**Burlington, Washington  98233**

(Address of PrincipalExecutive Offices) (Zip Code)

 

**(360) 755-0411**

(Registrant’s TelephoneNumber, Including Area Code)

 

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

 

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

 

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

 

| Large accelerated filer o |   | Accelerated filer o         |
|---------------------------|--------|-----------------------------|
|                      |   |                        |
| Non-accelerated filer o   |   | Smaller Reporting Company x |

 

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

 

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

 

The number of shares of the issuer’s Common Stock outstanding at November 4,2010 was 588,346.

 

 

 

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**SKAGIT STATE BANCORP, INC.AND SUBSIDIARY**

**TABLE OF CONTENTS**

 
| **PART I.**  | **FINANCIAL  INFORMATION** |                                                                                                                                                 |   |
|-------------------|----------------------------|------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|              |                       |                                                                                                                                                 |   |
|              | Item 1.                    | Financial Statements                                                                                                                                 |   |   |
|              |                       |                                                                                                                                                 |   |   |
|              |                       | Consolidated Balance Sheet as of September 30,  2010 and December 31, 2009                                                                 |   | Page 3 |
|              |                       |                                                                                                                                                 |   |   |
|              |                       | Consolidated  Statement of Income for the three and nine months ended September 30,  2010 and 2009                                              |   | Page 4 |
|              |                       |                                                                                                                                                 |   |   |
|              |                       | Consolidated  Statement of Changes in Stockholders’ Equity and Comprehensive Income for the  nine months ended September 30, 2010 and 2009 |   | Page 5 |
|              |                       |                                                                                                                                                 |   |   |
|              |                       | Consolidated Statement of Cash Flows for the nine  months ended September 30, 2010 and 2009                                                     |   | Page 6 |
|              |                       |                                                                                                                                                 |   |   |
|              |                       | Notes to Consolidated Financial Statements                                                                                                           |   | Pages 7-15 |
|              |                       |                                                                                                                                                 |   |   |
|              | Item 2.                    | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                                          |   | Pages 15-26 |
|              |                       |                                                                                                                                                 |   |   |
|              | Item 3.                    | Quantitative  and Qualitative Disclosures About Market Risk                                                                                          |   | Page 27 |
|              |                       |                                                                                                                                                 |   |   |
|              | Item 4.                    | Controls and  Procedures                                                                                                                             |   | Page 27 |
|              |                       |                                                                                                                                                 |   |   |
| **PART II.** | **OTHER INFORMATION**      |                                                                                                                                                 |   |
|              |                       |                                                                                                                                                 |   |   |
|              | Item 1.                    | Legal Proceedings                                                                                                                                    |   | Page 27 |
|              |                       |                                                                                                                                                 |   |   |
|              | Item 1 A.                  | Risk Factors                                                                                                                                         |   | Page 27-30 |
|              |                       |                                                                                                                                                 |   |   |
|              | Item 2.                    | Unregistered  Sales of Equity Securities and Use of Proceeds                                                                                         |   | Page 30 |
|              |                       |                                                                                                                                                 |   |   |
|              | Item 3.                    | Defaults Upon  Senior Securities                                                                                                                     |   | Page 31 |
|              |                       |                                                                                                                                                 |   |   |
|              | Item 4.                    | Removed and Reserved                                                                                                                                 |   | Page 31 |
|              |                       |                                                                                                                                                 |   |   |
|              | Item 5.                    | Other Information                                                                                                                                    |   | Page 31 |
|              |                       |                                                                                                                                                 |   |   |
|              | Item 6.                    | Exhibits                                                                                                                                             |   | Page 31 |
|              |                       |                                                                                                                                                 |   |   |
|              |                       | Signatures                                                                                                                                           |   | Page 32 |

 

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**Item 1.   Financial Statements**

 

**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

**CONSOLIDATEDBALANCE SHEET (Unaudited)**

 
| **(dollars in thousands except share data)**                                                                                                 | ** ** | **September 30, 2010** | ** ** | **December 31, 2009** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| **ASSETS**                                                                                                                                                            | ** ** | ** **                       | ** ** | ** **                      | ** ** |
| ** **                                                                                                                                                            | ** ** | ** **                       | ** ** | ** **                      | ** ** |
| **ASSETS**                                                                                                                                                            | ** ** | ** **                       | ** ** | ** **                      | ** ** |
| Cash and due from banks                                                                                                                                               |       | $                                | 11,163     |                            | $          | 14,441 |   |
| Federal funds sold                                                                                                                                                    |       | 77,104                           |       | 62,531                          |       |
| Investment securities                                                                                                                                                 |       |                             |       |                            |       |
| Available-for-sale, at fair value                                                                                                                                     |       | 149,914                          |       | 118,561                         |       |
| Held-to-maturity, at amortized cost                                                                                                                                   |       | 39,813                           |       | 40,298                          |       |
| Loans held for sale                                                                                                                                                   |       | 817                              |       | 574                             |       |
| Loans                                                                                                                                                                 |       | 384,292                          |       | 393,532                         |       |
| Allowance for loan losses                                                                                                                                             |       | (7,498                           | )          | (6,883                          | )          |
| Net loans                                                                                                                                                             |       | 376,794                          |       | 386,649                         |       |
| Bank premises and equipment, net                                                                                                                                      |       | 11,110                           |       | 10,944                          |       |
| Other real estate owned                                                                                                                                               |       | 5,688                            |       | 6,284                           |       |
| Accrued interest receivable                                                                                                                                           |       | 2,561                            |       | 2,531                           |       |
| Other assets                                                                                                                                                          |       | 5,078                            |       | 5,075                           |       |
| **TOTAL ASSETS**                                                                                                                                                      |       | $                                | 680,042    |                            | $          | 647,888 |   |
| ** **                                                                                                                                                            | ** ** | ** **                       | ** ** | ** **                      | ** ** |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                        | ** ** | ** **                       | ** ** | ** **                      | ** ** |
| ** **                                                                                                                                                            | ** ** | ** **                       | ** ** | ** **                      | ** ** |
| **LIABILITIES**                                                                                                                                                       |       |                             |       |                            |       |
| Deposits                                                                                                                                                              |       |                             |       |                            |       |
| Interest-bearing                                                                                                                                                      |       | $                                | 501,891    |                            | $          | 471,597 |   |
| Non-interest-bearing                                                                                                                                                  |       | 74,445                           |       | 73,839                          |       |
| Total deposits                                                                                                                                                        |       | 576,336                          |       | 545,436                         |       |
| Other borrowings                                                                                                                                                      |       | 34,320                           |       | 38,128                          |       |
| Other liabilities                                                                                                                                                     |       | 1,872                            |       | 1,467                           |       |
| Total liabilities                                                                                                                                                     |       | 612,528                          |       | 585,031                         |       |
|                                                                                                                                                                  |       |                             |       |                            |       |
| **STOCKHOLDERS’ EQUITY**                                                                                                                                         |       |                             |       |                            |       |
| Common stock no par value, 5,000,000 shares  authorized, 587,194 and 586,905 shares issued and outstanding at Sept. 30,  2010 and December 31, 2009 respectively |       | 12,509                           |       | 12,303                          |       |
| Accumulated other comprehensive income, net of tax                                                                                                                    |       | 3,430                            |       | 1,872                           |       |
| Retained earnings                                                                                                                                                     |       | 51,575                           |       | 48,682                          |       |
| Total stockholders’ equity                                                                                                                                       |       | 67,514                           |       | 62,857                          |       |
| **TOTAL LIABILITIES AND  STOCKHOLDERS’ EQUITY**                                                                                                                  |       | $                                | 680,042    |                            | $          | 647,888 |   |

 

*Seeaccompanying notes to these consolidated financial statements*

 

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**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

**CONSOLIDATED STATEMENT OF INCOME (Unaudited)**

* *
| ** **                                                                     | ** ** | **Three months ended Sept. 30,** | ** ** | **Nine months ended Sept. 30,** | ** ** |
|--------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| **(dollars in thousands except per share data)** | ** ** | **2010**                                             | ** ** | **2009**                                            | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                                                                     |       |                                                 |       |                                                |       |   |   |   |   |
| **INTEREST INCOME**                                                            |       |                                                 |       |                                                |       |   |   |   |   |
| Interest and fees on loans                                                     |       | $                                                    | 5,587      |                                                | $          | 5,791 |   | $ | 16,993 |   | $ | 17,458 |   |
| Investment securities                                                          |       |                                                 |       |                                                |       |   |   |   |   |
| Taxable                                                                        |       | 1,024                                                |       | 1,051                                               |       | 3,106 |   | 3,165 |   |
| Exempt from federal income tax                                                 |       | 276                                                  |       | 282                                                 |       | 826 |   | 844 |   |
| Federal funds sold                                                             |       | 56                                                   |       | 22                                                  |       | 161 |   | 34 |   |
| Total interest income                                                          |       | 6,943                                                |       | 7,146                                               |       | 21,086 |   | 21,501 |   |
| **INTEREST EXPENSE**                                                           |       |                                                 |       |                                                |       |   |   |   |   |
| Deposits                                                                       |       | 1,377                                                |       | 1,736                                               |       | 4,353 |   | 5,213 |   |
| Other borrowings                                                               |       | 85                                                   |       | 70                                                  |       | 254 |   | 223 |   |
| Total interest expense                                                         |       | 1,462                                                |       | 1,806                                               |       | 4,607 |   | 5,436 |   |
| **NET INTEREST INCOME**                                                        |       | 5,481                                                |       | 5,340                                               |       | 16,479 |   | 16,065 |   |
| Provision for loan losses                                                      |       | 390                                                  |       | 1,320                                               |       | 1,310 |   | 2,220 |   |
| **NET INTEREST INCOME AFTER PROVISION  FOR LOAN LOSSES**                       |       | 5,091                                                |       | 4,020                                               |       | 15,169 |   | 13,845 |   |
| **NON-INTEREST INCOME**                                                        |       |                                                 |       |                                                |       |   |   |   |   |
| Service charges on deposits                                                    |       | 798                                                  |       | 770                                                 |       | 2,343 |   | 2,259 |   |
| Other                                                                          |       | 193                                                  |       | 184                                                 |       | 570 |   | 563 |   |
| Gains on sale of assets and loans                                              |       | 73                                                   |       | 74                                                  |       | 169 |   | 193 |   |
| Total non-interest income                                                      |       | 1,064                                                |       | 1,028                                               |       | 3,082 |   | 3,015 |   |
| **NON-INTEREST EXPENSES**                                                      |       |                                                 |       |                                                |       |   |   |   |   |
| Salaries                                                                       |       | 1,899                                                |       | 1,897                                               |       | 5,734 |   | 5,769 |   |
| Payroll taxes and employee benefits                                            |       | 465                                                  |       | 447                                                 |       | 1,444 |   | 1,426 |   |
| Provision for other real estate owned losses                                   |       | 170                                                  |       | 541                                                 |       | 435 |   | 914 |   |
| Bank premises and equipment                                                    |       | 249                                                  |       | 234                                                 |       | 707 |   | 718 |   |
| Occupancy                                                                      |       | 184                                                  |       | 179                                                 |       | 567 |   | 592 |   |
| Loan collection and OREO expenses                                              |       | 81                                                   |       | 72                                                  |       | 361 |   | 364 |   |
| Advertising                                                                    |       | 173                                                  |       | 163                                                 |       | 531 |   | 536 |   |
| Deposit Insurance                                                              |       | 235                                                  |       | 223                                                 |       | 728 |   | 985 |   |
| Other                                                                          |       | 1,013                                                |       | 961                                                 |       | 3,018 |   | 2,889 |   |
| Total non-interest expenses                                                    |       | 4,469                                                |       | 4,717                                               |       | 13,525 |   | 14,193 |   |
| **INCOME BEFORE PROVISION FOR  INCOME TAX**                                    |       | 1,686                                                |       | 331                                                 |       | 4,726 |   | 2,667 |   |
| **PROVISION FOR INCOME TAX**                                                   |       |                                                 |       |                                                |       |   |   |   |   |
| Current                                                                        |       | 305                                                  |       | 30                                                  |       | 750 |   | 280 |   |
| Deferred                                                                       |       | —                                               |       | —                                              |       | 53 |   | — |   |
| Total provision for income tax                                                 |       | 305                                                  |       | 30                                                  |       | 803 |   | 280 |   |
| **NET INCOME**                                                                 |       | $                                                    | 1,381      |                                                | $          | 301 |   | $ | 3,923 |   | $ | 2,387 |   |
| **BASIC EARNINGS PER SHARE**                                                   |       | $                                                    | 2.35       |                                                | $          | 0.51 |   | $ | 6.68 |   | $ | 4.07 |   |
| **DILUTED EARNINGS PER SHARE**                                                 |       | $                                                    | 2.35       |                                                | $          | 0.51 |   | $ | 6.67 |   | $ | 4.04 |   |
| **DIVIDENDS DECLARED PER SHARE**                                               |       | —                                               |       | —                                              |       | $ | 1.75 |   | $ | 2.25 |   |

 

*Seeaccompanying notes to these consolidated financial statements*

 

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**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

**CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY ANDCOMPREHENSIVE INCOME (Unaudited)**

* *

Nine months ended September 30, 2010 and 2009

 
| ** **                                                                                            | ** ** | ** **            | ** ** | **Accum. Other** | ** ** | ** **   | ** ** | **Total**              | ** ** | ** **        | ** ** |
|-------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|-----------------------|------------|--------------|------------|------------------------|------------|-------------------|------------|
| ** **                                                                                            | ** ** | **Common Stock** | ** ** | **Comprehensive**     | ** ** | **Retained** | ** ** | **Stockholders’** | ** ** | **Comprehensive** | ** ** |
| **(dollars in thousands except share and per share amounts)** | ** ** | **Shares**            | ** ** | **Amount**            | ** ** | **Income**   | ** ** | **Earnings**           | ** ** | **Equity**        | ** ** | **Income** | ** ** |
| **BALANCE,**January 1, 2009                                                                           |       | 586,285               |       | $                     | 12,042     |         | $          | 2,325                  |       | $                 | 47,434     |   | $ | 61,801 |   |   |   |
| Comprehensive income:                                                                                 |       |                  |       |                  |       |         |       |                   |       |              |       |   |   |
| Net income                                                                                            |       | —                |       | —                |       | —       |       | 2,387                  |       | 2,387             |       | $ | 2,387 |   |
| Other comprehensive income:                                                                           |       |                  |       |                  |       |         |       |                   |       |              |       |   |   |
| Unrealized loss on available-for-sale securities,  net of tax benefit of $170                         |       | —                |       | —                |       | 330          |       | —                 |       | 330               |       | 330 |   |
| Total other comprehensive income                                                                      |       |                  |       |                  |       |         |       |                   |       |              |       | 330 |   |
| Comprehensive income                                                                                  |       |                  |       |                  |       |         |       |                   |       |              |       | $ | 2,717 |   |
| Cash dividend declared, $2.25 per share                                                               |       | —                |       | —                |       | —       |       | (1,324                 | )          | (1,324            | )          |   |   |
| Stock options exercised                                                                               |       | 25                    |       | 4                     |       | —       |       | —                 |       | 4                 |       |   |   |
| Stock compensation expense and restricted stock  awards                                               |       | 385                   |       | 192                   |       | —       |       | —                 |       | 192               |       |   |   |
| **BALANCE,**September 30,  2009                                                                       |       | 586,695               |       | $                     | 12,238     |         | $          | 2,655                  |       | $                 | 48,497     |   | $ | 63,390 |   |   |   |
|                                                                                                  |       |                  |       |                  |       |         |       |                   |       |              |       |   |   |
|                                                                                                  |       |                  |       |                  |       |         |       |                   |       |              |       |   |   |
| **BALANCE,**January 1,  2010                                                                          |       | 586,905               |       | $                     | 12,303     |         | $          | 1,872                  |       | $                 | 48,682     |   | $ | 62,857 |   |   |   |
| Comprehensive income:                                                                                 |       |                  |       |                  |       |         |       |                   |       |              |       |   |   |
| Net income                                                                                            |       | —                |       | —                |       | —       |       | 3,923                  |       | 3,923             |       | $ | 3,923 |   |
| Other comprehensive income:                                                                           |       |                  |       |                  |       |         |       |                   |       |              |       |   |   |
| Unrealized gains on available-for-sale securities,  net of tax expense of $802                        |       | —                |       | —                |       | 1,558        |       | —                 |       | 1,558             |       | 1,558 |   |
| Total other comprehensive income                                                                      |       |                  |       |                  |       |         |       |                   |       |              |       | 1,558 |   |
| Comprehensive income                                                                                  |       |                  |       |                  |       |         |       |                   |       |              |       | $ | 5,481 |   |
| Cash dividend declared, $1.75 per share                                                               |       | —                |       | —                |       | —       |       | (1,030                 | )          | (1,030            | )          |   |   |
| Stock compensation expense and restricted stock  awards                                               |       | 289                   |       | 206                   |       | —       |       | —                 |       | 206               |       |   |   |
| **BALANCE,**September 30,  2010                                                                       |       | 587,194               |       | $                     | 12,509     |         | $          | 3,430                  |       | $                 | 51,575     |   | $ | 67,514 |   |   |   |

 

*Seeaccompanying notes to these consolidated financial statements.*

 

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**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

**CONSOLIDATED STATEMENT OF CASH FLOWS (Unaudited**)

 
| **(dollars in thousands)**                                                                        | ** ** | ** ** | ** ** | ** ** | ** ** |
|-------------------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| **Nine months ended September 30,**                                                     | ** ** | **2010**   | ** ** | **2009**   | ** ** |
| **CASH FLOWS FROM OPERATING  ACTIVITIES**                                                                   |       |       |       |       |       |
| Net income                                                                                                  |       | $          | 3,923      |       | $          | 2,387 |   |
| *Adjustments to reconcile net  income to net cash flows from operating activities*                          |       |       |       |       |       |
| Provision for loan losses                                                                                   |       | 1,310      |       | 2,220      |       |
| Provision for other real estate owned losses                                                                |       | 435        |       | 914        |       |
| Depreciation                                                                                                |       | 620        |       | 632        |       |
| Loss on sale of premises and equipment                                                                      |       | —     |       | 8          |       |
| Gains on sale of other real estate owned                                                                    |       | (11        | )          | —     |       |
| Gains on loans held for sale                                                                                |       | (158       | )          | (193       | )          |
| Amortization of investment security premiums and  discounts, net                                            |       | (26        | )          | (139       | )          |
| Provision for deferred income taxes                                                                         |       | 53         |       | —     |       |
| Stock compensation for employee services                                                                    |       | 206        |       | 192        |       |
| *Changes in operating assets and  liabilities*                                                              |       |       |       |       |       |
| Originations of loans held for sale                                                                         |       | (10,728    | )          | (14,133    | )          |
| Proceeds from sales of loans held for sale                                                                  |       | 10,643     |       | 14,263     |       |
| Decrease in interest receivable                                                                             |       | (30        | )          | (176       | )          |
| Increase (decrease) in other assets                                                                         |       | (858       | )          | 532        |       |
| (Decrease) increase in other liabilities                                                                    |       | 405        |       | (854       | )          |
| Net cash flows from operating activities                                                                    |       | 5,784      |       | 5,653      |       |
| **CASH FLOWS FROM INVESTING  ACTIVITIES**                                                                   |       |       |       |       |       |
| Proceeds from maturities, calls, and principal  payments of investment securities — available-for-sale |       | 39,430     |       | 21,087     |       |
| Purchases of investment securities —  available-for-sale                                               |       | (68,403    | )          | (26,946    | )          |
| Proceeds from maturities, calls, and principal payments  of investment securities — held-to-maturity   |       | 3,434      |       | 5,584      |       |
| Purchases of investment securities —  held-to-maturity                                                 |       | (2,943     | )          | (9,077     | )          |
| Net increase in federal funds sold                                                                          |       | (14,573    | )          | (41,108    | )          |
| Net decrease in loans                                                                                       |       | 7,126      |       | 13,643     |       |
| Purchase of premises and equipment                                                                          |       | (447       | )          | (131       | )          |
| Capitalized expenditures for improvements to other  real estate owned                                       |       | —     |       | (136       | )          |
| Proceeds from sale of other real estate owned                                                               |       | 1,252      |       | —     |       |
| Net cash flows from investing activities                                                                    |       | (35,124    | )          | (37,084    | )          |
| **CASH FLOWS FROM FINANCING  ACTIVITIES**                                                                   |       |       |       |       |       |
| Net increase in demand deposits, money market, NOW  and savings accounts                                    |       | 20,668     |       | 18,333     |       |
| Net increase in time deposits                                                                               |       | 10,232     |       | 30,350     |       |
| Net decrease in other borrowings                                                                            |       | (3,808     | )          | (16,839    | )          |
| Proceeds from exercise of stock options                                                                     |       | —     |       | 4          |       |
| Cash dividends                                                                                              |       | (1,030     | )          | (1,324     | )          |
| Net cash flows from financing activities                                                                    |       | 26,062     |       | 30,524     |       |
| **NET CHANGE IN CASH AND DUE FROM  BANKS**                                                                  |       | (3,278     | )          | (907       | )          |
| **CASH AND DUE FROM BANKS,**beginning of  period                                                            |       | 14,441     |       | 11,954     |       |
| **CASH AND DUE FROM BANKS,** end of  period                                                                 |       | $          | 11,163     |       | $          | 11,047 |   |
| **SUPPLEMENTAL DISCLOSURES OF CASH  FLOW INFORMATION**                                                      |       |       |       |       |       |
| Cash paid during the period for income taxes                                                                |       | $          | 1,530      |       | $          | 266 |   |
| Cash paid during the period for interest                                                                    |       | $          | 4,718      |       | $          | 5,364 |   |
| **NONCASH FINANCING AND INVESTING  TRANSACTIONS**                                                           |       |       |       |       |       |
| Property taken in settlement of loans                                                                       |       | $          | 1,419      |       | $          | 1,309 |   |

 

*Seeaccompanying notes to these consolidated financial statements*

 

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**SKAGIT STATE BANCORP, INC. AND SUBSIDIARY**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

 

**Note 1:   BASIS OF PRESENTATION**

 

Theaccompanying consolidated financial statements include the accounts of SkagitState Bancorp, Inc. and its subsidiary Skagit State Bank, (collectively, “Company”or “Bancorp”). All significant inter-company accounts and transactions havebeen eliminated. The consolidated financial statements have been prepared inconformity with accounting principles generally accepted in the United Statesof America for interim financial information and with instructions to Form 10-Q.Accordingly they do not include all of the information and footnotes requiredby accounting principles generally accepted in the United States of America forcomplete financial statements. In the opinion of management, all adjustments(consisting of normal recurring accruals) considered necessary for a fairpresentation have been included. Operating results for the nine months ended September 30,2010 are not necessarily indicative of the results anticipated for the yearending December 31, 2010. For additional information, refer to the auditedfinancial statements and footnotes for the most recent annual period ended  December 31, 2009 contained in theAnnual Report on Form 10-K.  Alldollar amounts in tables, except share and per share information, are stated inthousands.

 

**Note 2:   CRITICALACCOUNTING POLICIES AND ESTIMATES**

 

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

 

**Note 3:   RECLASSIFICATIONS**

 

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

 

**Note 4:   NEW ACCOUNTING PRONOUNCEMENTS**

 

InJanuary 2010, the FASB issued ASU 2010-06, an update to ASU 820-10, “FairValue Measurements”. This update adds a new requirement to disclose transfersin and out of level 1 and level 2, along with the reasons for the transfers,and requires a gross presentation of purchases and sales of level 3 activities.Additionally, the update clarifies that entities provide fair value measurementdisclosures for each class of assets and liabilities and that entities provideenhanced disclosures around level 2 valuation techniques and inputs. Bancorpadopted the disclosure requirements for level 1 and level 2 transfers and theexpanded fair value measurement and valuation disclosures effective January 1,2010. The disclosure requirements for level 3 activities are effective forBancorp for interim and annual periods beginning after December 15, 2010.The adoption of the disclosure requirements for level 1 and level 2 transfersand the expanded qualitative disclosures had no impact on Bancorp’s financialposition, results of operations, and earnings per share. Bancorp does notexpect the adoption of the level 3 disclosure requirements to have an impact onits financial position, results of operations, and earnings per share.

 

OnJuly 21, 2010, the FASB issued ASU 2010-20 which amends ASU 310 andexpands required disclosures for the Financing Receivables and the Allowancefor Loan and Lease Losses.  The objectiveof these enhanced disclosures is to improve financial statements users’understanding of (i) the nature of a company’s credit risk associated withfinancing receivables and (ii) the company’s assessment of risk inestimating its allowance for loan and lease losses as well as changes in theallowance and the reasons for those changes. For public companies, thisguidance is effective for interim and annual periods beginning on or after December 15,2010.  Bancorp does not anticipate theadoption of this guidance will have a material impact on its consolidatedfinancial statements.

 

**Note 5:   EARNINGS PER SHARE**

 

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

 

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**SKAGIT STATE BANCORP, INC. AND SUBSIDIARY**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

(dollars in thousands except share and per share amounts)

 
| ** **                                                                       | ** ** | **Three months ended Sept. 30,** | ** ** | **Nine months ended Sept. 30,** | ** ** |
|----------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                       | ** ** | **2010**                                             | ** ** | **2009**                                            | ** ** | **2010** | ** ** | **2009** | ** ** |
| Numerator:                                                                       |       |                                                 |       |                                                |       |   |   |   |   |
| Net income                                                                       |       | $                                                    | 1,381      |                                                | $          | 301 |   | $ | 3,923 |   | $ | 2,387 |   |
| Denominator:                                                                     |       |                                                 |       |                                                |       |   |   |   |   |
| Denominator for basic earnings per share - Weighted  average shares outstanding  |       | 587,194                                              |       | 586,658                                             |       | 587,144 |   | 586,566 |   |
| Effect of dilutive securities:                                                   |       |                                                 |       |                                                |       |   |   |   |   |
| Stock options and unvested restricted stock grants                               |       | 1,175                                                |       | 3,141                                               |       | 1,319 |   | 4,168 |   |
| Denominator for diluted earning per share - Weighted  average shares outstanding |       | 588,369                                              |       | 589,799                                             |       | 588,463 |   | 590,734 |   |
| Basic earnings per share                                                         |       | $                                                    | 2.35       |                                                | $          | 0.51 |   | $ | 6.68 |   | $ | 4.07 |   |
| Diluted earnings per share                                                       |       | $                                                    | 2.35       |                                                | $          | 0.51 |   | $ | 6.67 |   | $ | 4.04 |   |

 

**Note 6:   STOCK-BASED COMPENSATION**

 

Bancorphas one share-based payment plan, which is shareholder approved, and permitsthe grant of share-based awards to its employees and directors up to 100,000shares and at September 30, 2010 there were 69,608 common shares availablefor grant. Total equity compensation expense was $206,000 for the nine monthsended September 30, 2010 and $192,000 for the like period in 2009.

 

**StockOptions**: No grants of options were awarded for the nine months ended September 30,2010.  All options granted during 2009were Incentive Stock Options and were granted at a price equal to the marketvalue of the stock on the grant date, have a term of 10 years and vest over afive year period.  Bancorp measures thefair value of each stock option at the date of the grant, using the BlackScholes option valuation model.  Theapplication of this valuation model involves assumptions that are judgmentaland sensitive in the determination of compensation expense.  The unrecognized share-based compensationcost relating to stock option expense at September 30, 2010 was $373,000,which will be recognized over the remaining vesting schedule through 2014.

 

Thefollowing table summarizes the activity related to options outstanding duringthe nine months ended September 30, 2010. The aggregate intrinsic valuerepresents the total pretax intrinsic value (amount by which the fair value ofthe underlying stock exceeds the exercise price of an option or award, timesthe number of shares):

 

(dollars in thousands except share and per share amounts)

 
| ** **                             | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise/Grant  Price** | ** ** | **Weighted  Average  Remaining  Contractual Terms  (in years)** | ** ** | **Aggregate  Intrinsic Value** | ** ** |
|----------------------------------------|------------|------------|------------|----------------------------------------------|------------|----------------------------------------------------------------------|------------|-------------------------------------|------------|
| Outstanding at January 1, 2010    |       | 28,761     |       | $                                            | 179.40     |                                                                 | 7.58       |                                | $          | — |   |
| Granted                                |       | —     |       |                                         |       |                                                                 |       |                                |       |
| Exercised                              |       | —     |       |                                         |       |                                                                 |       |                                |       |
| Forfeited                              |       | 775        |       | 161.00                                       |       |                                                                 |       |                                |       |
| Outstanding at September 30, 2010 |       | 27,986     |       | $                                            | 179.91     |                                                                 | 6.85       |                                | $          | — |   |
| Exercisable at September 30, 2010 |       | 11,578     |       | $                                            | 173.70     |                                                                 | 6.25       |                                | $          | — |   |

 

**StockAwards**: Recipients of restricted stock awards do not pay any cashconsideration to Bancorp for the shares and receive all dividends with respectto all such shares, whether or not shares have vested.  The awards vest over a five year period.  Bancorp measures the fair value of each stockaward at the date of the grant and recognizes compensation expense based on themarket price of Bancorp’s common stock on the date of grant.

 

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**SKAGIT STATE BANCORP, INC. AND SUBSIDIARY**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

Theunrecognized share-based compensation cost relating to restricted stock awardsexpense at September 30, 2010 was $147,000, which will be recognized overthe remaining years of the original five year vesting period of theawards.  There were no awards granted forthe nine months ended September 30, 2010. The total intrinsic value of stock awards exercised and vested duringthe nine months ended September 30, 2010 was $45,000.

 

Theaggregate intrinsic value in the table below represents the total pretax intrinsicvalue (amount by which the fair value of the underlying stock exceeds theexercise price of an option or award, times the number of shares).  The following table summarizes the activityrelating to restricted stock awards outstanding for the nine months ended September 30,2010.

 

(dollarsin thousands except share and per share amounts)

 
| ** **                             | ** ** | **Shares** | ** ** | **Weighted Average  Remaining  Contractual Terms (in  years)** | ** ** | **Aggregate  Intrinsic Value** | ** ** |
|----------------------------------------|------------|------------|------------|-------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| Outstanding at January 1, 2010    |       | 1,564      |       | 2.80                                                                          |       | $                                   | 145        |   |
| Granted                                |       | —     |       |                                                                          |       |                                |       |
| Vested                                 |       | 289        |       | —                                                                        |       | 45                                  |       |
| Forfeited                              |       | 123        |       |                                                                          |       |                                |       |
| Outstanding at September 30, 2010 |       | 1,152      |       | 1.99                                                                          |       | $                                   | 184        |   |
| Exercisable at September 30, 2010 |       | —     |       |                                                                          |       |                                |       |

 

**Note 7:   INVESTMENT SECURITIES**

 

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

 

**September 30, 2010**
| ** **                                                                      | ** ** | **Amortized** | ** ** | **Gross Unrealized** | ** ** | **Estimated** | ** ** |
|---------------------------------------------------------------------------------|------------|---------------|------------|---------------------------|------------|---------------|------------|
| **(dollars in thousands)**                                            | ** ** | **Cost**      | ** ** | **Gains**                 | ** ** | **Losses**    | ** ** | **Fair Value** | ** ** |
| *Available-For-Sale Securities*                                                 |       |          |       |                      |       |          |       |   |   |
| U.S. Treasury and government agencies                                           |       | $             | 70,090     |                      | $          | 841           |       | $ | — |   | $ | 70,931 |   |
| Residential mortgage-backed securities and collateralized  mortgage obligations |       | 65,363        |       | 3,859                     |       | —        |       | 69,222 |   |
| State and political subdivisions                                                |       | 9,264         |       | 497                       |       | —        |       | 9,761 |   |
| Total available-for-sale                                                        |       | 144,717       |       | 5,197                     |       | —        |       | 149,914 |   |
| *Held-To-Maturity Securities*                                                   |       |          |       |                      |       |          |       |   |   |
| State and political subdivisions                                                |       | 39,813        |       | 2,086                     |       | —        |       | 41,899 |   |
| Total held-to-maturity                                                          |       | 39,813        |       | 2,086                     |       | —        |       | 41,899 |   |
| Total investment securities                                                     |       | $             | 184,530    |                      | $          | 7,283         |       | $ | — |   | $ | 191,813 |   |

 

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**SKAGIT STATE BANCORP, INC. AND SUBSIDIARY**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

**December 31,2009**

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

 

Thefollowing tables show the aggregate gross unrealized losses and fair value ofsecurities with an amortized cost greater than the fair value as of the datesindicated;

 

**December 31, 2009**
| ** **                             | ** ** | **Less Than 12 Months** | ** ** | **12 Months or Greater** | ** ** | **Total**       | ** ** |
|----------------------------------------|------------|----------------------------------------|------------|-----------------------------------------|------------|-----------------|------------|
| **(dollars in thousands)**   | ** ** | **Fair  Value**                        | ** ** | **Unrealized  Losses**                  | ** ** | **Fair  Value** | ** ** | **Unrealized  Losses** | ** ** | **Fair  Value** | ** ** | **Unrealized  Losses** | ** ** |
| *Available-For-Sale Securities*        |       |                                   |       |                                    |       |            |       |   |   |   |   |   |   |
| U.S. government agencies               |       | $                                      | 18,933     |                                    | $          | 132             |       | $ | — |   | $ | — |   | $ | 18,933 |   | $ | 132 |   |
| Residential mortgage-backed securities |       | 10,916                                 |       | 200                                     |       | —          |       | — |   | 10,916 |   | 200 |   |
| State and political subdivisions       |       | $                                      | 221        |                                    | $          | 1               |       | $ | 470 |   | $ | 27 |   | $ | 691 |   | $ | 28 |   |
| Total available-for-sale               |       | 30,070                                 |       | 333                                     |       | 470             |       | 27 |   | 30,540 |   | 360 |   |
| *Held-To-Maturity Securities*          |       |                                   |       |                                    |       |            |       |   |   |   |   |   |   |
| State and political subdivisions       |       | 15,725                                 |       | 626                                     |       | —          |       | — |   | 15,725 |   | 626 |   |
| Total held-to-maturity                 |       | 15,725                                 |       | 626                                     |       | —          |       | — |   | 15,725 |   | 626 |   |
| Total investment securities            |       | $                                      | 45,795     |                                    | $          | 959             |       | $ | 470 |   | $ | 27 |   | $ | 46,265 |   | $ | 986 |   |

 

AtSeptember 30, 2010, Bancorp held no security in the available-for-saleportfolio or in the held-to-maturity portfolio that had an unrealized loss formore than one year.  There were nosecurities in an unrealized loss position for the nine months ended September 30,2010.

 

Foreach security in an unrealized loss position, management assesses whether thesecurity is other-than—temporarily impaired. Bancorp does not intend to sellsecurities that are identified as temporarily impaired nor does availableevidence suggest it is more likely than not that management will be required tosell any impaired securities. The unrealized losses are largely due toincreases in market interest rates over the yields available at the time theunderlying securities were purchased. Management believes the nature ofthe securities in the investment portfolio present a high probably ofcollecting all contractual amounts due. Based on the evaluation, management has determined that no investmentsecurity in Bancorp’s investment portfolio is other-than-temporarily impaired.

 

IfBancorp intends to sell the security or it is more likely than not that it willbe required to sell the security, the other-than-temporary impairment will berecognized in earnings equal to the entire difference between the cost basisand fair value.  If Bancorp does notintend to sell the security and it is not more likely than not that Bancorpwill sell the security before recovery of its cost basis, the differencebetween the cost basis and fair value is reflected in earnings as realizedlosses to the extent the impairment is related to credit losses.  The amount of the impairment related to otherfactors is recognized in other comprehensive income. The previous cost basisless the other-than-temporary impairment recognized in earnings becomes the newcost basis of the security.

 

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**SKAGIT STATE BANCORP, INC. AND SUBSIDIARY**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

 

Available-for-sale investment securities with a carrying value of $95.6million and $101.3 million as of September 30, 2010 and December 31,2009, were pledged as collateral for public fund deposits, securities soldunder agreement to repurchase, Treasury Tax and Loan payments, and FederalReserve Bank discount window borrowings.

 

**Note 8:   ALLOWANCE FOR LOANLOSSES**

 

Thefollowing table presents the activity in the allowance for loan losses for thedates indicated.

 

**Allowancefor Loan Losses Activity**

** **
| ** **                                                   | ** ** | **Three months ended,** | ** ** | **Nine months ended,** | ** ** |
|--------------------------------------------------------------|------------|-----------------------------------|------------|----------------------------------|------------|
| **(dollars in thousands)**                         | ** ** | **2010**                          | ** ** | **2009**                         | ** ** | **2010** | ** ** | **2009** | ** ** |
| Allowance as of beginning of period                          |       | $                                 | 7,392      |                             | $          | 5,629 |   | $ | 6,883 |   | $ | 5,450 |   |
| Provision for loan losses                                    |       | 390                               |       | 1,320                            |       | 1,310 |   | 2,220 |   |
| Charge-offs                                                  |       | (302                              | )          | (1,221                           | )          | (813 | ) | (2,031 | ) |
| Recoveries                                                   |       | 18                                |       | 70                               |       | 118 |   | 159 |   |
| Net charge-offs                                              |       | (284                              | )          | (1,151                           | )          | (695 | ) | (1,872 | ) |
| Balance at end of period                                     |       | $                                 | 7,498      |                             | $          | 5,798 |   | $ | 7,498 |   | $ | 5,798 |   |
| Ratio of net charge-offs to average loans during  the period |       | (0.30                             | )%         | (1.22                            | )%         | (0.24 | )% | (0.65 | )% |
| Ratio of allowance to net loans at end of period             |       | 1.99                              | %          | 1.54                             | %          | 1.99 | % | 1.54 | % |
| Ratio of non-performing loans to allowance                   |       | 113.00                            | %          | 184.58                           | %          | 113.00 | % | 184.58 | % |

 

Impairedloans were $10.9 million as of September 30, 2010 compared to $24.4million as of December 31, 2009. Impaired loans had specific reserve allocations of $601,000 and $1.2million as of September 30, 2010 and December 31, 2009, respectively.

 

**Note 9:   COMMITMENTS**

 

In the ordinary course of business, Bancorp has entered intooff-balance-sheet financial instruments consisting of commitments to extendcredit, commitments under credit-card arrangements, commercial letters ofcredit, and standby letters of credit. Such financial instruments are recordedin the financial statements when they are funded or related fees are incurredor received.

 

Thefollowing is a summary of the off-balance-sheet financial instruments orcontracts outstanding as of September 30, 2010: (dollars in thousands)

 
| Unfunded commitments to extend credit  |   | $      | 55,087 |   |
|----------------------------------------|--------|--------|--------|--------|
| Credit card arrangements               |   | 11,490 |   |
| Commitments to fund municipal warrants |   | 4,249  |   |
| Standby letters of credit              |   | 1,726  |   |

 

**Note 10: INCOME TAXES**

 

Bancorp files a consolidated federal income tax return.  Bancorp accounts for income taxes using theliability method and deferred taxes are reflected at currently enacted income taxrates applicable to the period in which the deferred tax assets or liabilitiesare expected to be realized or settled. Deferred taxes result from temporary differences in the recognition ofcertain income and expense amounts between Bancorp’s financial statements andits tax returns. As changes in tax laws or rates are enacted, deferred taxassets and liabilities are adjusted through the provision for income taxes.

 

FASBASU 740, “Accounting for Income Taxes” seeks to reduce the diversity inpractice associated with certain aspects of measurement and recognition inaccounting for income taxes. ASU 740 provides guidance on de-recognition,classification, interest and penalties and accounting in interim periods andrequires expanded disclosure with respect to uncertainty in income taxes.  As a result of the implementation of ASU 740,Bancorp recognized no adjustments for unrecognized income tax benefits, all ofwhich would affect Bancorp’s effective income tax rate if recognized.  Our accounting policy with respect tointerest and penalties arising from income tax settlements is to recognize themas non-interest expense.

 

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**SKAGIT STATE BANCORP, INC. AND SUBSIDIARY**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

 

**Note11:  FAIR VALUE MEASUREMENTS**

 

Disclosuresregarding the fair value of financial asset and liabilities, including thosefinancial assets and liabilities that are not measured and reported at fairvalue on a recurring basis or non-recurring basis are requireddisclosures.  The estimated fair valueshave been determined by Bancorp using available market information and appropriatevaluation methodologies and considerable judgment is necessary to interpretmarket data in the development of the estimates of fair value.  The use of different market assumptionsand/or estimation methodologies may have a material effect on the estimatedfair value amounts. In that regard, the fair value estimates cannot besubstantiated by comparison to independent markets and, in many cases, couldnot be realized in immediate settlement on the instrument. Accordingly, theaggregate fair value amounts presented do not represent the underlying value ofBancorp.

 

***Financial Instruments***

 

Cash, Due From Banks, Federal Funds Sold, Loans Held For Sale, OtherBorrowings**and Accrued Interest Receivable andPayable*—*The carrying amount of these financialassets and liabilities approximates fair value.

 

Investment Securities — The securities classified as available for saleare reported at fair value utilizing Level 2 inputs. The fair values forheld-to-maturity securities including fixed rate warrants and qualified zoneacademy bonds, included in state and political subdivisions investmentsecurities, are estimated using discounted cash flow analysis using interestrates currently being offered for warrants of similar terms or the currentqualified zone academy bond interest rates.

 

Loans*—* The fair value of loans isestimated by discounting anticipated future cash flows using interest ratescurrently being offered for loans with similar terms to borrowers of similarcredit quality as of the balance sheet date. An overall liquidity discount was also used for 2010 and 2009 to reflectthe decline of loan sales in the marketplace. Collateral dependant impaired loans were not subjected to discountedcash flow analysis as they are already considered to be held at fair value.

 

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

 

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

 

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**SKAGIT STATE BANCORP, INC. AND SUBSIDIARY**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

The carrying amounts and estimated fair values of Bancorp’s financialinstruments are as follows:

** **
| ** **                           | ** ** | **September 30, 2010** | ** ** | **December 31, 2009** | ** ** |
|--------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                           | ** ** | **Carrying**                     | ** ** | ** **                      | ** ** | **Carrying** | ** ** | ** ** | ** ** |
| **(dollars in thousands)** | ** ** | **Amount**                       | ** ** | **Fair Value**             | ** ** | **Amount** | ** ** | **Fair Value** | ** ** |
| *Financial Assets*                   | * *   | * *                         | * *   | * *                        | * *   | * * | * * | * * | * * |
| Cash and due from banks              |       | $                                | 11,163     |                            | $          | 11,163 |   | $ | 14,441 |   | $ | 14,441 |   |
| Federal funds sold                   |       | 77,104                           |       | 77,104                          |       | 62,531 |   | 62,531 |   |
| Investment securities                |       | 189,727                          |       | 191,813                         |       | 158,859 |   | 159,122 |   |
| Loans held for sale                  |       | 817                              |       | 817                             |       | 574 |   | 574 |   |
| Net loans                            |       | 376,794                          |       | 359,020                         |       | 386,649 |   | 361,780 |   |
| Accrued interest receivable          |       | 2,561                            |       | 2,561                           |       | 2,531 |   | 2,531 |   |
| * *                             |       |                             |       |                            |       |   |   |   |   |
| *Financial Liabilities*              |       |                             |       |                            |       |   |   |   |   |
| Demand and savings deposits          |       | 359,669                          |       | 359,669                         |       | 339,001 |   | 339,001 |   |
| Time deposits                        |       | 216,667                          |       | 218,210                         |       | 206,435 |   | 208,142 |   |
| Other borrowings                     |       | 34,320                           |       | 34,320                          |       | 38,128 |   | 38,128 |   |
| Accrued interest payable             |       | 255                              |       | 255                             |       | 366 |   | 366 |   |
|                                      |            |                                  |            |                                 |            |  |  |  |  |  |  |  |  |

 

***Fair Value Hierarchy***

 

FASB ASU 820 establishes a hierarchy that prioritizes the use of fairvalue inputs used in the valuation methodologies into the following threelevels:

 

Level1 — Quoted prices for identical instruments in active markets that Bancorp hasthe ability to access at the measurement date.

 

Level2 — Significant other observable inputs other than Level 1 prices such asquoted prices for similar instruments in active markets, quoted prices foridentical or similar instruments in markets that are not active, or otherinputs that are observable or can be derived from or corroborated by observablemarket data by correlation or other means.

 

Level3 — Significant unobservable inputs that reflect the Bancorp’s own assumptionabout the assumptions that market participants would use in pricing an asset orliability.

 

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

 

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**SKAGIT STATE BANCORP, INC. AND SUBSIDIARY**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

***Assets and Liabilities Measured at Fair Value on a Recurring Basis***

 

The table below shows assets measured at fair value on a recurringbasis as of the dates indicated.

 

(dollars in thousands)

 
| ** **                                                                      | ** ** | ** ** | ** ** | **Quoted  Prices in  Active  Markets for  Identical   Assets** | ** ** | **Significant  Other  Observable  Inputs** | ** ** | **Significant  Unobservable  Inputs** | ** ** |
|---------------------------------------------------------------------------------|------------|------------|------------|--------------------------------------------------------------------------|------------|--------------------------------------------|------------|---------------------------------------|------------|
| **Description**                                                                 | ** ** | ** ** | ** ** | **(Level 1)**                                                       | ** ** | **(Level 2)**                         | ** ** | **(Level 3)**                    | ** ** |
| **September 30, 2010**                                                     |       |       |       |                                                                     |       |                                       |       |                                  |       |
| Available-for-sale securities                                                   |       |       |       |                                                                     |       |                                       |       |                                  |       |
| U.S. Treasury and government agencies                                           |       | $          | 70,931     |                                                                     | $          | —                                     |       | $                                     | 70,931     |   | $ | — |   |
| Residential mortgage-backed securities and collateralized  mortgage obligations |       | 69,222     |       | —                                                                   |       | 69,222                                     |       | $                                     | —     |   |
| State and political subdivisions                                                |       | 9,761      |       | —                                                                   |       | 9,761                                      |       | $                                     | —     |   |
| Total                                                                           |       | $          | 149,914    |                                                                     | $          | —                                     |       | $                                     | 149,914    |   | $ | — |   |
|                                                                            |       |       |       |                                                                     |       |                                       |       |                                  |       |
| **December 31, 2009**                                                      |       |       |       |                                                                     |       |                                       |       |                                  |       |
| Available-for-sale securities                                                   |       |       |       |                                                                     |       |                                       |       |                                  |       |
| U.S. government agencies                                                        |       | $          | 39,840     |                                                                     | $          | —                                     |       | $                                     | 39,840     |   | $ | — |   |
| Residential mortgage-backed-securities                                          |       | 68,996     |       | —                                                                   |       | 68,996                                     |       | $                                     | —     |   |
| State and political subdivisions                                                |       | 9,725      |       | —                                                                   |       | 9,725                                      |       | $                                     | —     |   |
| Total                                                                           |       | $          | 118,561    |                                                                     | $          | —                                     |       | $                                     | 118,561    |   | $ | — |   |

 

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

 

***Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis***

 

Thetable below shows assets measured at fair value on a non-recurring basis as ofthe dates indicated.

 

(dollarsin thousands)

 
| ** **                  | ** ** | ** ** | ** ** | **Quoted  Prices in  Active  Markets for  Identical   Assets** | ** ** | **Significant  Other  Observable  Inputs** | ** ** | **Significant  Unobservable  Inputs** | ** ** |
|-----------------------------|------------|------------|------------|--------------------------------------------------------------------------|------------|--------------------------------------------|------------|---------------------------------------|------------|
| **Description**             | ** ** | ** ** | ** ** | **(Level 1)**                                                       | ** ** | **(Level 2)**                         | ** ** | **(Level 3)**                    | ** ** |
| **September 30, 2010** |       |       |       |                                                                     |       |                                       |       |                                  |       |
| Impaired loans              |       | $          | 10,268     |                                                                     | $          | —                                     |       | $                                     | —     |   | $ | 10,268 |   |
| Other real estate owned     |       | 5,688      |       | —                                                                   |       | —                                     |       | 5,688                                 |       |
| Total                       |       | $          | 15,956     |                                                                     | $          | —                                     |       | $                                     | —     |   | $ | 15,956 |   |
|                        |       |       |       |                                                                     |       |                                       |       |                                  |       |
| **December 31, 2009**  |       |       |       |                                                                     |       |                                       |       |                                  |       |
| Impaired loans              |       | $          | 23,188     |                                                                     | $          | —                                     |       | $                                     | —     |   | $ | 23,188 |   |
| Other real estate owned     |       | 6,284      |       | —                                                                   |       | —                                     |       | 6,284                                 |       |
| Total                       |       | $          | 29,472     |                                                                     | $          | —                                     |       | $                                     | —     |   | $ | 29,472 |   |

 

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**SKAGIT STATE BANCORP, INC. AND SUBSIDIARY**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

*ImpairedLoans* — The recorded net investment in impaired loans, including accruedinterest, is limited to the present value of the expected cash flows of theimpaired loan, the observable fair market value of the loan or the estimatedfair value of the loan’s collateral. Impaired loans were written down $410,000 via partial charge-offs and inaddition had specific reserve allocation decreases of $490,000, which wasrecorded through the****allowance forloan losses for the nine months ended September 30, 2010.  Impaired loans were written down $1.7 millionvia partial charge-offs and in addition had specific reserve allocationincreases of $1.3 million which was recorded through the allowance for loanlosses for the twelve months ended December 31, 2009.

 

*OtherReal Estate Owned* — Other real estate owned includes properties acquiredthrough foreclosure.  These propertiesare recorded at the lower of the recorded amount of the loan, or estimated fairvalue less estimated costs to sell based on periodic evaluations using Level 3inputs.  Valuation of the property occurswhen it is foreclosed upon and annually thereafter.  Write-downs arising from the acquisition ofproperty, in full or partial satisfaction of loans, are charged to theallowance for loan losses.  Subsequentwrite-downs after acquisition, identified through management’s periodicvaluations, are written down through non-interest expenses. Other real estateowned with a carrying amount of $6.1 million, were written down to their fairvalue of $5.7 million, resulting in write-downs of $435,000, which was chargedagainst earnings for the nine months ended September 30, 2010.  Other real estate owned with a carryingamount of $7.5 million, were written down to their fair value of $6.3 million,resulting in write-downs of $1.2 million, which was charged against earningsfor the twelve months ended December 31, 2009.

 

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

 

*Thefollowing discussion should be read in conjunction with the consolidatedfinancial statements and notes thereto presented elsewhere in this report.  For additional information, refer to thefinancial statements and footnotes for the year ended December 31, 2009 inthe Annual Report on Form 10-K.*

 

**FORWARD LOOKING STATEMENTS**

 

ThisForm 10-Q may contain forward-looking statements within the meaning of thePrivate Securities Litigation Reform Act of 1995.  These forward-looking statements include, butare not limited to, statements about management’s plans, objectives,expectations and intentions that are not historical facts, and other statementsidentified by words such as “expects,” “anticipates,” “intends,” “plans,” “believes,”“should,” “projects,” “seeks,” “estimates” or words of similar meaning. Theseforward-looking statements are based on current beliefs and expectations ofmanagement and are inherently subject to significant business, economic andcompetitive uncertainties and contingencies, many of which are beyond Bancorp’scontrol. In addition, these forward-looking statements are subject toassumptions with respect to future business strategies and decisions that aresubject to change. The following factors, among others, could cause actualresults to differ materially from the anticipated results or other expectationsin the forward-looking statements, including those set forth in this Form 10-Q,or the documents incorporated by reference:

 

·              the risks associated withlending and potential adverse changes in credit quality;

·              increased loan delinquencyrates;

·              the risks presented by acontinued economic slowdown, which could adversely affect credit quality, loancollateral values, investment values, liquidity levels, and loan originations;

·              changes in market interestrates, which could adversely affect our net interest income and profitability;

·              legislative or regulatorychanges that adversely affect our business or our ability to complete pendingor prospective future acquisitions;

·              reduced demand for bankingproducts and services;

·              competition from otherfinancial services companies in our markets; and

·              Bancorp’s success inmanaging risks involved in the foregoing.

 

Additionalfactors that could cause actual results to differ materially from thoseexpressed in the forward-looking statements are discussed in Risk Factors inItem 1A. Please take into account that forward-looking statements speak only asof the date of this Form 10-Q or documents incorporated by reference.Bancorp does not undertake any obligation to publicly correct or update anyforward-looking statement if we later become aware that it is not likely to beachieved.

 

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**BUSINESS**

 

SkagitState Bancorp, Inc. is a bank holding company with one wholly ownedsubsidiary - Skagit State Bank (collectively, “Company” or “Bancorp”).  Skagit State Bank began operations in 1958and is headquartered in Burlington (Skagit County), Washington.  The Bank provides a full range of bankingservices and products to both businesses and individuals through 12 fullservice banking offices located in Skagit, Snohomish and Whatcom counties, aconsumer loan center, and a business banking center.

 

**OVERVIEW**

 

Netincome was $1.4 million and $301,000 for the quarters ended September 30,2010, and 2009 with diluted earnings per share at $2.35 and $0.51, respectively.  Net income was $3.9 million and $2.4 millionfor the nine months ended September 30, 2010, and 2009 with dilutedearnings per share at $6.67 and $4.04, respectively. The increases in netincome were primarily attributable to lower loan loss reserve provisions, lowerprovisions for OREO losses, and decreased interest expense partially offset bydecreased interest income. Annualized return on average assets was 0.80 percentand 0.78 percent for the quarter and nine months ended September 30, 2010,compared to 0.20 percent and 0.55 percent during the same time periods as2009.  Annualized return on averageequity was 8.20 percent and 8.04 percent for the quarter and nine months endingSeptember 30, 2010 compared to 1.90 percent and 5.04 percent, respectively,for the same time periods in 2009.

 

Theprovision for loan losses was $390,000 and $1.3 million for the quarter andnine months ended September 30, 2010, compared to $1.3 million and $2.2million for the same time periods in 2009. The decreases in the provisions forloan losses were primarily attributable to decreases in net charge-offs.Bancorp increased its allowance for loan losses to 1.99 percent of net loans atSeptember 30, 2010 compared to 1.78 percent at December 31,2009.  For the quarter and nine monthsended September 30, 2010, respectively, net charge-offs were $284,000 and$695,000, down from $1.2 million and $1.9 million for the same time periods in2009.

 

Non-interestexpense was $4.5 million and $13.5 million for the quarter and nine monthsended September 30, 2010 compared to $4.7 million and $14.2 million in thelike periods in 2009.  For the quarterended September 30, 2010 compared to the same quarter in 2009, thedecrease was primarily attributable to a $371,000 decrease in provision forOREO losses. For the nine months ended September 30, 2010 compared to thesame period in 2009, the decrease was primarily attributable to the $479,000decrease in provision for other real estate losses and a $257,000 decrease inFDIC deposit insurance premiums.  The2009 deposit insurance premiums included a one-time assessment of $260,000.

 

Totalassets increased to $680.0 million at September 30, 2010, compared to$647.9 million at December 31, 2009. The increase was primarily due to deposit growth of $30.9 million.  Net loans decreased by $9.8 million or 2.5percent to $376.8 million at September 30, 2010, compared to $386.6million at December 31, 2009. During 2010 and 2009, Bancorp continued to originate and fund loans tocustomers within our markets.  Decreasedloan balances reflect the current market conditions and the lower demand andlower availability of quality loans.

 

**RESULTSOF OPERATIONS**

 

Bancorp’sresults of operations are dependent to a large degree on net interest income,operating efficiency and the level of the provision for loan losses. Bancorp’soperations are sensitive to interest rate changes and the resulting impact onnet interest income. In addition, changes in net interest income are influencedby the volume of assets and liabilities and the rates earned and paidrespectively.  Bancorp generatesnon-interest income primarily through fees and service charges on depositaccounts and gains on the sale of mortgage loans. Bancorp’s non-interestexpenses consist primarily of salaries and employee benefits expense, bankpremises and equipment expenses and other operating expenses.

 

**NET INTEREST 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.

 

Netinterest income was $5.5 million and $16.5 million for the quarter and ninemonths ended September 30, 2010 compared to $5.3 million and $16.1 millionfor the like periods in 2009.  Theincreases in net interest income were primarily attributable to a $344,000 and$829,000 decrease in interest expense for the quarter and nine months in 2010compared to 2010, partially offset by decreases in loan interest income of$204,000 and $465,000, respectively. Interest income on investments remainedrelatively unchanged from 2009 to 2010.

 

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Forthe quarter and nine months ended September 30, 2010, the net interestmargin decreased to 3.35 percent and 3.46 percent compared to 3.81 percent and3.94 percent for the like periods in 2009. The decreases in net interest margin were primarily due to decreases inthe average yield on securities and the negative impact of the change in theinterest-earning asset composition with lower yielding federal funds soldcomprising a higher percentage of total interest-earning assets.  The yield on interest-earning assetsdecreased 85 basis points for both the quarter and nine months ended September 30,2010 compared to the like periods in 2009. These yield decreases were partially offset by decreases in the cost offunds of 49 basis points and 48 points for the same time periods.

 

Thefollowing tables present information regarding average balances of assets andliabilities as well as the total amounts of interest income from averageinterest-earning assets and interest expense on average interest-bearingliabilities, resulting yield and cost ratios, interest rate spread and netinterest margin. Tax exempt securities, included in investment securities beloware stated at their contractual interest rate. Loan fees of $134,000 and $560,000 for the quarter and nine months endedSeptember 30, 2010, and $207,000 and $646,000 for the quarter and ninemonths ended September 30, 2009, respectively, are included in interestearned on loans. Non-accruing loans have been included in the computation ofaverage loans.

 

**Condensed Average Balance Sheets**

(dollars in thousands except share data)

 
| ** **                                               | ** ** | **2010**             | ** ** | **2009**     | ** ** |
|----------------------------------------------------------|------------|----------------------|------------|--------------|------------|
| **Three months ended September 30,** | ** ** | **Average  Balance** | ** ** | **Interest** | ** ** | **Yield  /Cost** | ** ** | **Average  Balance** | ** ** | **Interest** | ** ** | **Yield  /Cost** | ** ** |
| **Assets**                                               |       |                 |       |         |       |   |   |   |   |   |   |   |   |
| Federal funds sold                                       |       | $                    | 87,816     |         | $          | 56 |   | 0.25 | % | $ | 34,140 |   | $ | 22 |   | 0.26 | % |
| Taxable investment securities                            |       | 134,895              |       | 1,024        |       | 3.01 |   | 93,918 |   | 1,051 |   | 4.44 |   |
| Tax exempt securities                                    |       | 49,111               |       | 276          |       | 2.23 |   | 49,314 |   | 282 |   | 2.27 |   |
| Loans                                                    |       | 376,390              |       | 5,587        |       | 5.89 |   | 378,955 |   | 5,791 |   | 6.06 |   |
| Total interest-earning assets                            |       | 648,212              |       | 6,943        |       | 4.25 | % | 556,327 |   | 7,146 |   | 5.10 | % |
| Non-interest earning assets                              |       | 34,672               |       |         |       |   |   | 32,278 |   |   |   |   |   |
| Total assets                                             |       | $                    | 682,884    |         |       |   |   |   | $ | 588,605 |   |   |   |   |   |
| ** **                                               |       |                 |       |         |       |   |   |   |   |   |   |   |   |
| **Liabilities and Stockholders’  Equity**           |       |                 |       |         |       |   |   |   |   |   |   |   |   |
| Interest-bearing demand                                  |       | $                    | 102,563    |         | $          | 110 |   | 0.43 | % | $ | 89,187 |   | $ | 81 |   | 0.36 | % |
| Savings and money market                                 |       | 184,373              |       | 329          |       | 0.71 |   | 165,315 |   | 405 |   | 0.97 |   |
| Certificates of deposit                                  |       | 216,676              |       | 938          |       | 1.72 |   | 188,232 |   | 1,250 |   | 2.63 |   |
| Total interest-bearing deposits                          |       | 503,612              |       | 1,377        |       | 1.08 |   | 442,734 |   | 1,736 |   | 1.56 |   |
| Other borrowings                                         |       | 38,269               |       | 85           |       | 0.88 |   | 16,117 |   | 70 |   | 1.72 |   |
| Total interest-bearing deposits & liabilities        |       | 541,881              |       | 1,462        |       | 1.07 | % | 458,851 |   | 1,806 |   | 1.56 | % |
| Non interest-bearing demand deposits                     |       | 72,417               |       |         |       |   |   | 64,353 |   |   |   |   |   |
| Other non-interest-bearing liabilities                   |       | 1,738                |       |         |       |   |   | 2,055 |   |   |   |   |   |
| Total liabilities                                        |       | 616,036              |       |         |       |   |   | 525,259 |   |   |   |   |   |
| Stockholders’ equity                                |       | 66,848               |       |         |       |   |   | 63,346 |   |   |   |   |   |
| Total liabilities and stockholders equity                |       | $                    | 682,884    |         |       |   |   |   | $ | 588,605 |   |   |   |   |   |
| Net interest income                                      |       |                 |       | $            | 5,481      |   |   |   |   |   | $ | 5,340 |   |   |   |
| Interest rate spread                                     |       |                 |       |         |       | 3.18 | % |   |   |   |   | 3.53 | % |
| Net interest margin                                      |       |                 |       |         |       | 3.35 | % |   |   |   |   | 3.81 | % |

 

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**Condensed Average Balance Sheets**

(dollars in thousands except share data)

 
| ** **                                              | ** ** | **2010**    | ** ** | **2009**     | ** ** |
|---------------------------------------------------------|------------|-------------|------------|--------------|------------|
| ** **                                              | ** ** | **Average** | ** ** | ** **   | ** ** | **Yield** | ** ** | **Average** | ** ** | ** ** | ** ** | **Yield** | ** ** |
| **Nine months ended September 30,** | ** ** | **Balance** | ** ** | **Interest** | ** ** | **/Cost** | ** ** | **Balance** | ** ** | **Interest** | ** ** | **/Cost** | ** ** |
| **Assets**                                              |       |        |       |         |       |   |   |   |   |   |   |   |   |
| Federal funds sold                                      |       | $           | 85,171     |         | $          | 161 |   | 0.25 | % | $ | 20,798 |   | $ | 34 |   | 0.22 | % |
| Taxable investment securities                           |       | 121,796     |       | 3,106        |       | 3.41 |   | 90,765 |   | 3,165 |   | 4.66 |   |
| Tax exempt securities                                   |       | 49,411      |       | 826          |       | 2.24 |   | 48,499 |   | 844 |   | 2.33 |   |
| Loans                                                   |       | 381,004     |       | 16,993       |       | 5.96 |   | 385,071 |   | 17,458 |   | 6.06 |   |
| Total interest-earning assets                           |       | 637,382     |       | 21,086       |       | 4.42 | % | 545,133 |   | 21,501 |   | 5.27 | % |
| Non-interest earning assets                             |       | 36,030      |       |         |       |   |   | 32,525 |   |   |   |   |   |
| Total assets                                            |       | $           | 673,412    |         |       |   |   |   | $ | 577,658 |   |   |   |   |   |
| ** **                                              |       |        |       |         |       |   |   |   |   |   |   |   |   |
| **Liabilities and Stockholders’  Equity**          |       |        |       |         |       |   |   |   |   |   |   |   |   |
| Interest-bearing demand                                 |       | $           | 104,957    |         | $          | 306 |   | 0.39 | % | $ | 88,327 |   | $ | 230 |   | 0.35 | % |
| Savings and money market                                |       | 176,466     |       | 1,016        |       | 0.77 |   | 161,385 |   | 1,193 |   | 0.99 |   |
| Certificates of deposit                                 |       | 214,350     |       | 3,031        |       | 1.89 |   | 176,718 |   | 3,790 |   | 2.87 |   |
| Total interest-bearing deposits                         |       | 495,773     |       | 4,353        |       | 1.17 |   | 426,430 |   | 5,213 |   | 1.63 |   |
| Other borrowings                                        |       | 38,792      |       | 254          |       | 0.88 |   | 18,562 |   | 223 |   | 1.61 |   |
| Total interest-bearing deposits & liabilities       |       | 534,565     |       | 4,607        |       | 1.15 | % | 444,992 |   | 5,436 |   | 1.63 | % |
| Non interest-bearing demand deposits                    |       | 71,932      |       |         |       |   |   | 67,476 |   |   |   |   |   |
| Other non-interest-bearing liabilities                  |       | 1,686       |       |         |       |   |   | 2,042 |   |   |   |   |   |
| Total liabilities                                       |       | 608,183     |       |         |       |   |   | 514,510 |   |   |   |   |   |
| Stockholders’ equity                               |       | 65,229      |       |         |       |   |   | 63,148 |   |   |   |   |   |
| Total liabilities and stockholders equity               |       | $           | 673,412    |         |       |   |   |   | $ | 577,658 |   |   |   |   |   |
| Net interest income                                     |       |        |       | $            | 16,479     |   |   |   |   |   | $ | 16,065 |   |   |   |
| Interest rate spread                                    |       |        |       |         |       | 3.27 | % |   |   |   |   | 3.64 | % |
| Net interest margin                                     |       |        |       |         |       | 3.46 | % |   |   |   |   | 3.94 | % |

 

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Thefollowing table sets forth information on changes in net interest income whichare attributable to changes in interest rates and changes in volume for theperiods indicated.  Changes attributableto the combined effect of volume and interest rates have been allocatedproportionately.

 

**Analysisof Changes in Interest Income and Expense Due to Changes in Volume and Rate**

 
| ** **                                                   | ** ** | **Three months ended Sept. 30,** | ** ** | **Nine months ended Sept. 30,** | ** ** |
|--------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                   | ** ** | **2010 vs. 2009**                          | ** ** | **2010 vs. 2009**                         | ** ** |
| ** **                                                   | ** ** | **Increase (Decrease) Due to**        | ** ** | **Increase (Decrease) Due to**       | ** ** |
| **(dollars in thousands)**                         | ** ** | **Volume**                                           | ** ** | **Rate**                                            | ** ** | **Total** | ** ** | **Volume** | ** ** | **Rate** | ** ** | **Total** | ** ** |
| **Interest-Earning Assets**                                  | ** ** | ** **                                           | ** ** | ** **                                          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Federal funds sold                                           |       | $                                                    | 36         |                                                | $          | (2 | ) | $ | 34 |   | $ | 121 |   | $ | 6 |   | $ | 127 |   |
| Investment securities                                        |       | 1,528                                                |       | (1,561                                              | )          | (33 | ) | 1,263 |   | (1,340 | ) | (77 | ) |
| Loans                                                        |       | (39                                                  | )          | (165                                                | )          | (204 | ) | (183 | ) | (282 | ) | (465 | ) |
| Total net change in income on interest-earning  assets       |       | 1,525                                                |       | (1,728                                              | )          | (203 | ) | 1,201 |   | (1,616 | ) | (415 | ) |
| **Interest-Bearing Liabilities**                             |       |                                                 |       |                                                |       |   |   |   |   |   |   |   |   |
| Deposits                                                     |       | 1,038                                                |       | (1,397                                              | )          | (359 | ) | 1,083 |   | (1,943 | ) | (860 | ) |
| Other borrowings                                             |       | 211                                                  |       | (196                                                | )          | 15 |   | 213 |   | (182 | ) | 31 |   |
| Total net change in expense on interest-bearing  liabilities |       | 1,249                                                |       | (1,593                                              | )          | (344 | ) | 1,296 |   | (2,125 | ) | (829 | ) |
| Net change in net interest income                            |       | $                                                    | 276        |                                                | $          | (135 | ) | $ | 141 |   | $ | (95 | ) | $ | 509 |   | $ | 414 |   |

 

**PROVISIONFOR LOAN LOSSES**               The provision for loanlosses was $390,000 and $1.3 million for the quarter and nine months ended September 30,2010 compared to $1.3 million and $2.2 million provision for loan losses forthe like periods in 2009. The decreases in the provision for loan losses wereprimarily attributable to decreases in net charge-offs. For the quarter andnine months ended September 30, 2010, net charge-offs were $284,000 and$695,000 compared to $1.2 million and $1.9 million for the like periods in2009.  For the nine months ended September 30,2010, charge-offs on two credit relationships were 45 percent of total netcharge-offs.

 

Theprovision for loan losses is highly dependent upon Bancorp’s ability to manageasset quality and control the level of net charge-offs through prudentunderwriting standards. In the future, continued growth of the loan portfolioor further declines in economic conditions and real estate values couldincrease future provisions for loan losses and impact Bancorp’s net income.Additional discussion on loan quality and the allowance for loan losses isprovided under Allowance for Loan Losses and Asset Quality.

 

**NON-INTERESTINCOME**            Non-interest income, whichconsists primarily of fees and service charges on deposits and other income,was relatively unchanged at $1.1 million and $3.1 million for the quarter andnine months ended September 30, 2010, and $1.0 million and $3.0 millionfor the like periods in 2009.

 

**NON-INTERESTEXPENSE**          Non-interest expense was$4.5 million and $13.5 million for the quarter and nine months ended September 30,2010 compared to $4.7 million and $14.2 million in the like periods in2009.  For the quarter ended September 30,2010 compared to the same quarter in 2009, the decrease was primarilyattributable to a $371,000 decrease in provision for OREO losses. For the ninemonths ended September 30, 2010 compared to the same period in 2009, thedecrease was primarily attributable to the $479,000 decrease in provision forother real estate losses and a $257,000 decrease in FDIC deposit insurancepremiums.  The 2009 deposit insurancepremiums included a one-time assessment of $260,000.

 

Theefficiency ratio is computed by dividing total operating expenses bynon-interest income and net interest income before provision for loanlosses.  An increase in the efficiencyratio indicates that more resources are being utilized to generate the same orgreater volume of income. The efficiency ratio for the quarter and nine monthsended September 30, 2010 was 68.3 percent and 69.1 percent compared to74.1 percent and 74.4 percent for the same time periods in 2009.

 

**INCOME TAX EXPENSE**              Income taxexpense for the quarter and nine months ended September 30, 2010 was$305,000 and $803,000 compared to $30,000 and $280,000 expense for the quarterand nine months ended September 30, 2009, respectively. Bancorp’seffective tax rates were 17.0 percent and 10.5 percent for the nine monthsended September 30, 2010 and 2009, respectively. The effective tax rate islower than the federal statutory rate due to tax credits from tax-exempt bondsand tax-exempt interest from municipal bonds and loans.  As of September 30, 2010, Bancorp had$49.6 million in tax-exempt securities compared to $51.2 million as of September 30,2009.

 

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**REVIEWOF FINANCIAL CONDITION**

 

Totalassets increased to $680.0 million at September 30, 2010 compared to$647.9 million at December 31, 2009. This increase was primarily due to a $30.9 million increase in depositsfrom $545.4 million to $576.3 million. Net loans decreased $9.8 million from$386.6 million to $376.8 million during the same time period.

 

**INVESTMENT SECURITIES AND FEDERAL FUNDS SOLD**Totalinvestment securities, including federal funds sold, increased to $266.8million at September 30, 2010 compared to $221.4 million at December 31,2009. Federal funds sold increased to $77.1 million at September 30, 2010from $62.5 million as of December 31, 2009. This increase resultedprimarily from the growth in deposits.

 

Theavailable-for-sale investment portfolio is comprised of 46.2 percent GovernmentSponsored Agencies and Government Agencies mortgage-backed pass-throughsecurities and collateralized mortgage obligations, 6.5 percent of state andmunicipals and 47.3 percent of U.S Treasury and Government Sponsored Agenciesand Government Agencies securities.  Theheld-to-maturity portfolio is concentrated in municipal securities andQualified Zone Academy Bonds. Security purchases for the quarter and ninemonths ended September 30, 2010, respectively, were $21.0 million and$71.3 million.  Security maturities,calls, and pay-downs were $19.2 million and $42.9 million for the quarter andnine months ended September 30, 2010, respectively.

 

Theamortized cost and estimated fair value of investment securities at September 30,2010, by contractual maturity, are shown in the following table.  Actual maturities may differ from contractualmaturities because issuers may have the right to call or prepay obligationswith or without call or prepayments penalties. Mortgage-backed securities and collateralized mortgage obligations arenot all due at a single maturity date, therefore, they are disclosedseparately. 

 
| ** **                                                                      | ** ** | **2010**               | ** ** |
|---------------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                      | ** ** | **Available-For-Sale** | ** ** | **Held-To-Maturity** | ** ** |
| ** **                                                                      | ** ** | **Amortized**          | ** ** | **Estimated ** | ** ** | **Amortized** | ** ** | **Estimated** | ** ** |
| **(dollars in thousands)**                                            | ** ** | **Cost**               | ** ** | **Fair Value** | ** ** | **Cost** | ** ** | **Fair Value** | ** ** |
| 0-1 year                                                                        |       | $                      | 6,518      |   | $ | 6,535 |   | $ | 4,999 |   | $ | 5,034 |   |
| 1-5 years                                                                       |       | 62,743                 |       | 63,865 |   | 13,355 |   | 13,881 |   |
| 5-10 years                                                                      |       | 5,394                  |       | 5,537 |   | 10,965 |   | 11,613 |   |
| Over 10 years                                                                   |       | 4,698                  |       | 4,755 |   | 10,494 |   | 11,371 |   |
| Residential mortgage-backed securities and  collateralized mortgage obligations |       | 65,364                 |       | 69,222 |   | — |   | — |   |
| Total investment securities                                                     |       | $                      | 144,717    |   | $ | 149,914 |   | $ | 39,813 |   | $ | 41,899 |   |

 

**LOANS**                 Net loans decreased 2.5percent to $376.8 million at September 30, 2010 compared to $386.6 millionat December 31, 2009.  Net loansrepresented 55.4 percent of total assets at September 30, 2010.  During 2010 and 2009, Bancorp continued tooriginate and fund loans to customers within our markets.  Decreased loan balances reflect the currentmarket conditions and the lower demand and lower availability of quality loans.

 

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

 

*RealEstate Loans:* Real estate loans comprise the largest category ofloans and our real estate portfolio consists of commercial and residentialloans which are secured by property such as office buildings, retail buildings,owner occupied commercial business properties, farm land, timber land,residential land development properties and residential properties.  Real estate loans compromised 66.2% of totalloans at September 30, 2010.  Theprimary repayment source of these specific loan types are from the cash flowsgenerated by the occupant business, occupant farm operation, or the sale ofproperties. While Bancorp has significant balances secured by real estate,Bancorp believes that its lending policies and concentration policies aresufficient to minimize risks.  However,economic conditions may affect a borrower’s ability to meet the statedrepayment terms.

 

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*CommercialLoans*: Commercial loans, secured and unsecured, are made primarily to smalland medium-sized businesses including farms operating within Skagit, Snohomishand Whatcom Counties.  These loans areavailable for general operating purposes, acquisition of assets, purchases ofequipment and machinery, financing of inventory and accounts receivable, andother business purposes.  Bancorporiginates Small Business Administration (SBA) loans, including 504 and 7Aloans.

 

*Consumer Loans:* Bancorp makes secured and unsecured consumerloans including loans to individuals, primarily customers of Bancorp, forvarious purposes, including home equity loans, purchases of automobiles, mobilehomes, boats and other recreational vehicles, home improvement loans and loansfor education and personal investments.

 

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

 

**LoanComposition**

 
| ** **                                           | ** ** | **September 30, 2010** | ** ** | **December 31, 2009** | ** ** |
|------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| **(dollars in thousands)**                 | ** ** | **Amount**                       | ** ** | **%**                           | ** ** | **Amount** | ** ** | **%** | ** ** |
| Real estate — residential & commercial |       | $                                | 247,633    |                            | 64.3       | % | $ | 248,658 |   | 63.0 | % |
| Real estate construction                             |       | 7,466                            |       | 1.9                             | %          | 13,261 |   | 3.4 | % |
| Commercial, industrial & agricultural       |       | 76,246                           |       | 19.8                            | %          | 76,716 |   | 19.4 | % |
| Consumer                                             |       | 53,739                           |       | 14.0                            | %          | 55,910 |   | 14.2 | % |
| Total loans                                          |       | 385,084                          |       | 100                             | %          | 394,545 |   | 100 | % |
| Less:                                                |       |                             |       |                            |       |   |   |   |   |
| Allowance for loan losses                            |       | 7,498                            |       |                            |       | 6,883 |   |   |   |
| Deferred loan fees                                   |       | 792                              |       |                            |       | 1,013 |   |   |   |
| Net loans                                            |       | $                                | 376,794    |                            |       |   | $ | 386,649 |   |   |   |

 

*Concentrations*

 

Asshown in the table above, a concentration of loans in commercial andresidential real estate existed as of September 30, 2010.  At September 30,2010, Bancorp’s real estate portfolio included $157.7 million in non-farmnon-residential real estate loans of which $94.1 million is owner occupied.Total loans also included $46.2 million in raw land, land development andconstruction loans and $60.1 million in one-to-four family residential loans.

 

During2006, the FDIC issued guidance entitled “Concentrations in Commercial RealEstate Lending, Sound Risk Management Practices”.  The guidance set forthtwo thresholds to identify institutions with Commercial Real Estate (CRE) loanconcentrations. Financial institutions are deemed to have a CRE concentrationif loans for construction, land development, and other land represent 100percent or more of total capital or if loans for construction, landdevelopment, and other land and loans secured by multifamily and nonfarm nonresidentialproperty(excluding loans secured by owner-occupied properties) represent 300percent or more of total capital. Bancorp’s construction, land development, rawland, multifamily and nonfarm nonresidential non-owner occupied real estateloans outstanding (total commercial real estate) were 163% and 180% of totalrisk based capital for September 30, 2010 and 2009, respectively. Totalreported loans for construction, land development, and raw land were 66% and78% of total risk based capital for September 30, 2010 and 2009,respectively. Bancorp considers both ratios noted above to be within acceptablelevels of concentration risk.

 

Managementemploys risk management practices, including board and management oversight andstrategic planning, development of underwriting standards, risk assessment andmonitoring through stress testing.  Inaddition, Bancorp monitors concentrations of commercial real estate for whichthe cash flow from the real estate is the primary source of repayment ratherthan loans to a borrower for which real estate collateral is taken as asecondary source of repayment. These types of commercial real estate loans haverisk profiles which are more sensitive to changes in market demand, vacancyrates, rents or changes in capitalization rates. Included in these commercialreal estate concentrations are loans for construction, land development, rawland, multifamily, and nonfarm nonresidential non-owner occupiedproperties.  Excluded from these commercialreal estate concentrations are nonfarm nonresidential owner occupied propertieswhere the primary source of repayment is the cash flow from the ongoingoperations and activities conducted by the party, or affiliate of the party,who owns the property.

 

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*CreditRisk Management*

 

Theextension of credit to individuals and businesses is a significant portion ofBancorp’s principal business activity and requires ongoing portfolio and creditmanagement.  Bancorp has establishedlending policies and procedures to manage and monitor risk. These lendingpolicies and procedures include guidelines for concentrations of credit, loanterms, loan-to-value ratios, collateral appraisals and loan approval limits. Inaddition, Bancorp monitors its loan portfolio for potential risk of lossaccording to an internal risk-grading system and monitors its credit quality toidentify potential problem credits and any loss exposure in a timelymanner.  Bancorp has assessed and willcontinue to assess on an on-going basis, the impact of the economy on thecredit risk in the loan portfolio.

 

Furtherdeclines in the performance of the economy, in general, or further declines inreal estate values in our market areas, in particular, could have an adverseimpact on collectability, increase the level of real estate non-performingloans or have other adverse effects which alone or in aggregate could have amaterial adverse effect on our business, financial condition, results ofoperation and cash flows.  In addition, most of Bancorp’s businessactivity is with customers located within Skagit, Snohomish and WhatcomCounties.

 

**ALLOWANCEFOR LOAN LOSSES     **The allowance for loanlosses was $7.5 million or 1.99 percent of net loans as of September 30,2010 compared to $6.9 million or 1.78 percent of net loans as of December 31,2009. The increase in the allowance for loan losses is primarily due to thecontinued uncertainty related to the weakness in the economy. Additions to theallowance, in the form of provision, are reflected in current operatingresults, while charge-offs to the allowance are made when a loss is determinedto have occurred. The provision for loan losses was $390,000 and $1.3 million forthe quarter and nine months ended September 30, 2010, respectively,compared to $1.3 million and $2.2 million for the like periods in 2009. For thequarter and nine month ended September 30, 2010, net charge-offs were$284,000 and $695,000 compared to $1.2 million and $1.9 million for the likeperiods in 2009.

 

Theallowance consists of specific, general and unallocated components; (i) aspecific valuation allowance based on a review of classified or non-performingloans for specific weaknesses and evaluation of those loans for impairment andloss exposure; (ii) a general allowance which is based on historical loanloss experience for different loan types and different risk gradings withadjustments for current events and conditions. Bancorp’s process is designed to account for credit deterioration as itoccurs.  The adjustments are a result ofmanagement’s judgment about risks inherent in the portfolio and include suchfactors as loan quality trends, levels of and trends of non-accrual loans, pastdue loans, potential problem loans, criticized loan balances, net charge-offsand current economic and business conditions, among other factors and (iii) unallocatedgeneral allowances determined based on general economic conditions and otherqualitative risk factors.  Theunallocated allowance provides for other credit losses inherent in the loanportfolio that may not have been contemplated in the general and specificcomponents of the allowance. The unallocated amount is reviewed periodicallybased on trends in credit losses, the results of credit reviews and overalleconomic trends. At September 30, 2010 and December 31, 2009, thegeneral allocated reserve was $5.8 million and $5.0 million, respectively. At September 30,2010 and December 31, 2009, respectively, $601,000 and $1.2 millionrelated to loans for which there was a specific reserve. The increase in theunallocated portion of the allowance for possible loan losses during 2010 isreflective of continued recessionary economic conditions. While we strive tocarefully monitor credit quality and to identify loans that may becomenonperforming, at any time there are loans in the portfolio that could resultin losses, but that have not been identified as nonperforming or potentialproblem loans.

 

WhileBancorp believes that it uses the best information available to determine theallowance for loan losses, unforeseen market conditions could result inadjustments to the allowance for loan losses, and net income could besignificantly affected if circumstances differ substantially from theassumptions used in making the final determination.  The growth of the loan portfolio and afurther decline in the performance of the economy, in general, or a furtherdecline in real estate values in our market areas, in particular, could have anadverse impact on collectability, increase the level of non-performing loans orhave other adverse effects which alone or in aggregate could have a materialadverse effect on our business, financial condition, results of operation and cashflows which may require additional provisions to our allowance for loan losses.The ultimate recovery of loans is susceptible to future market factors beyondBancorp’s control. Additionally, loans are subject to examinations byregulators, who, based upon their judgment, may require Bancorp to makeadditional provisions or adjustments to its allowance for loan losses.

 

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Thefollowing table presents Bancorp’s allocation of the allowance for loan lossesby loan category as of the dates indicated. (dollars in thousands)

 
| ** **                                     | ** ** | **September 30, 2010** | ** ** | **December 31, 2009** | ** ** |
|------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| Commercial, industrial & agricultural |       | $                                | 1,403      |                            | $          | 1,456 |   |
| Real estate-residential & commercial  |       | 4,297                            |       | 4,013                           |       |
| Consumer                                       |       | 732                              |       | 683                             |       |
| Unallocated                                    |       | 1,066                            |       | 731                             |       |
| Total                                          |       | $                                | 7,498      |                            | $          | 6,883 |   |

 

Thefollowing table presents the activity in the allowance for loan losses for thedates indicated.

 

**Allowance for Loan LossesActivity**

 
| ** **                                                   | ** ** | **Three months ended,** | ** ** | **Nine months ended,** | ** ** |
|--------------------------------------------------------------|------------|-----------------------------------|------------|----------------------------------|------------|
| **(dollars in thousands)**                         | ** ** | **2010**                          | ** ** | **2009**                         | ** ** | **2010** | ** ** | **2009** | ** ** |
| Allowance as of beginning of period                          |       | $                                 | 7,392      |                             | $          | 5,629 |   | $ | 6,883 |   | $ | 5,450 |   |
| Provision for loan losses                                    |       | 390                               |       | 1,320                            |       | 1,310 |   | 2,220 |   |
| Charge-offs                                                  |       | (302                              | )          | (1,221                           | )          | (813 | ) | (2,031 | ) |
| Recoveries                                                   |       | 18                                |       | 70                               |       | 118 |   | 159 |   |
| Net charge-offs                                              |       | (284                              | )          | (1,151                           | )          | (695 | ) | (1,872 | ) |
| Balance at end of period                                     |       | $                                 | 7,498      |                             | $          | 5,798 |   | $ | 7,498 |   | $ | 5,798 |   |
| Ratio of net charge-offs to average loans during  the period |       | (0.30                             | )%         | (1.22                            | )%         | (0.24 | )% | (0.65 | )% |
| Ratio of allowance to net loans at end of period             |       | 1.99                              | %          | 1.54                             | %          | 1.99 | % | 1.54 | % |
| Ratio of non-performing loans to allowance                   |       | 113.00                            | %          | 184.58                           | %          | 113.00 | % | 184.58 | % |

 

***ASSET QUALITY*****    **Non-performing assetsconsist of nonaccrual loans, accruing loans past due 90 days or more, and otherreal estate owned. At September 30, 2010, non-performing assets decreasedto $14.2 million or 2.08 percent of total assets compared to $17.0 million or2.63 percent as of December 31, 2009.

 

*Non-accrual*- It is Bancorp’s policy to discontinue the accrualof interest on all loans that are 90 days or more past due or when there areotherwise serious doubts about the collectability of principal or interestwithin the existing terms of the loan and place them on non-accrual.  When a loan is placed on non-accrual status,any accrued but unpaid interest on that date is removed from interestincome.  Non-accruing loans decreased to$8.5 million as of September 30, 2010 compared to $10.7 million as of December 31,2009 with $1.4 million of the December balance transferring into otherreal estate owned during 2010. Raw land, construction, and land developmentloans are the primary components of non-performing loans representing $5.5million or 65.0% of non-performing loans as of September 30, 2010.

 

*Restructured loans* — Loans are consideredrestructured on loans for which concessions, including the reduction ofinterest rates below a rate otherwise available to that borrower or thedeferral or forgiveness, of interest or principal, have been granted due to theborrower’s weakened financial condition. Restructured loans included in impaired loans were $5.6 million as of September 30,2010, of which, $5.2 million was included in non-accrual loans.   Restructured loans included in impairedloans were $945,000 as of December 31, 2009, of which, $555,000 wasincluded in non-accrual loans.

 

*Otherreal estate owned* —   Otherreal estate owned decreased to $5.7 million at September 30, 2010 from$6.3 million at December 31, 2009. During 2010, Bancorp foreclosed on a non-accrual credit relationship of$1.4 million. In addition, Bancorp transferred the former Boulevard branch witha balance of $339,000 from other real estate owned back into bank premises foruse as the bank’s consumer loan administrative facility. During 2010, threeproperties with a total of balance of $1.2 million were sold. As of September 30,2010, Bancorp held five properties which represent three separate landdevelopment projects consisting of finished lots with a carrying balance of$3.4 million, two commercial real estate properties with a carrying balance of$2.3 million.

 

Valuationof the property occurs when it is foreclosed upon and annually thereafter.Based on current appraisals received and the decrease in fair market values ofthese real estate properties, Bancorp recorded a provision on other real estateowned of $170,000 and $435,000 for the quarter and nine months ended September 30,2010. Bancorp plans to continue its collection efforts and liquidation of collateral,as necessary, to recover as large a portion of the non-accrual assets or otherreal estate owned as possible.

 

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Thefollowing table presents non-performing asset information related to loansaccounted for on a non-accrual basis, accruing loans 90 days or more past dueand other real estate owned for the dates indicated.

 

**Non-PerformingAssets**

 
| **(dollars in thousands)**        | ** ** | **September 30, 2010** | ** ** | **December 31, 2009** | ** ** |
|---------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| Non-accrual loans                           |       | $                                | 8,473      |                            | $          | 10,742 |   |
| Loans past due 90 days or more              |       | —                           |       | —                          |       |
| Total non-performing loans                  |       | 8,473                            |       | 10,742                          |       |
| Other real estate owned                     |       | 5,688                            |       | 6,284                           |       |
| Total non-performing assets                 |       | $                                | 14,161     |                            | $          | 17,026 |   |
| Total non-performing loans to net loans     |       | 2.25                             | %          | 2.78                            | %          |
| Total non-performing loans to total assets  |       | 1.25                             | %          | 1.66                            | %          |
| Total non-performing assets to total assets |       | 2.08                             | %          | 2.63                            | %          |

 

*Impairedloans -*At September 30, 2010, impaired loans decreasedto $10.9 million compared to $24.4 million at December 31, 2009.  Four credit relationships of $6.8 million,accounted for 62.6 percent of impaired loans as of September 30, 2010.Impaired loans had specific reserve allocations of $601,000 and $1.2 million asof September 30, 2010 and December 31, 2009, respectively. Allmaterial loan restructurings have been included in impaired loans.

 

Aloan is considered impaired when management determines that it is probable thatBancorp will be unable to collect all amounts of principal and interestaccording to contractual terms. Factors considered by management in determiningimpairment include payment status, and the probability of collecting scheduledprincipal and interest payments when due. Impaired loans include loans innonaccrual status, troubled debt restructures and other loans that managementconsiders to be impaired. Other loans include loans that management hasreviewed for impairment and has determined to be impaired even though the loanmay be current and performing in accordance with the contractual loanterms.   As a result, these otherimpaired loans continue to remain on accrual status and are not considerednon-performing assets.  Loans thatexperience insignificant payment delays and payment shortfalls generally arenot classified as impaired.

 

*Potentialproblem loans* —   Potentialproblem loans consist of loans that are currently performing, are not onnonaccrual status, restructured or impaired, but for which management haveidentified as having a well defined weakness or weaknesses and which there aresufficient doubts as to the borrower’s future ability to comply with repaymentterms.  These loans are identifiedthrough our internal risk grading processes and management monitors these loansclosely and reviews their performance on a regular basis. As of September 30,2010 and December 31, 2009, Bancorp had classified $19.1 million and $8.8million, respectively, as other potential problem loans.

 

**DEPOSITS     **Bancorp offersa full range of deposit services including checking accounts, savings accounts,money market accounts and various types of certificates of deposit.  The transaction accounts and certificates ofdeposit are tailored to Bancorp’s primary market area at rates competitive withthose offered in the area. Bancorp offers both interest and non-interestbearing checking accounts. Bancorp offers deposits through Certificate ofDeposit Account Registry Service (CDARS) which allows us to assist ourcustomers in maximizing their FDIC insurance.  These deposits represent direct customer relationships with Bancorp.

 

Totaldeposits increased to $576.3 million at September 30, 2010 compared to$545.4 million at December 31, 2009. Within the total, core deposits increased $20.7 million and timedeposits increased $10.2 million.  Coredeposits, which consist of non-interest and interest bearing demand accounts,money market accounts, and saving accounts, represented 62.4 percent and 62.1percent of total deposits at September 30, 2010 and December 31, 2009,respectively.

 

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Thefollowing table presents the balance and percent of total deposits in thevarious categories of deposits offered by Bancorp as of the dates indicated.

 

**DepositComposition**

 
| ** **                           | ** ** | **September 30, 2010** | ** ** | **December 31, 2009** | ** ** |
|--------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| **(dollars in thousands)** | ** ** | **Amount**                       | ** ** | **% of Total**        | ** ** | **Amount** | ** ** | **% of Total** | ** ** |
| Non-interest bearing demand          |       | $                                | 74,445     |                            | 12.9       | % | $ | 73,839 |   | 13.5 | % |
| Interest bearing demand              |       | 99,246                           |       | 17.2                            | %          | 101,504 |   | 18.6 | % |
| Money market                         |       | 86,913                           |       | 15.1                            | %          | 77,288 |   | 14.2 | % |
| Savings                              |       | 99,065                           |       | 17.2                            | %          | 86,370 |   | 15.8 | % |
| Time                                 |       | 195,006                          |       | 33.8                            | %          | 182,441 |   | 33.4 | % |
| Brokered time deposits (CDARS)       |       | 21,661                           |       | 3.8                             | %          | 23,994 |   | 4.5 | % |
| Total deposits                       |       | $                                | 576,336    |                            | 100.0      | % | $ | 545,436 |   | 100.0 | % |

 

**OTHERBORROWINGS     **Securities sold underagreement to repurchase decreased to $34.3 million at September 30, 2010compared to $38.1 million as of December 31, 2009.  These borrowings are collateralized bysecurities with an estimated fair value exceeding the face value of theborrowings. Investment securities with a carrying amount of $43.0 million,consisting of U.S. government agency debt securities and U.S. government agencyresidential mortgage-backed securities were pledged as collateral forsecurities sold under agreement to repurchase at September 30, 2010.  Securities sold under agreement to repurchaseare overnight funds or borrowings that typically mature within one year.

 

Periodically,Bancorp uses federal funds purchased and Federal Reserve borrowings as afunding source. Bancorp had no Federal Reserve borrowings or federal fundspurchased at September 30, 2010 or December 31, 2009.

 

**CAPITALRESOURCES     **Stockholders’ equityincreased to $67.5 million at September 30, 2010 from $62.9 million at December 31,2009.  Book value per share at September 30,2010 was $114.98 compared to a book value of $107.10 at December 31, 2009.

 

Bancorphas only one class of stock, which is common stock and at September 30, 2010,there were 774 shareholders of record. 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 numberof shares of stock that will be repurchased and the price that will be paid isthe result of many factors including market and economic conditions, the numberof shares available, Bancorp’s liquidity and capital needs and regulatoryrequirements. Bancorp repurchased no shares of stock in 2010 or 2009.

 

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Bankingregulations require bank holding companies and banks to maintain certainminimum capital levels.  As the followingtable indicates as of September 30, 2010 and December 31, 2009,Skagit State Bancorp, Inc. and Skagit State Bank both exceeded thewell-capitalized requirements.

 
| ** **                                | ** ** | ** ** | ** ** | ** **                 | ** ** | ** **                 | ** ** | ** ** | ** ** | **To Be Well** | ** ** |
|-------------------------------------------|------------|------------|------------|----------------------------|------------|----------------------------|------------|------------|------------|--------------------------|------------|
| ** **                                | ** ** | ** ** | ** ** | ** **                 | ** ** | **Capitalized Under** | ** ** |
| ** **                                | ** ** | ** ** | ** ** | **For Capital**       | ** ** | **Prompt Corrective** | ** ** |
| ** **                                | ** ** | **Actual** | ** ** | **Adequacy Purposes** | ** ** | **Action Provisions** | ** ** |
| **(dollars in thousands)**      | ** ** | **Amount** | ** ** | **Ratio**                  | ** ** | **Amount**                 | ** ** | **Ratio**  | ** ** | **Amount**               | ** ** | **Ratio** | ** ** |
| As of September 30, 2010             |       |       |       |                       |       |                       |       |       |       |                     |       |   |   |
| Total Capital  (to Risk-Weighted Assets)  |       |       |       |                       |       |                       |       |       |       |                     |       |   |   |
| Skagit State Bank                         |       | $          | 69,471     |                       | 15.44      | %                          | $          | 35,988     |       | > 8.00                | %          | $ | 44,986 |   | > 10.00 | % |
| Skagit State Bancorp, Inc.           |       | $          | 69,732     |                       | 15.50      | %                          | $          | 35,999     |       | > 8.00                | %          | $ | 44,999 |   | > 10.00 | % |
| Tier I Capital  (to Risk-Weighted Assets) |       |       |       |                       |       |                       |       |       |       |                     |       |   |   |
| Skagit State Bank                         |       | $          | 63,825     |                       | 14.19      | %                          | $          | 17,994     |       | > 4.00                | %          | $ | 26,991 |   | > 6.00 | % |
| Skagit State Bancorp, Inc.           |       | $          | 64,084     |                       | 14.24      | %                          | $          | 18,000     |       | > 4.00                | %          | $ | 26,999 |   | > 6.00 | % |
| Tier I Capital  (to Average Assets)       |       |       |       |                       |       |                       |       |       |       |                     |       |   |   |
| Skagit State Bank                         |       | $          | 63,825     |                       | 9.36       | %                          | $          | 27,277     |       | > 4.00                | %          | $ | 34,096 |   | > 5.00 | % |
| Skagit State Bancorp, Inc.           |       | $          | 64,084     |                       | 9.40       | %                          | $          | 27,277     |       | > 4.00                | %          | $ | 34,096 |   | > 5.00 | % |
|                                      |       |       |       |                       |       |                       |       |       |       |                     |       |   |   |
| As of December 31, 2009              |       |       |       |                       |       |                       |       |       |       |                     |       |   |   |
| Total Capital  (to Risk-Weighted Assets)  |       |       |       |                       |       |                       |       |       |       |                     |       |   |   |
| Skagit State Bank                         |       | $          | 66,563     |                       | 14.39      | %                          | $          | 37,002     |       | > 8.00                | %          | $ | 46,252 |   | > 10.00 | % |
| Skagit State Bancorp, Inc.           |       | $          | 66,783     |                       | 14.43      | %                          | $          | 37,021     |       | > 8.00                | %          | $ | 46,276 |   | > 10.00 | % |
| Tier I Capital  (to Risk-Weighted Assets) |       |       |       |                       |       |                       |       |       |       |                     |       |   |   |
| Skagit State Bank                         |       | $          | 60,768     |                       | 13.14      | %                          | $          | 18,501     |       | > 4.00                | %          | $ | 27,751 |   | > 6.00 | % |
| Skagit State Bancorp, Inc.           |       | $          | 60,985     |                       | 13.18      | %                          | $          | 18,510     |       | > 4.00                | %          | $ | 27,765 |   | > 6.00 | % |
| Tier I Capital  (to Average Assets)       |       |       |       |                       |       |                       |       |       |       |                     |       |   |   |
| Skagit State Bank                         |       | $          | 60,768     |                       | 9.74       | %                          | $          | 24,959     |       | > 4.00                | %          | $ | 31,199 |   | > 5.00 | % |
| Skagit State Bancorp, Inc.           |       | $          | 60,985     |                       | 9.77       | %                          | $          | 24,959     |       | > 4.00                | %          | $ | 31,199 |   | > 5.00 | % |

 

**LIQUIDITY**

 

Themajority of our funding comes from customer deposits within the Bank’s marketarea. In addition, funding needs are met through loan repayments, investmentsecurities repayments, earnings and other borrowings through pre-approvedcredit lines. As of September 30, 2010 Bancorp had approximately $47.0million in approved unsecured credit lines from various financial institutionsand had securities with a market value of $40.0 million pledged as collateralfor borrowing at the Federal Reserve Discount Window, and unpledged marketablesecurities with a market value of $54.3 million available for funding needs.

 

Becausethe Bank’s primary sources and uses of funds are deposits and loans, therelationship between net loans and total deposits provides one measure of theBank’s liquidity.  The Bank’s loan todeposit ratio decreased to 65.4 percent at September 30, 2010 compared to70.9 percent at December 31, 2009, as a result of the increase in depositsand the decrease in loans.

 

SkagitState Bancorp, Inc. is a separate legal entity from the Bank and mustprovide for its own liquidity. Substantially all of Bancorp’s revenues are obtained from dividendsdeclared and paid by the Bank. Skagit State Bank’s ability to pay dividends islimited by its earnings, financial condition and capital requirements, as wellas regulatory restrictions.

 

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**Item 3.**    **QUANTITATIVE AND QUALITATIVEDISCLOSURES 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 sheet, to reviewprojected earnings trends, and to formulate strategies consistent with theseobjectives for liquidity, interest rate risk, and capital adequacy.

 

Bancorpbelieves that there have not been any material changes about Bancorp’s marketrisk from the information that was provided in the Form 10-K for the yearended December 31, 2009.

 

**Item 4.**           **CONTROLS AND PROCEDURES**

 

Evaluationof Disclosure Controls and Procedures

 

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

 

Changesin Internal Controls

 

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

 

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

 

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

 

Fromtime to time, Bancorp may be a plaintiff and/or defendant in certain claims andlegal actions arising in the ordinary course of commercial banking involvingreal estate lending transactions and other ordinary routine litigationincidental to the business of Bancorp. Bancorp is not a party to any pending legal proceedings that Bancorpbelieves would have a material adverse effect on the financial condition ofBancorp.

 

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

 

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

 

**Wecannot accurately predict the effect of the national economic situation onBancorp’s future results of operations.**

 

Thenational economy and the financial services sector in particular are currentlyfacing challenges of a scope unprecedented in recent history.  The Company cannot accurately predict theseverity or duration of the current economic downturn, which has adverselyimpacted the markets we serve.  Anyfurther deterioration in the economies of the nation as a whole or in ourmarkets would have an adverse effect, which could be material, on our business,financial condition, results of operations and prospects.  While it is impossible to predict how longthese conditions may exist, the economic downturn could continue to presentrisks for some time for the industry and our company.

 

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

 

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Realestate related loans, including those loans that are collateralized by realestate, comprise the largest category of loans, representing 75.8 percent ofBancorp’s total loans.  Our real estate portfolio consists of commercial and residentiallending.  These loans are secured by property such as office buildings,commercial business properties, healthcare buildings, agricultural land, timberland and residential properties.  Commercial and commercial real estateloans generally are viewed as having more risk of default than residential realestate loans or certain other types of loans or investments.  Typically,these types of loans are larger than residential real estate loans and otherloans.  Because the loan portfolio contains a number of commercial realestate loans with relatively large balances, the deterioration of one or a fewof these loans may cause a significant increase in nonperforming loans. An increase in nonperforming loans could result in a loss of earnings fromthese loans, an increase in the provision for loan losses or an increase inloan charge-offs, which could have an adverse impact on our results ofoperations and financial condition.

 

There has been an economic downturn throughout thecountry, particularly in the housing and commercial real estate sectors. While the Pacific Northwest economy typically lags the national economy, theeffects of the economic downturn are now significantly impacting our marketarea.  Further downturn in the market areas we serve may cause us to havelower earnings and could increase our credit risk associated with our loanportfolio, as the collateral securing those loans may decrease in value. A continued downturn in the local economy could have a material adverse effecton both the ability of borrowers to repay loans, as well as the value of thereal property held as collateral.  Substantially all of our loans are tobusinesses and individuals in Skagit, Snohomish or Whatcom Counties and anydecline in the economy of this market area could impact us adversely.  Asa lender, we are exposed to the risk that our customers will be unable to repaytheir loans in accordance with their terms, and that any collateral securingthe payment of their loans may not be sufficient to assure repayment.

 

**Ourallowance for loan losses may not be adequate to cover actual loan losses,which could adversely affect our earnings.**

 

Bancorpmaintains an allowance for loan losses in an amount that we believe is adequateto provide for losses inherent in the portfolio.  While we strive tocarefully manage and monitor credit quality and to identify loans that maybecome nonperforming, at any time there are loans included in the portfoliothat will result in losses, but that have not been identified as nonperformingor potential problem loans.  By closely monitoring our creditquality, we attempt to identify deteriorating loans before they becomenonperforming assets and adjust the loan loss reserveaccordingly.  However, because future events are uncertain, and ifthe economy continues to deteriorate, there may be loans that deteriorate to anonperforming status in an accelerated time frame.  As a result,future additions to the allowance may be necessary.  Because the loanportfolio contains a number of loans with relatively large balances, thedeterioration of one or a few of these loans may cause a significant increasein nonperforming loans, requiring an increase to the loan lossallowance.  As a result, future additions to the allowance atelevated levels may be required based on changes in the mix of loans comprisingthe portfolio, changes in the financial condition of borrowers, such as mayresult from changes in economic conditions, or as a result of incorrectassumptions by management in determining theallowance.  Additionally, banking regulators, as an integral part oftheir supervisory function, periodically review our loan portfolio and theadequacy of our allowance for loan losses.  These regulatory agenciesmay require us to recognize further loan loss provisions or charge-offs basedupon their judgments, which may be different from ours.  Any increasein the allowance for loan losses could have a negative effect on our financialcondition and results of operation.

 

**A continued tightening of the credit markets may make itdifficult to obtain adequate funding for loan growth, which could adverselyaffect our earnings.**

 

A continued tightening of the credit markets and theinability to obtain or retain adequate funds for continued loan growth at anacceptable cost may negatively affect our asset growth and liquidity positionand, therefore, our earnings capability.  In addition to core depositgrowth, maturity of investment securities and loan payments, Bancorp alsorelies on alternative funding sources through correspondent banking, andborrowing lines with the Federal Reserve Bank to fund loans.  In the eventthe current economic downturn continues, particularly in the housing market,these resources could be negatively affected, both as to price andavailability, which would limit and or raise the cost of the funds available toBancorp.

 

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**Fluctuating interest rates can adversely affect Bancorp’sprofitability**

 

Bancorp’s profitability and cash flows are dependentto a large extent upon net interest income. Net interest income is thedifference (or “spread”) between the interest earned on loans, securities andother interest-earning assets and Bancorp’s cost of funds, primarily interestexpense on deposits and borrowings. Interest rates are highly sensitive to manyfactors that are beyond our control including, but not limited to, generaleconomic conditions, and policies of various governmental and regulatoryagencies. Changes in monetary policy, including changes in interest rates,impact the level of loans, deposits and investments, the credit profile ofexisting loans and the rates received on loans and investment securities andthe rates paid on deposits and borrowings. If the interest paid on depositsincreases at a faster rate than the interest received on loans and investmentsecurities, Bancorp’s net interest income, and therefore earnings could beadversely affected.  Earnings could also be adversely affected if interestreceived on loans and investments decrease faster than interest paid ondeposits.

 

**Competition in our market area may limit Bancorp’s futuresuccess**

 

Commercialbanking is a highly competitive business. Bancorp competes with other commercial banks, savings and loanassociations, credit unions and finance companies operating in our marketarea.  We are subject to substantialcompetition for loans and deposits from other financial institutions.  Some of our competitors are not subject tothe same degree of regulation and restriction as we are.  Some of our competitors have greaterfinancial resources than we do.  Wecompete for funds with other financial institutions that, in most cases, arelarger and able to provide a greater variety of services than we do and thusmay obtain deposits at lower rates of interest. If we are unable to effectively compete in our market area, our businessand results of operations could be adversely affected.

 

**We operate in a highly regulated environment and changes ofor increases in, or supervisory enforcement of, banking or other laws andregulations or governmental fiscal or monetary policies could adversely affectus.**

 

Bancorp is subject to extensive regulation,supervision and examination by federal and state banking authorities. Inaddition, as a publicly-traded company, Bancorp is subject to regulation by theSecurities and Exchange Commission. Any change in applicable regulations orfederal, state or local legislation or in policies or interpretations orregulatory approaches to compliance and enforcement, income tax laws andaccounting principles could have a substantial impact on Bancorp and itsoperations. Changes in laws and regulations may also increase Bancorp’sexpenses by imposing additional fees or taxes or restrictions on itsoperations. Additional legislation and regulations that could significantlyaffect Bancorp’s powers, authority and operations may be enacted or adopted inthe future, which could have a material adverse effect on Bancorp’s financialcondition and results of operations. Failure to appropriately comply with anysuch laws, regulations or principles could result in sanctions by regulatoryagencies or damage to Bancorp’s reputation, all of which could adversely affectour business, financial condition or results of operations.

 

In that regard, sweeping financial regulatory reformlegislation was enacted in July 2010. Among other provisions, the new legislation (i) creates a new Bureau ofConsumer Financial Protection with broad powers to regulate consumer financialproducts such as credit cards and mortgages, (ii) creates a FinancialStability Oversight Council comprised of the heads of other regulatoryagencies, (iii) will lead to new capital requirements from federal bankingagencies, (iv) places new limits on electronic debt card interchange fees,and (v) will require the Securities and Exchange Commission and national stockexchanges to adopt significant new corporate governance and executivecompensation reforms.  The newlegislation and regulations are expected to increase the overall costs ofregulatory compliance.

 

Further, regulators have significant discretion andauthority to prevent or remedy unsafe or unsound practices or violations oflaws or regulations by financial institutions and holding companies in theperformance of their supervisory and enforcement duties. Recently, these powershave been utilized more frequently due to the serious national, regional andlocal economic conditions we are facing. The exercise of regulatory authoritymay have a negative impact on Bancorp’s financial condition and results ofoperations. Additionally, Bancorp’s business is affected significantly by thefiscal and monetary policies of the U.S. federal government and its agencies,including the Federal Reserve Board.

 

Bancorp cannot accurately predict the full effects ofrecent legislation or the various other governmental, regulatory, monetary andfiscal initiatives which have been and may be enacted on the financial markets,on Bancorp and on the Bank. The terms and costs of these activities, or thefailure of these actions to help stabilize the financial markets, asset prices,market liquidity and a continuation or worsening of current financial marketand economic conditions could materially and adversely affect our business,financial condition, results of operations, and the trading price of our commonstock.

 

**Ourability to access markets for funding and acquire and retain customers could beadversely affected by the deterioration of other financial institutions or tothe extent the financial service industry’s reputation is damaged.**

 

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Reputation risk is the risk to liquidity, earnings andcapital arising from negative publicity regarding the financial servicesindustry.  The financial services industry continues to be featured innegative headlines about the global and national credit crisis and theresulting stabilization legislation enacted by the U.S. federal government. These reports can be damaging to the industry’s image and potentially erodeconsumer confidence in insured financial institutions, such as our bankingsubsidiary.  In addition, our ability to engage in routine funding andother transactions could be adversely affected by the actions and financialcondition of other financial institutions. Financial services institutions areinterrelated as a result of trading, clearing, counterparty or otherrelationships. As a result, defaults by, or even rumors or questions about, oneor more financial services institutions, or the financial services industrygenerally, could lead to market-wide liquidity problems, losses of depositor,creditor and counterparty confidence and could lead to losses or defaults by usor by other institutions. We could experience material changes in the level ofdeposits as a direct or indirect result of other banks’ difficulties orfailure, which could affect the amount of capital we need.

 

**The FDIC has increased insurance premiums to restore and maintain thefederal deposit insurance fund, and there may be additional future premiumincreases and special assessments.**

 

The FDIC recently adopted anew deposit insurance fund restoration plan to ensure that the fund reserveratio reaches 1.35 percent by September 30, 2020, as required by financialreform legislation passed in 2010.

 

The FDIC has requiredinsured institutions to prepay estimated quarterly risk-based assessments forthe fourth quarter of 2009 and for 2010, 2011 and 2012, and. The prepayment wascollected on December 30, 2009, and was accounted for as a prepaid expenseamortized over the prepayment period. In 2009, the FDIC also adopted a final rule revisingits risk-based assessment system, which became effective April 1, 2009.The changes to the assessment system involve adjustments to the risk-basedcalculation of an institution’s unsecured debt, secured liabilities andbrokered deposits.

 

The FDIC imposed a specialdeposit insurance assessment of five basis points on all insured institutionsin 2009. This emergency assessment was calculated based on the insuredinstitution’s assets at June 30, 2009, and collected on September 30,2009. Based on our June 30, 2009 assets subject to the FDIC assessment,the special assessment was approximately $260,000. This special assessment wasin addition to the regular quarterly risk-based assessment.

 

Despite the FDIC’s recentlyadopted plan to restore the deposit insurance fund, the fund may sufferadditional losses in the future due to unexpected bank failures. There can beno assurance that there will not be additional significant deposit insurancepremium increases, special assessments or prepayments in order to restore theinsurance fund’s reserve ratio. Any significant premium increases, special assessmentsor prepayment requirements could have a material adverse effect on ourfinancial condition and results of operations.

 

**There is little trading activity in Bancorp’s stock**

 

Thereis no active market for our outstanding shares, and it is unlikely that anestablished market for our shares will develop in the near future.  We presently do not intend to seek listing ofthe shares on any securities exchange. It is not known whether significant trading activity will take place forseveral years, if at all.  Accordingly,our shares should be considered as a long-term investment.

 

**Thereare restrictions on changes in control of Bancorp that could decrease ourshareholders’ chance to realize a premium on their shares.**

 

Provisionsin our Articles of Incorporation include a staggered Board of Directors, andnon-monetary factor provisions and an affirmative vote of two-thirds of shares(entitled to be counted) to approve an interested shareholder transaction, anyor all of which could have the effect of hindering, delaying or preventing atakeover bid.

 

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

 

None

 

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

 

None

 

**Item 4.**                    **Removedand Reserved**

 

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**

 

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

 

 
|   |                   | SKAGIT  STATE BANCORP, INC.                  |
|--------|------------------------|---------------------------------------------------|
|   |                   | (Registrant)                                      |
|   |                   |                                              |
|   |                   |                                              |
| Dated: | November 9,  2010 |                                              | /s/  Cheryl R. Bishop |
|   |                   | Cheryl  R. Bishop                                 |
|   |                   | President  and Chief Executive Officer            |
|   |                   |                                              |
|   |                   |                                              |
| Dated: | November 9,  2010 |                                              | /s/  Carla F. Tucker |
|   |                   | Carla  F. Tucker                                  |
|   |                   | Executive  Vice-President Chief Financial Officer |

 

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