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**UNITED STATES SECURITIES AND EXCHANGE COMMISSION**

**Washington D.C., 20549**

** **

**FORM 10-Q**

 
| **x**                                                    | ** ** | **Quarterly Report Pursuant to   Section 13 or 15(d) of the Securities Exchange Act of 1934** |
|----------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------|
| ** **                                               |
| **For the quarterly period ended March 31,   2011** |
| ** **                                               |
| **o**                                                    | ** ** | **Transition Report Under   Section 13 or 15(d) of the Exchange Act**                         |

 

**For the transition period from                         to                        **

 

**Commission File Number  000-52096**

 

**SKAGIT STATE BANCORP, INC.**

(Exact Name of Registrant as Specified in Its Charter)

 

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

 

**301 East Fairhaven Avenue**

**Burlington, Washington  98233**

(Address of Principal Executive Offices) (Zip Code)

 

**(360) 755-0411**

(Registrant’s Telephone Number, Including Area Code)

 

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

 

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

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated 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 (as defined in Rule 12b-2 of the Exchange  Yes o   No x

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:

 

The number of shares of the issuer’s Common Stock outstanding at May 4th, 2011 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 March 31, 2011   and December 31, 2010                                                                   | Page 3 |
|              |                        |                                                                                                                                                |   |
|              |                        | Consolidated Statement of Income for the three months   ended March 31, 2011 and 2010                                                          | Page 4 |
|              |                        |                                                                                                                                                |   |
|              |                        | Consolidated Statement of Changes in Stockholders’   Equity and Comprehensive Income for the three months ended March 31,   2011 and 2010 | Page 5 |
|              |                        |                                                                                                                                                |   |
|              |                        | Consolidated   Statement of Cash Flows for the three months ended March 31, 2011 and   2010                                                    | Page 6 |
|              |                        |                                                                                                                                                |   |
|              |                        | Notes to   Consolidated Financial Statements                                                                                                        | Pages 7-25 |
|              |                        |                                                                                                                                                |   |
|              | Item 2.                     | Management’s   Discussion and Analysis of Financial Condition and Results of Operations                                                        | Pages 25-36 |
|              |                        |                                                                                                                                                |   |
|              | Item 3.                     | Quantitative   and Qualitative Disclosures About Market Risk                                                                                        | Page 36 |
|              |                        |                                                                                                                                                |   |
|              | Item 4.                     | Controls and   Procedures                                                                                                                           | Page 36 |
|              |                        |                                                                                                                                                |   |
| **PART II.** | **OTHER INFORMATION**       |                                                                                                                                                |
|              |                        |                                                                                                                                                |   |
|              | Item 1.                     | Legal Proceedings                                                                                                                                   | Page 36 |
|              |                        |                                                                                                                                                |   |
|              | Item 1 A.                   | Risk Factors                                                                                                                                        | Page 36-40 |
|              |                        |                                                                                                                                                |   |
|              | Item 2.                     | Unregistered   Sales of Equity Securities and Use of Proceeds                                                                                       | Page 40 |
|              |                        |                                                                                                                                                |   |
|              | Item 3.                     | Defaults   Upon Senior Securities                                                                                                                   | Page 40 |
|              |                        |                                                                                                                                                |   |
|              | Item 4.                     | Removed and Reserved                                                                                                                                | Page 40 |
|              |                        |                                                                                                                                                |   |
|              | Item 5.                     | Other Information                                                                                                                                   | Page 40 |
|              |                        |                                                                                                                                                |   |
|              | Item 6.                     | Exhibits                                                                                                                                            | Page 40 |
|              |                        |                                                                                                                                                |   |
|              |                        | Signatures                                                                                                                                          | Page 41 |

 

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**Item 1. ****    ****Financial Statements**

 

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

**CONSOLIDATED BALANCE SHEET (Unaudited)**

 
| **(dollars in thousands except share data)**                                                                                                        | ** ** | **March 31, 2011** | ** ** | **December 31, 2010** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|---------------------------------|------------|
| **ASSETS**                                                                                                                                                                   |
| **ASSETS**                                                                                                                                                                   | ** ** | ** **                   | ** ** | ** **                      | ** ** |
| Cash and due from banks                                                                                                                                                      |       | $                            | 10,759     |                            | $          | 10,461 |   |
| Federal funds sold                                                                                                                                                           |       | 71,167                       |       | 80,413                          |       |
| Investment securities                                                                                                                                                        |       |                         |       |                            |       |
| Available-for-sale, at fair value                                                                                                                                            |       | 214,516                      |       | 180,971                         |       |
| Held-to-maturity, at amortized cost                                                                                                                                          |       | 38,308                       |       | 38,367                          |       |
| Loans held for sale                                                                                                                                                          |       | —                       |       | 78                              |       |
| Loans                                                                                                                                                                        |       | 358,968                      |       | 365,319                         |       |
| Allowance for loan losses                                                                                                                                                    |       | (7,346                       | )          | (7,079                          | )          |
| Net loans                                                                                                                                                                    |       | 351,622                      |       | 358,240                         |       |
| Bank premises and equipment, net                                                                                                                                             |       | 10,671                       |       | 10,772                          |       |
| Other real estate owned                                                                                                                                                      |       | 4,334                        |       | 5,813                           |       |
| Accrued interest receivable                                                                                                                                                  |       | 2,400                        |       | 2,521                           |       |
| Other assets                                                                                                                                                                 |       | 5,349                        |       | 5,235                           |       |
| **TOTAL ASSETS**                                                                                                                                                             |       | $                            | 709,126    |                            | $          | 692,871 |   |
| ** **                                                                                                                                                                   |       |                         |       |                            |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                |
| **LIABILITIES**                                                                                                                                                              |       |                         |       |                            |       |
| Deposits                                                                                                                                                                     |       |                         |       |                            |       |
| Interest-bearing                                                                                                                                                             |       | $                            | 527,956    |                            | $          | 511,782 |   |
| Non-interest-bearing                                                                                                                                                         |       | 78,372                       |       | 79,099                          |       |
| Total deposits                                                                                                                                                               |       | 606,328                      |       | 590,881                         |       |
| Other borrowings                                                                                                                                                             |       | 34,464                       |       | 34,118                          |       |
| Other liabilities                                                                                                                                                            |       | 1,472                        |       | 1,900                           |       |
| Total liabilities                                                                                                                                                            |       | 642,264                      |       | 626,899                         |       |
| **COMMITMENTS AND CONTINGENCIES**(Note 8)                                                                                                                                    |       |                         |       |                            |       |
|                                                                                                                                                                         |       |                         |       |                            |       |
| **STOCKHOLDERS’ EQUITY**                                                                                                                                                |       |                         |       |                            |       |
| Common stock no par value, 5,000,000 shares   authorized, 587,639 and 587,377 shares issued and outstanding at   March 31, 2011 and December 31, 2010 respectively |       | 12,601                       |       | 12,541                          |       |
| Accumulated other comprehensive income, net of tax                                                                                                                           |       | 1,494                        |       | 1,639                           |       |
| Retained earnings                                                                                                                                                            |       | 52,767                       |       | 51,792                          |       |
| Total stockholders’ equity                                                                                                                                              |       | 66,862                       |       | 65,972                          |       |
| **TOTAL LIABILITIES AND   STOCKHOLDERS’ EQUITY**                                                                                                                        |       | $                            | 709,126    |                            | $          | 692,871 |   |

 

*See accompanying notes to these consolidated financial statements*

 

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

**CONSOLIDATED STATEMENT OF INCOME (Unaudited)**

 
| ** **                                                                     | ** ** | **Three months ended March 31,** | ** ** |
|--------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| **(dollars in thousands except per share data)** | ** ** | **2011**                                             | ** ** | **2010** | ** ** |
| ** **                                                                     |       |                                                 |       |   |   |
| **INTEREST INCOME**                                                            |       |                                                 |       |   |   |
| Interest and fees on loans                                                     |       | $                                                    | 4,905      |   | $ | 5,640 |   |
| Investment securities                                                          |       |                                                 |       |   |   |
| Taxable                                                                        |       | 1,108                                                |       | 1,018 |   |
| Exempt from federal income tax                                                 |       | 257                                                  |       | 274 |   |
| Federal funds sold                                                             |       | 52                                                   |       | 49 |   |
| Total interest income                                                          |       | 6,322                                                |       | 6,981 |   |
| **INTEREST EXPENSE**                                                           |       |                                                 |       |   |   |
| Deposits                                                                       |       | 1,180                                                |       | 1,520 |   |
| Other borrowings                                                               |       | 74                                                   |       | 82 |   |
| Total interest expense                                                         |       | 1,254                                                |       | 1,602 |   |
| **NET INTEREST INCOME**                                                        |       | 5,068                                                |       | 5,379 |   |
| Provision for loan losses                                                      |       | 325                                                  |       | 550 |   |
| **NET INTEREST INCOME AFTER PROVISION   FOR LOAN LOSSES**                      |       | 4,743                                                |       | 4,829 |   |
| **NON-INTEREST INCOME**                                                        |       |                                                 |       |   |   |
| Service charges on deposits                                                    |       | 787                                                  |       | 713 |   |
| Other                                                                          |       | 175                                                  |       | 181 |   |
| Gains on sale of assets and loans                                              |       | 78                                                   |       | 51 |   |
| Total non-interest income                                                      |       | 1,040                                                |       | 945 |   |
| **NON-INTEREST EXPENSES**                                                      |       |                                                 |       |   |   |
| Salaries                                                                       |       | 1,860                                                |       | 1,905 |   |
| Payroll taxes and employee benefits                                            |       | 475                                                  |       | 496 |   |
| Provision for other real estate owned losses                                   |       | 213                                                  |       | 20 |   |
| Bank premises and equipment                                                    |       | 187                                                  |       | 228 |   |
| Occupancy                                                                      |       | 182                                                  |       | 197 |   |
| Loan collection and OREO expenses                                              |       | 135                                                  |       | 91 |   |
| Advertising                                                                    |       | 220                                                  |       | 157 |   |
| Deposit Insurance                                                              |       | 246                                                  |       | 230 |   |
| Other                                                                          |       | 1,074                                                |       | 1,023 |   |
| Total non-interest expenses                                                    |       | 4,592                                                |       | 4,347 |   |
| **INCOME BEFORE PROVISION FOR   INCOME TAX**                                   |       | 1,191                                                |       | 1,427 |   |
| **PROVISION FOR INCOME TAX**                                                   |       |                                                 |       |   |   |
| Provision for income tax                                                       |       | 216                                                  |       | 218 |   |
| **NET INCOME**                                                                 |       | $                                                    | 975        |   | $ | 1,209 |   |
| **BASIC EARNINGS PER SHARE**                                                   |       | $                                                    | 1.66       |   | $ | 2.06 |   |
| **DILUTED EARNINGS PER SHARE**                                                 |       | $                                                    | 1.66       |   | $ | 2.05 |   |

 

*See accompanying notes to these consolidated financial statements*

 

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** **

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

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

* *

Three months ended March 31, 2011 and 2010

 
| ** **                                                                                            | ** ** | ** **            | ** ** | ** **        | ** ** | **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,   2010                                                                    |       | 586,905               |       | $                 | 12,303     |                  | $          | 1,872                  |       | $                 | 48,682     |       | $          | 62,857 |   |   |   |
| Comprehensive income:                                                                                 |       |                  |       |              |       |                  |       |                   |       |              |       |       |       |
| Net income                                                                                            |       | —                |       | —            |       | —                |       | 1,209                  |       | 1,209             |       | $          | 1,209      |   |
| Other comprehensive income:                                                                           |       |                  |       |              |       |                  |       |                   |       |              |       |       |       |
| Unrealized gains on available-for-sale securities,   net of taxes of $284                             |       | —                |       | —            |       | 552                   |       | —                 |       | 552               |       | 552        |       |
| Total other comprehensive income                                                                      |       |                  |       |              |       |                  |       |                   |       |              |       | 552        |       |
| Comprehensive income                                                                                  |       |                  |       |              |       |                  |       |                   |       |              |       | $          | 1,761      |   |
| Stock compensation expense and restricted stock   awards                                              |       | 289                   |       | 64                |       | —                |       | —                 |       | 64                |       |       |       |
| **BALANCE,**March 31,   2010                                                                     |       | 587,194               |       | $                 | 12,367     |                  | $          | 2,424                  |       | $                 | 49,891     |       | $          | 64,682 |   |   |   |
|                                                                                                  |       |                  |       |              |       |                  |       |                   |       |              |       |       |       |
| **BALANCE,**January 1,   2011                                                                    |       | 587,377               |       | $                 | 12,541     |                  | $          | 1,639                  |       | $                 | 51,792     |       | $          | 65,972 |   |   |   |
| Comprehensive income:                                                                                 |       |                  |       |              |       |                  |       |                   |       |              |       |       |       |
| Net income                                                                                            |       | —                |       | —            |       | —                |       | 975                    |       | 975               |       | $          | 975        |   |
| Other comprehensive income:                                                                           |       |                  |       |              |       |                  |       |                   |       |              |       |       |       |
| Unrealized losses on available-for-sale securities,   net of tax benefit of $75                       |       | —                |       | —            |       | (145                  | )          | —                 |       | (145              | )          | (145       | )          |
| Total other comprehensive income                                                                      |       |                  |       |              |       |                  |       |                   |       |              |       | (145       | )          |
| Comprehensive income                                                                                  |       |                  |       |              |       |                  |       |                   |       |              |       | $          | 830        |   |
| Stock compensation expense and restricted stock   awards                                              |       | 262                   |       | 60                |       | —                |       | —                 |       | 60                |       |       |       |
| **BALANCE,**March 31,   2011                                                                     |       | 587,639               |       | $                 | 12,601     |                  | $          | 1,494                  |       | $                 | 52,767     |       | $          | 66,862 |   |   |   |

 

*See accompanying notes to these consolidated financial statements*

 

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

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

 
| **(dollars in thousands)**                                                                         | ** ** | ** ** | ** ** | ** ** | ** ** |
|--------------------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| **Three months ended March 31,**                                                         | ** ** | **2011**   | ** ** | **2010**   | ** ** |
| **CASH FLOWS FROM OPERATING   ACTIVITIES**                                                                   |       |       |       |       |       |
| Net income                                                                                                   |       | $          | 975        |       | $          | 1,209 |   |
| *Adjustments to reconcile net   income to net cash flows from operating activities*                          |       |       |       |       |       |
| Provision for loan losses                                                                                    |       | 325        |       | 550        |       |
| Provision for other real estate owned losses                                                                 |       | 213        |       | 20         |       |
| Depreciation                                                                                                 |       | 156        |       | 212        |       |
| Gains on sale of other real estate owned                                                                     |       | (18        | )          | —     |       |
| Gains on loans held for sale                                                                                 |       | (60        | )          | (51        | )          |
| Amortization of investment security premiums and   discounts, net                                            |       | 91         |       | (29        | )          |
| Stock compensation for employee services                                                                     |       | 60         |       | 64         |       |
| *Changes in operating assets and   liabilities*                                                              |       |       |       |       |       |
| Originations of loans held for sale                                                                          |       | (2,256     | )          | (3,976     | )          |
| Proceeds from sales of loans held for sale                                                                   |       | 2,394      |       | 3,940      |       |
| Decrease in interest receivable                                                                              |       | 121        |       | 145        |       |
| Increase in other assets                                                                                     |       | (39        | )          | (167       | )          |
| (Decrease) increase in other liabilities                                                                     |       | (428       | )          | 148        |       |
| Net cash flows from operating activities                                                                     |       | 1,534      |       | 2,065      |       |
| **CASH FLOWS FROM INVESTING   ACTIVITIES**                                                                   |       |       |       |       |       |
| Proceeds from maturities, calls, and principal   payments of investment securities — available-for-sale |       | 13,417     |       | 8,697      |       |
| Purchases of investment securities —   available-for-sale                                               |       | (47,274    | )          | (5,000     | )          |
| Proceeds from maturities, calls, and principal   payments of investment securities — held-to-maturity   |       | 61         |       | 1,032      |       |
| Purchases of investment securities —   held-to-maturity                                                 |       | —     |       | (1,457     | )          |
| Net (increase) decrease in federal funds sold                                                                |       | 9,246      |       | (31,558    | )          |
| Net decrease in loans                                                                                        |       | 7,576      |       | 2,503      |       |
| Purchase of premises and equipment                                                                           |       | (55        | )          | (97        | )          |
| Net cash flows from investing activities                                                                     |       | (17,029    | )          | (25,880    | )          |
| **CASH FLOWS FROM FINANCING   ACTIVITIES**                                                                   |       |       |       |       |       |
| Net increase in demand deposits, money market, NOW   and savings accounts                                    |       | 20,546     |       | 13,884     |       |
| Net increase (decrease) in time deposits                                                                     |       | (5,099     | )          | 8,542      |       |
| Net increase (decrease) in other borrowings                                                                  |       | 346        |       | (2,950     | )          |
| Net cash flows from financing activities                                                                     |       | 15,793     |       | 19,476     |       |
| **NET CHANGE IN CASH AND DUE FROM   BANKS**                                                                  |       | 298        |       | (4,339     | )          |
| **CASH AND DUE FROM BANKS,**beginning of   period                                                            |       | 10,461     |       | 14,441     |       |
| **CASH AND DUE FROM BANKS,** end of   period                                                                 |       | $          | 10,759     |       | $          | 10,102 |   |
| **SUPPLEMENTAL DISCLOSURES OF CASH   FLOW INFORMATION**                                                      |       |       |       |       |       |
| Cash paid during the period for income taxes                                                                 |       | $          | —     |       | $          | 375 |   |
| Cash paid during the period for interest                                                                     |       | $          | 1,273      |       | $          | 1,663 |   |
| **NONCASH FINANCING AND INVESTING   TRANSACTIONS**                                                           |       |       |       |       |       |
| Property taken in settlement of loans                                                                        |       | $          | 126        |       | $          | 1,419 |   |
| Property sold through seller financing                                                                       |       | $          | 1,409      |       | $          | — |   |

 

* See accompanying notes to these consolidated financial statements*

 

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

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

**Note 1:****        ****SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

*** ***

***Financial Statement Presentation:***The accompanying consolidated financial statements include the accounts of Skagit State Bancorp, Inc. and its subsidiary Skagit State Bank, (collectively, “Company” or “Bancorp”). All significant inter-company accounts and transactions have been eliminated. The consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America for interim financial information and with instructions to Form 10-Q. Accordingly they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three months ended March 31, 2011 are not necessarily indicative of the results anticipated for the year ending December 31, 2011. For additional information, refer to the audited financial statements and footnotes for the most recent annual period ended December 31, 2010 contained in the Annual Report on Form 10-K.  All dollar amounts in tables, except share and per share information, are stated in thousands.

 

***Critical Accounting Policies:*** Bancorp’s financial statements are based upon the selection and application of significant accounting policies which by their nature are inherently subject to estimation techniques, valuation assumptions and other subjective assessments. Bancorp considers accounting estimates to be critical to reported financial results if (i) the accounting estimate requires management to make assumptions about matters that are highly uncertain and (ii) different estimates that management reasonably could have used for the accounting estimate in the current period, or changes in the accounting estimate that are reasonably likely to occur from period to period, could have a material impact on Bancorp’s consolidated financial statements. Management has identified specific accounting policies that due to judgments, estimates and assumptions and economic assumptions which may prove inaccurate or are subject to variation that may significantly affect our reported results of operations and financial positions for the periods presented or in future periods.  These policies relate to the determination of the allowance for loan losses, deferred income taxes and the valuation of real estate owned and investment securities. These policies and the judgments, estimates and assumptions are described in the Annual Report on Form 10-K for the year ended December 31, 2010.

 

***Reclassifications:*** Certain reclassifications have been made to the 2010 financial statements to conform to the 2011 presentation. Such classifications have no affect on net income.

 

***Subsequent Events:*** Subsequent events are events or transactions that occur after the balance sheet date, but before financial statements are issued.  Recognized subsequent events are events or transactions that provide additional evidence about conditions that existed at the date of the balance sheet.  Non-recognized subsequent events are events that provided evidence about conditions that did not exist at the date of the balance sheet, but arose after that date. Bancorp has evaluated subsequent events for potential recognition or disclosure through the date the financial statements were issued.

 

***Loans Held-for-Sale:***Loans originated and intended for sale are carried at the lower of aggregate cost or fair value. Gains and losses on sales of mortgage loans are recognized on the difference between the selling price and the carrying value of the related mortgage loans sold.

 

***Loans:***Loans are reported at their outstanding principal balance adjusted for any charge-offs, the allowance for loan losses, and any deferred fees or costs. Interest income is accrued on the unpaid principal balance. Loan origination fees including commitment fees and direct loan origination costs are capitalized and the net amount is amortized into interest income as an adjustment to the loan yield.

 

*Risk-Rating System:* The Bank risk rates the commercial loan portfolio on a nine scale system and the Bank’s consumer loans are risk rated on a four scale system. Risk ratings in both scales are based on levels of risk as defined by the internal risk rating guidance within the Bank’s Loan Policy.  A commercial loan’s risk rating may change as risk factors change throughout the life of the loan.  In contrast, consumer loan ratings are based on an individual borrower’s overall credit history at loan origination and are therefore, primarily based on payment performance. Consumer loans retain their original risk rating during the life of the loan, unless payment performance or other information indicates the loans should be moved to nonaccrual, at which time the loan is risk rated substandard.  Risk ratings are reviewed through various channels including the loan approval process, the loan reporting process, an external loan review process and through the regulatory review process. For risk-rating purposes, commercial, commercial real estate, other real estate and real estate construction segments are typically graded using the commercial risk ratings.

 

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*Impairment:* A loan is considered impaired when management determines that it is probable that Bancorp will be unable to collect all amounts of principal and interest as scheduled in the loan agreement. Impaired loans include all non-accrual loans and all troubled debt restructuring and other loans that management considers to be impaired. Factors considered by management in determining impairment include payment status and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. The recorded net investment in impaired loans, including accrued interest, is limited to the present value of the expected cash flows of the impaired loan, the observable fair market value of the loan or the estimated fair value of the loan’s collateral. Payments received on impaired nonaccrual loans are generally applied to principal, while payments received on impaired accruing loans are applied according to the contractual terms of the loan.

 

*Delinquency and Non-accrual:* Loans are defined as delinquent when any payment of principal and/or interest is past due. Loans are placed on nonaccrual status when, in the opinion of management, the collection of full principal and interest is doubtful or when the loan becomes 90 or more days past due. When a loan is placed on nonaccrual status, all interest previously accrued, but not collected, is reversed and charged against interest income. Payments received on nonaccrual loans are generally applied to principal.  However, based on management’s assessment of the ultimate collectability of a nonaccrual loan, interest income may be recognized on a cash basis. Nonaccrual loans are returned to accrual status when the loan is brought current and when management determines that circumstances have improved and there has been a sustained period of repayment performance by the borrower.

 

*Troubled Debt Restructures:* Loan are reported as troubled debt restructures when Bancorp grants a concession to the borrower experiencing financial difficulties that would it would not otherwise consider.  Examples of such concessions include forgiveness of principal or accrued interest or providing a lower interest rate than “market” for loans of similar risk.  Interest income on restructured loans is recognized pursuant to the terms of a new loan agreement. At March 31, 2011 there was $5.7 million in troubled debt restructures with $1.0 million in commitments to lend additional funds to borrowers whose terms have been modified in a troubled debt restructuring.

 

***Allowance for Loan Losses:*** The allowance for loan losses represents management’s best estimate of losses inherent in the portfolio and is evaluated on a regular basis and reviewed by the Board of Directors.  In analyzing the adequacy of the allowance for loan losses, we utilize a comprehensive loan grading system to determine the risk potential in the portfolio and also consider the results of independent third party credit reviews. The allowance consists of specific, general and unallocated components; (i) a specific valuation allowance, which is based on a review of substandard or non-accrual loans for specific weaknesses and evaluation of those loans for impairment and loss exposure; (ii) a general allowance, which is based on historical loan loss experience for different loan types and different risk gradings with adjustments for current events and conditions. The unallocated allowance provides for other credit losses inherent in the loan portfolio that may not have been contemplated in the general and specific components of the allowance.

 

The allowance is based upon Bancorp’s evaluation of the pertinent factors underlying the quality and composition of the loan portfolio, levels and trends in losses and delinquencies, current economic conditions, specific industry conditions and estimated value of any underlying collateral. Additions to the allowance, in the form of provisions, are reflected in current operating results, while charge-offs to the allowance are made when a loss is determined to have occurred. Bancorp’s evaluation of the allowance for loan losses is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.  Further information regarding Bancorp’s policies and methodology used to estimate the allowance for possible loan losses is presented in Note 7 Allowance for Loan Losses in the accompanying notes to consolidated financial statements found elsewhere is this report.

 

***Commitments:***In the ordinary course of business, Bancorp has entered into off-balance-sheet financial instruments consisting of commitments to extend credit, commitments under credit-card arrangements, commercial letters of credit, and standby letters of credit. Such financial instruments are recorded in the financial statements when they are funded or related fees are incurred or received.

 

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**Note 2:****        ****NEW ACCOUNTING PRONOUNCEMENTS**

 

In January 2010, the FASB issued ASU 2010-06, an update to ASU 820-10, “Fair Value Measurements”. This update adds a new requirement to disclose transfers in 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 measurement disclosures for each class of assets and liabilities and that entities provide enhanced disclosures around level 2 valuation techniques and inputs. Bancorp adopted the disclosure requirements for level 1 and level 2 transfers and the expanded fair value measurement and valuation disclosures effective January 1, 2010. The disclosure requirements for level 3 activities were effective for Bancorp for interim and annual periods beginning after December 15, 2010. The adoption of the disclosure requirements had no impact on Bancorp’s financial position, results of operations, and earnings per share.

 

On July 21, 2010, the FASB issued ASU 2010-20 which amends ASU 310 and expands required disclosures for the Financing Receivables and the Allowance for Loan and Lease Losses.  The objective of these enhanced disclosures is to improve financial statements users’ understanding of (i) the nature of a company’s credit risk associated with financing receivables and (ii) the company’s assessment of risk in estimating its allowance for loan and lease losses as well as changes in the allowance and the reasons for those changes. These disclosures with the exception of the troubled debt restructurings disclosure were implemented by the Bank on December 31, 2010.  In April 2011, the FASB issued ASU No. 2011-02, Receivables (Topic 310) — Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring Deferral. These amended disclosures requirements relating to troubled debt restructures are effective for the interim or annual periods beginning on or after June 30, 2011 and are to be applied retrospectively to the beginning of the annual period of adoption.  Bancorp does not anticipate the adoption of this guidance will have a material impact on its consolidated financial statements.

 

**Note 3:****        ****EARNINGS PER SHARE**

 

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

 
| ** **                                                                                            | ** ** | **Three months ended March 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| **(dollars in thousands except share and per share amounts)** | ** ** | **2011**                                             | ** ** | **2010** | ** ** |
| Numerator:                                                                                            |       |                                                 |       |   |   |
| Net income                                                                                            |       | $                                                    | 975        |   | $ | 1,209 |   |
| Denominator:                                                                                          |       |                                                 |       |   |   |
| Denominator for basic earnings per share -   Weighted average shares outstanding                      |       | 587,496                                              |       | 587,043 |   |
| Effect of dilutive securities:                                                                        |       |                                                 |       |   |   |
| Stock options and unvested restricted stock grants                                                    |       | 850                                                  |       | 1,472 |   |
| Denominator for diluted earning per share - Weighted   average shares outstanding                     |       | 588,346                                              |       | 588,515 |   |
| Basic earnings per share                                                                              |       | $                                                    | 1.66       |   | $ | 2.06 |   |
| Diluted earnings per share                                                                            |       | $                                                    | 1.66       |   | $ | 2.05 |   |

 

**Note 4:****        ****STOCK-BASED COMPENSATION**

 

Bancorp has one share-based payment plan, which is shareholder approved, and permits the grant of share-based awards to its employees and directors up to 100,000 shares and at March 31, 2011 there were 69,608 common shares available for grant. Total equity compensation expense was $60,000 for the three months ended March 31, 2011 and $64,000 for the like period in 2010.

 

**Stock Options**: No grants of options were awarded for the three months ended March 31, 2011 or the twelve months ended December 31, 2010.  The unrecognized share-based compensation cost relating to stock option expense at March 31, 2011 was $292,000, which will be recognized over the remaining vesting schedule through 2014.

 

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The following table summarizes the activity related to options outstanding during the three months ended March 31, 2011. The aggregate intrinsic value represents the total pretax intrinsic value (amount by which the fair value of the underlying stock exceeds the exercise price of an option or award, times the number of shares):

 
| **(dollars in thousands except share and per share amounts)** | ** ** | **Shares** | ** ** | **Weighted   Average   Exercise/Grant   Price** | ** ** | **Weighted   Average   Remaining   Contractual Terms** | ** ** | **Aggregate   Intrinsic Value** | ** ** |
|-------------------------------------------------------------------------------------------------------|------------|------------|------------|-------------------------------------------------|------------|-------------------------------------------------------------|------------|--------------------------------------|------------|
| Outstanding at January 1, 2011                                                                   |       | 27,986     |       | $                                               | 179.91     |                                                        | 6.60       |                                 | $          | — |   |
| Granted                                                                                               |       | —     |       |                                            |       |                                                        |       |                                 |       |
| Exercised                                                                                             |       | —     |       |                                            |       |                                                        |       |                                 |       |
| Forfeited                                                                                             |       | —     |       |                                            |       |                                                        |       |                                 |       |
| Outstanding at March 31, 2011                                                                    |       | 27,986     |       | $                                               | 179.91     |                                                        | 6.35       |                                 | $          | — |   |
| Exercisable at March 31, 2011                                                                    |       | 17,186     |       | $                                               | 175.72     |                                                        | 5.95       |                                 | $          | — |   |

 

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

 

The unrecognized share-based compensation cost relating to restricted stock awards expense at March 31, 2011 was $108,000, which will be recognized over the remaining years of the original five year vesting period of the awards.  There were no awards granted for the three months ended March 31, 2011 or for the twelve months ended December 31, 2010.  The total intrinsic value of stock awards exercised and vested during the three months ended March 31, 2011 was $42,000.

 

The aggregate intrinsic value in the table below represents the total pretax intrinsic value (amount by which the fair value of the underlying stock exceeds the exercise price of an option or award, times the number of shares).  The following table summarizes the activity relating to restricted stock awards outstanding for the three months ended March 31, 2011.

 
| **(dollars in thousands except share and per share amounts)** | ** ** | **Shares** | ** ** | **Weighted Average   Remaining   Contractual Terms (in   years)** | ** ** | **Aggregate   Intrinsic Value** | ** ** |
|-------------------------------------------------------------------------------------------------------|------------|------------|------------|----------------------------------------------------------------------------------|------------|--------------------------------------|------------|
| Outstanding at January 1, 2011                                                                   |       | 969        |       | 1.90                                                                             |       | $                                    | 145        |   |
| Granted                                                                                               |       | —     |       |                                                                             |       |                                 |       |
| Vested                                                                                                |       | 262        |       |                                                                             |       | 42                                   |       |
| Forfeited                                                                                             |       | —     |       |                                                                             |       |                                 |       |
| Outstanding at March 31, 2011                                                                    |       | 707        |       | 1.57                                                                             |       | $                                    | 113        |   |

 

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**Note 5:****        ****INVESTMENT SECURITIES**

 

The following tables summarize the aggregate amortized cost and estimated fair value of investment securities as of the dates indicated.

 

**March 31, 2011**

 
| ** **                                                                       | ** ** | **Amortized** | ** ** | **Gross Unrealized** | ** ** | **Estimated** | ** ** |
|----------------------------------------------------------------------------------|------------|---------------|------------|---------------------------|------------|---------------|------------|
| **(dollars in thousands)**                                             | ** ** | **Cost**      | ** ** | **Gains**                 | ** ** | **Losses**    | ** ** | **Fair Value** | ** ** |
| *Available-For-Sale Securities*                                                  |       |          |       |                      |       |          |       |   |   |
| U.S. government agencies                                                         |       | $             | 119,539    |                      | $          | 532           |       | $ | 296 |   | $ | 119,775 |   |
| Residential mortgage-backed securities and collateralized   mortgage obligations |       | 83,994        |       | 2,582                     |       | 824           |       | 85,752 |   |
| State and political subdivisions                                                 |       | 8,719         |       | 320                       |       | 50            |       | 8,989 |   |
| Total available-for-sale                                                         |       | 212,252       |       | 3,434                     |       | 1,170         |       | 214,516 |   |
| *Held-To-Maturity Securities*                                                    |       |          |       |                      |       |          |       |   |   |
| State and political subdivisions                                                 |       | 38,308        |       | 892                       |       | 63            |       | 39,137 |   |
| Total held-to-maturity                                                           |       | 38,308        |       | 892                       |       | 63            |       | 39,137 |   |
| Total investment securities                                                      |       | $             | 250,560    |                      | $          | 4,326         |       | $ | 1,233 |   | $ | 253,653 |   |

 

**December 31, 2010**

 
| ** **                                                                       | ** ** | **Amortized** | ** ** | **Gross Unrealized** | ** ** | **Estimated** | ** ** |
|----------------------------------------------------------------------------------|------------|---------------|------------|---------------------------|------------|---------------|------------|
| **(dollars in thousands)**                                             | ** ** | **Cost**      | ** ** | **Gains**                 | ** ** | **Losses**    | ** ** | **Fair Value** | ** ** |
| *Available-For-Sale Securities*                                                  |       |          |       |                      |       |          |       |   |   |
| U.S. government agencies                                                         |       | $             | 85,474     |                      | $          | 612           |       | $ | 311 |   | $ | 85,775 |   |
| Residential mortgage-backed securities and   collateralized mortgage obligations |       | 84,510        |       | 2,718                     |       | 797           |       | 86,431 |   |
| State and political subdivisions                                                 |       | 8,504         |       | 323                       |       | 62            |       | 8,765 |   |
| Total available-for-sale                                                         |       | 178,488       |       | 3,653                     |       | 1,170         |       | 180,971 |   |
| *Held-To-Maturity Securities*                                                    |       |          |       |                      |       |          |       |   |   |
| State and political subdivisions                                                 |       | 38,367        |       | 730                       |       | 235           |       | 38,862 |   |
| Total held-to-maturity                                                           |       | 38,367        |       | 730                       |       | 235           |       | 38,862 |   |
| Total investment securities                                                      |       | $             | 216,855    |                      | $          | 4,383         |       | $ | 1,405 |   | $ | 219,833 |   |

 

 

The following tables show the gross unrealized losses and fair value of investments with unrealized losses that are not deemed to be other-than-temporarily impaired as of the dates indicated;

 

**March 31, 2011**

** **
| ** **                                                                       | ** ** | **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                                                         |       | $                                      | 43,898     |                                    | $          | 296                 |       | $ | — |   | $ | — |   | $ | 43,898 |   | $ | 296 |   |
| Residential mortgage-backed securities and   collateralized mortgage obligations |       | 28,477                                 |       | 824                                     |       | —              |       | — |   | 28,477 |   | 824 |   |
| State and political subdivisions                                                 |       | 1,139                                  |       | 50                                      |       | —              |       | — |   | 1,139 |   | 50 |   |
| Total available-for-sale                                                         |       | 73,514                                 |       | 1,170                                   |       | —              |       | — |   | 73,514 |   | 1,170 |   |
| *Held-To-Maturity Securities*                                                    |       |                                   |       |                                    |       |                |       |   |   |   |   |   |   |
| State and political subdivisions                                                 |       | 5,476                                  |       | 63                                      |       | —              |       | — |   | 5,476 |   | 63 |   |
| Total held-to-maturity                                                           |       | 5,476                                  |       | 63                                      |       | —              |       | — |   | 5,476 |   | 63 |   |
| Total investment securities                                                      |       | $                                      | 78,990     |                                    | $          | 1,233               |       | $ | — |   | $ | — |   | $ | 78,990 |   | $ | 1,233 |   |

 

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**December 31, 2010**

 
| ** **                                                                       | ** ** | **Less Than 12 Months** | ** ** | **12 Months or Greater** | ** ** | **Total**           | ** ** |
|----------------------------------------------------------------------------------|------------|----------------------------------------|------------|-----------------------------------------|------------|---------------------|------------|
| **(dollars in thousands)**                                             | ** ** | **Fair Value**                    | ** ** | **Unrealized   Losses**                 | ** ** | **Fair Value** | ** ** | **Unrealized   Losses** | ** ** | **Fair Value** | ** ** | **Unrealized   Losses** | ** ** |
| *Available-For-Sale Securities*                                                  |       |                                   |       |                                    |       |                |       |   |   |   |   |   |   |
| U.S. government agencies                                                         |       | $                                      | 35,373     |                                    | $          | 311                 |       | $ | — |   | $ | — |   | $ | 35,373 |   | $ | 311 |   |
| Residential mortgage-backed securities and   collateralized mortgage obligations |       | 24,599                                 |       | 797                                     |       | —              |       | — |   | 24,599 |   | 797 |   |
| State and political subdivisions                                                 |       | 1,128                                  |       | 62                                      |       | —              |       | — |   | 1,128 |   | 62 |   |
| Total available-for-sale                                                         |       | 61,100                                 |       | 1,170                                   |       | —              |       | — |   | 61,100 |   | 1,170 |   |
| *Held-To-Maturity Securities*                                                    |       |                                   |       |                                    |       |                |       |   |   |   |   |   |   |
| State and political subdivisions                                                 |       | 12,076                                 |       | 235                                     |       | —              |       | — |   | 12,076 |   | 235 |   |
| Total held-to-maturity                                                           |       | 12,076                                 |       | 235                                     |       | —              |       | — |   | 12,076 |   | 235 |   |
| Total investment securities                                                      |       | $                                      | 73,176     |                                    | $          | 1,405               |       | $ | — |   | $ | — |   | $ | 73,176 |   | $ | 1,405 |   |

 

At March 31, 2011, Bancorp held no security in the available-for-sale portfolio or in the held-to-maturity portfolio that had an unrealized loss for more than one year.  Bancorp does not intend to sell securities that are identified as temporarily impaired nor does available evidence suggest it is more likely than not that management will be required to sell any impaired securities. The unrealized losses are largely due to increases in market interest rates over the yields available at the time the underlying securities were purchased. Management believes the nature of the securities in the investment portfolio present a high probability of collecting all contractual amounts due.  Based on the evaluation, management has determined that no investment security in Bancorp’s investment portfolio is other-than-temporarily impaired.  There were 30 securities in an unrealized loss position as of March 31, 2011.

 

Available-for-sale investment securities with a carrying value of $91.7  million and $96.0 million as of March 31, 2011 and December 31, 2010, were pledged as collateral for public fund deposits, securities sold under agreement to repurchase, Treasury Tax and Loan payments, and Federal Reserve Bank discount window borrowings. There were no sales of securities for the three months ended March 31, 2011 and March 31, 2010.

 

The amortized cost and estimated fair value of investment securities at March 31, 2011, by contractual maturity, are shown in the following table.  Actual maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayments penalties.  Mortgage-backed securities and collateralized mortgage obligations are not all due at a single maturity date, therefore, they are disclosed separately.

 
| ** **                                                                       | ** ** | **2011**               | ** ** |
|----------------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                       | ** ** | **Available-For-Sale** | ** ** | **Held-To-Maturity** | ** ** |
| ** **                                                                       | ** ** | **Amortized**          | ** ** | **Estimated** | ** ** | **Amortized** | ** ** | **Estimated** | ** ** |
| **(dollars in thousands)**                                             | ** ** | **Cost**               | ** ** | **Fair Value** | ** ** | **Cost** | ** ** | **Fair Value** | ** ** |
| 0-1 year                                                                         |       | $                      | 14,179     |   | $ | 14,255 |   | $ | 8,515 |   | $ | 8,560 |   |
| 1-5 years                                                                        |       | 93,171                 |       | 93,783 |   | 8,637 |   | 8,924 |   |
| 5-10 years                                                                       |       | 16,585                 |       | 16,460 |   | 13,360 |   | 13,568 |   |
| Over 10 years                                                                    |       | 4,323                  |       | 4,266 |   | 7,796 |   | 8,085 |   |
| Residential mortgage-backed securities and   collateralized mortgage obligations |       | 83,994                 |       | 85,752 |   | — |   | — |   |
| Total investment securities                                                      |       | $                      | 212,252    |   | $ | 214,516 |   | $ | 38,308 |   | $ | 39,137 |   |

 

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**Note 6:****        ****LOANS**

 

The major segments and classes of loans, as of the dates indicated, are as follows:

 
| **(dollars in thousands)**               | ** ** | **March 31, 2011** | ** ** | **December 31, 2010** | ** ** |
|----------------------------------------------------|------------|------------------------------|------------|---------------------------------|------------|
| Commercial                                         |       | $                            | 65,202     |                            | $          | 69,177 |   |
| Commercial real estate                             |       |                         |       |                            |       |
| Raw land and land development                      |       | 37,884                       |       | 37,233                          |       |
| Other commercial real estate                       |       | 65,082                       |       | 65,516                          |       |
| Other real estate                                  |       |                         |       |                            |       |
| Residential                                        |       | 33,218                       |       | 34,681                          |       |
| Farmland and owner occupied nonfarm nonresidential |       | 113,652                      |       | 115,291                         |       |
| Real estate construction                           |       |                         |       |                            |       |
| Commercial                                         |       | 892                          |       | 826                             |       |
| Residential                                        |       | 3,454                        |       | 3,210                           |       |
| Consumer                                           |       |                         |       |                            |       |
| Home equity                                        |       | 24,320                       |       | 23,522                          |       |
| Credit cards and other consumer                    |       | 15,956                       |       | 16,622                          |       |
|                                               |       | $                            | 359,660    |                            | $          | 366,078 |   |
| Less deferred loan fees                            |       | (692                         | )          | (759                            | )          |
| Total Loans                                        |       | $                            | 358,968    |                            | $          | 365,319 |   |

 

Bancorp’s primary lending activities includes real estate loans, commercial loans which include agriculture production loans and consumer purpose loans. Most of Bancorp’s business activity is with customers located within Skagit, Snohomish and Whatcom Counties.

 

*Commercial Loans*: Commercial loans, secured and unsecured, are made primarily for commercial and industrial purposes to small and medium-sized businesses including farms operating within Skagit, Snohomish and Whatcom Counties.  These loans are available for general operating purposes, acquisition of fixed assets, purchases of equipment and machinery, financing of inventory and accounts receivable, and other business purposes.  Bancorp originates Small Business Administration (SBA) loans, including 504 and 7A loans. These loans may have short or long term maturities. Such loans include working capital advances, term loans and loans to individuals for business purposes. Term loans may involve greater risk than do short term loans because the length of time the credit is outstanding increases the probability a future event may impact identified repayment sources. Term loans are generally secured because of this potential for greater risk.

 

*Commercial Real Estate:*Commercial real estate loans consist of real estate secured loans advanced for non-owner occupied commercial real estate which includes, but is not limited to, office buildings, retail centers, multifamily and warehouses. These loans are typically term loans and are made to purchase or refinance non-owner occupied commercial real estate.  Commercial real estate loans also include real estate secured raw land loans and land development loans which are made to acquire land or finance development preparatory to erecting residential or commercial structures. The primary repayment source for non-owner occupied real estate comes from the rental or lease income and the underlying cash flows generated by the occupant tenant. Risks include the tenants ability to pay rents and because the length of time the term loan is outstanding it increases the probability that future events may impact these identified repayment sources.

 

Land development financing usually involves the purchase of land and lot development in anticipation of further construction or sale of the property. The full value of the collateral does not exist at the time the land development loan is granted and completion of the project within specified costs and time limits results in additional risk. The primary repayment source for a land development loan is dependent on the value of the underlying real estate which is subject value variation resulting from various economic conditions.

 

Bancorp monitors concentrations of commercial real estate for which the cash flow from the real estate is the primary source of repayment rather than loans to a borrower for which real estate collateral is taken as a secondary source of repayment. These types of commercial real estate loans have risk profiles which are more sensitive to changes in market demand, vacancy rates, rents or changes in capitalization rates.

 

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*Other Real Estate Loans:* Other real estate loans are typically made for, the purchase of or refinance of, residential real estate, real estate used for agricultural purposes including timberland, and owner-occupied real estate utilized by small to medium sized businesses and individuals for their business operations. They are typically term loans secured by the property being purchased or refinanced.  Repayment comes from the cash flow of the ongoing operations and activities conducted by the party, or affiliate of the party, or individual who owns the property. Term loans involve risk because the length of time the loan is outstanding increases the probability that a future event may impact identified repayment sources or the underlying real estate collateral values may change.

 

*Real Estate Construction: *Real estate construction loans are short term loans made for the construction period required for both commercial construction projects and residential construction projects. These loans are generally secured by the real estate project being constructed.

 

Commercial construction loans are available for owner-occupied real estate utilized by small to**medium sized businesses and individuals for their business operations and for non-owner occupied real estate. Repayment for construction loans is generally from a long term loan either provided by the Bank or another lender.

 

Residential construction loans may be made to builders on a speculative basis or with a prearranged sale in place. These loans also may be made to individuals for the purpose of constructing their own residence. The full value of the collateral does not exist at the time the loan is granted and the construction project must be monitored to ensure it is completed within specified costs and time frames. Because of the short term nature of these loans collateral valuation changes is less typical.

* *

*Consumer Loans:* Bancorp makes secured and unsecured consumer loans including loans to individuals, primarily customers of Bancorp, for various purposes, including home equity loans, purchases of automobiles, mobile homes, boats and other recreational vehicles, home improvement loans and loans for education and personal investments. The primary risk in consumer loans resides in the home equity portfolio which is secured by housing assets, the value of which has historically performed well; however, housing asset valuations are subject to economic conditions which may impact these values.

 

Bancorp originates both variable and fixed-rate loans.  At March 31, 2011 and December 31, 2010, $153.9 million and $157.1 million of loans outstanding were variable rate loans. Loans participations sold to others totaled $2.9 million and $3.1 million as of March 31, 2011 and December 31, 2010.  Bancorp does originate loans intended for sale which are carried at the lower of aggregate cost or fair value. As of March 31, 2011 and December 31, 2010, Bancorp held $0 and $78,000 as loans held-for-sale.  There were no sales of loans, other than sales of loans originated as loans held for sale.  In addition, no loans were reclassified to held-for-sale and Bancorp acquired no loans with deteriorated credit quality. The following table is an aging analysis of past due loans as of March 31, 2011 and December 31, 2010:

 

**March 31, 2011**

 
| **(dollars in thousands)**               | ** ** | **30-59   Days Past   Due** | ** ** | **60-89   Days Past   Due** | ** ** | **Greater   Than 90   Days and   Accruing** | ** ** | **Total Past   Due** | ** ** | **Non-accrual** | ** ** | **Current** | ** ** | **Total Loan   Receivables** | ** ** |
|----------------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|-------------------------------------------------------|------------|---------------------------|------------|-----------------|------------|-------------|------------|-----------------------------------|------------|
| Commercial                                         |       | $                                | —     |                             | $          | 86                                                    |       | $                         | —     |            | $          | 86          |       | $                                 | 3,801      |   | $ | 61,315 |   | $ | 65,202 |   |
| Commercial real estate                             |       |                             |       |                             |       |                                                  |       |                      |       |            |       |        |       |                              |       |
| Raw land and land development                      |       | 991                              |       | —                           |       | —                                                |       | 991                       |       | 4,830           |       | 32,063      |       | 37,884                            |       |
| Other commercial real estate                       |       | —                           |       | —                           |       | —                                                |       | —                    |       | 1,116           |       | 63,966      |       | 65,082                            |       |
| Other real estate                                  |       |                             |       |                             |       |                                                  |       |                      |       |            |       |        |       |                              |       |
| Residential                                        |       | —                           |       | —                           |       | —                                                |       | —                    |       | 1,208           |       | 32,010      |       | 33,218                            |       |
| Farmland and owner occupied nonfarm nonresidential |       | 620                              |       | 127                              |       | —                                                |       | 747                       |       | 6,212           |       | 106,693     |       | 113,652                           |       |
| Real estate construction                           |       |                             |       |                             |       |                                                  |       |                      |       |            |       |        |       |                              |       |
| Commercial                                         |       | —                           |       | —                           |       | —                                                |       | —                    |       | —          |       | 892         |       | 892                               |       |
| Residential                                        |       | —                           |       | —                           |       | —                                                |       | —                    |       | 1,032           |       | 2,422       |       | 3,454                             |       |
| Consumer                                           |       |                             |       |                             |       |                                                  |       |                      |       |            |       |        |       |                              |       |
| Home equity                                        |       | —                           |       | —                           |       | —                                                |       | —                    |       | 104             |       | 24,216      |       | 24,320                            |       |
| Credit cards and other consumer                    |       | 116                              |       | 19                               |       | —                                                |       | 135                       |       | 45              |       | 15,776      |       | 15,956                            |       |
| Total                                              |       | $                                | 1,727      |                             | $          | 232                                                   |       | $                         | —     |            | $          | 1,959       |       | $                                 | 18,348     |   | $ | 339,353 |   | $ | 359,660 |   |

 

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**December 31, 2010**

 
| **(dollars in thousands)**               | ** ** | **30-59   Days Past   Due** | ** ** | **60-89   Days Past   Due** | ** ** | **Greater   Than 90   Days and   Accruing** | ** ** | **Total Past   Due** | ** ** | **Non-accrual** | ** ** | **Current** | ** ** | **Total Loan   Receivables** | ** ** |
|----------------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|-------------------------------------------------------|------------|---------------------------|------------|-----------------|------------|-------------|------------|-----------------------------------|------------|
| Commercial                                         |       | $                                | —     |                             | $          | 50                                                    |       | $                         | —     |            | $          | 50          |       | $                                 | 3,699      |   | $ | 65,428 |   | $ | 69,177 |   |
| Commercial real estate                             |       |                             |       |                             |       |                                                  |       |                      |       |            |       |        |       |                              |       |
| Raw land and land development                      |       | —                           |       | —                           |       | —                                                |       | —                    |       | 4,568           |       | 32,665      |       | 37,233                            |       |
| Other commercial real estate                       |       | 68                               |       | —                           |       | —                                                |       | 68                        |       | 1,135           |       | 64,313      |       | 65,516                            |       |
| Other real estate                                  |       |                             |       |                             |       |                                                  |       |                      |       |            |       |        |       |                              |       |
| Residential                                        |       | 72                               |       | —                           |       | —                                                |       | 72                        |       | 1,047           |       | 33,562      |       | 34,681                            |       |
| Farmland and owner occupied nonfarm nonresidential |       | —                           |       | —                           |       | —                                                |       | —                    |       | 1,209           |       | 114,082     |       | 115,291                           |       |
| Real estate construction                           |       |                             |       |                             |       |                                                  |       |                      |       |            |       |        |       |                              |       |
| Commercial                                         |       | —                           |       | —                           |       | —                                                |       | —                    |       | —          |       | 826         |       | 826                               |       |
| Residential                                        |       | —                           |       | —                           |       | —                                                |       | —                    |       | 968             |       | 2,242       |       | 3,210                             |       |
| Consumer                                           |       |                             |       |                             |       |                                                  |       |                      |       |            |       |        |       |                              |       |
| Home equity                                        |       | —                           |       | —                           |       | —                                                |       | —                    |       | 105             |       | 23,417      |       | 23,522                            |       |
| Credit cards and other consumer                    |       | 141                              |       | 69                               |       | —                                                |       | 210                       |       | 63              |       | 16,349      |       | 16,622                            |       |
| Total                                              |       | $                                | 281        |                             | $          | 119                                                   |       | $                         | —     |            | $          | 400         |       | $                                 | 12,794     |   | $ | 352,884 |   | $ | 366,078 |   |

 

The following is a summary of impaired loans as of the dates indicated:

 
| ** **                                         | ** ** | **March 31, 2011**     | ** ** |
|----------------------------------------------------|------------|----------------------------------|------------|
| **(dollars in thousands)**               | ** ** | **Unpaid   Principal   Balance** | ** ** | **Recorded   Investment   with No   Related   Allowance** | ** ** | **Recorded   Investment   with Related   Allowance** | ** ** | **Related   Allowance** | ** ** | **Total   Recorded   Investment** | ** ** |
| Commercial                                         |       | $                                | 4,325      |   | $ | 49 |   | $ | 3,752 |   | $ | 1,260 |   | $ | 3,801 |   |
| Raw land and land development                      |       | 6,138                            |       | 2,058 |   | 3,764 |   | 445 |   | 5,822 |   |
| Other commercial real estate                       |       | 1,119                            |       | 1,116 |   | — |   | — |   | 1,116 |   |
| Residential                                        |       | 1,293                            |       | 753 |   | 455 |   | 39 |   | 1,208 |   |
| Farmland and owner occupied nonfarm nonresidential |       | 6,375                            |       | 6,252 |   | — |   | — |   | 6,252 |   |
| Construction-commercial                            |       | —                           |       | — |   | — |   | — |   | — |   |
| Construction-residential                           |       | 1,530                            |       | 1,032 |   | — |   | — |   | 1,032 |   |
| Consumer-home equity                               |       | 108                              |       | — |   | 104 |   | 25 |   | 104 |   |
| Credit cards and other consumer                    |       | 65                               |       | 45 |   | — |   | — |   | 45 |   |
| Total                                              |       | $                                | 20,953     |   | $ | 11,305 |   | $ | 8,075 |   | $ | 1,769 |   | $ | 19,380 |   |

 

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| ** **                                         | ** ** | **December 31, 2010**  | ** ** |
|----------------------------------------------------|------------|----------------------------------|------------|
| **(dollars in thousands)**               | ** ** | **Unpaid   Principal   Balance** | ** ** | **Recorded   Investment   with No   Related   Allowance** | ** ** | **Recorded   Investment   with Related   Allowance** | ** ** | **Related   Allowance** | ** ** | **Total   Recorded   Investment** | ** ** |
| Commercial                                         |       | $                                | 4,245      |   | $ | 317 |   | $ | 3,382 |   | $ | 540 |   | $ | 3,699 |   |
| Raw land and land development                      |       | 5,880                            |       | 2,285 |   | 2,283 |   | 350 |   | 4,568 |   |
| Other commercial real estate                       |       | 1,138                            |       | 1,135 |   | — |   | — |   | 1,135 |   |
| Residential                                        |       | 1,236                            |       | 1,021 |   | 26 |   | 2 |   | 1,047 |   |
| Farmland and owner occupied nonfarm nonresidential |       | 6,409                            |       | 6,286 |   | — |   | — |   | 6,286 |   |
| Construction-commercial                            |       | —                           |       | — |   | — |   | — |   | — |   |
| Construction-residential                           |       | 1,467                            |       | 968 |   | — |   | — |   | 968 |   |
| Consumer-home equity                               |       | 109                              |       | — |   | 105 |   | 13 |   | 105 |   |
| Credit cards and other consumer                    |       | 78                               |       | 51 |   | 12 |   | 1 |   | 63 |   |
| Total                                              |       | $                                | 20,562     |   | $ | 12,063 |   | $ | 5,808 |   | $ | 906 |   | $ | 17,871 |   |

 
| ** **                                         | ** ** | **March 31, 2011**        | ** ** | **December 31, 2010**    | ** ** |
|----------------------------------------------------|------------|-------------------------------------|------------|------------------------------------|------------|
| **(dollars in thousands)**               | ** ** | **Average   Recorded   Investment** | ** ** | **Interest   Income   Recognized** | ** ** | **Average   Recorded   Investment** | ** ** | **Interest   Income   Recognized** | ** ** |
| Commercial                                         |       | $                                   | 3,750      |                               | $          | — |   | $ | 1,691 |   | $ | 4 |   |
| Raw land and land development                      |       | 5,195                               |       | 3                                  |       | 6,599 |   | 169 |   |
| Other commercial real estate                       |       | 1,126                               |       | 1                                  |       | 1,074 |   | 99 |   |
| Residential                                        |       | 1,128                               |       | —                             |       | 1,659 |   | 76 |   |
| Farmland and owner occupied nonfarm nonresidential |       | 6,270                               |       | —                             |       | 3,745 |   | 140 |   |
| Construction-commercial                            |       | —                              |       | —                             |       | — |   | — |   |
| Construction-residential                           |       | 1,000                               |       | —                             |       | 1,645 |   | 44 |   |
| Consumer-home equity                               |       | 105                                 |       | —                             |       | 84 |   | — |   |
| Credit cards and other consumer                    |       | 54                                  |       | —                             |       | 80 |   | — |   |
| Total                                              |       | $                                   | 18,628     |                               | $          | 4 |   | $ | 16,577 |   | $ | 532 |   |

 

*Risk Rating System:* An effective risk rating system provides information for use in determining the overall level of the allowance for loan loss. Accurate and timely risk rating recognition is a primary component of an effective risk rating system. Risk ratings are reviewed through various channels including the loan approval process, the loan approval and reporting process, an external loan review process and through the regulatory review process. Bancorp risk rates the commercial loan portfolio on a nine scale system and Bancorp’ consumer loans are risk rated on a four scale system. Risk ratings in both scales are based on levels of risk as defined by the internal risk rating guidance within the bank’s loan policy.  A commercial loan’s risk rating may change as risk factors change throughout the life of the loan, while with consumer loans the original risk rating assigned at loan origination remains for the life of the loan except when a consumer loan is moved to nonaccrual at which time it is risk rated a substandard loan.

 

For risk-rating purposes, commercial, commercial real estate, other real estate and real estate construction segments are typically graded using the commercial risk ratings.  The risk ratings used for commercial loans are as follows:

 

*Pass:* This group includes four distinct risk rating categories. The lowest level of risk in the pass categories are loans that are substantially free of risk primarily because these loans are secured by deposits held at the bank to the highest level of risk category in the pass categories which have been identified as loans that have acceptable levels of risk. Loans in this last category are acceptable, but also susceptible to deterioration. Loans in this category represent the typical borrower for the Bank and are considered to be representative of the majority of borrowers in the bank’s market place.

 

*Watch:* These are loans where the borrower is performing; however, some characteristics exist that require Bancorp to apply more than the usual management attention to an acceptable loan. This risk rating indicates that according to current information the borrower has the capacity to perform according to the terms of the loan documents; however some level of uncertainty exists. This is typically a temporary risk rating with the identified characteristics that caused this Watch risk rating likely to be clearer in the near term.

 

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*Special Mention:-*These loans have potential weaknesses that deserve management’s close attention. If not checked or left uncorrected, these potential weaknesses may result in the deterioration of the repayment prospects by the borrower or in Bancorp’s credit position at some future date. Special mention loans have potential weaknesses caused by characteristics which corrective actions could remedy. These characteristics include, but are not limited to, loans not performing as originally structured due to economic events or industry conditions. While potentially weak, these borrowers are currently marginally acceptable; no loss of principal or interest is envisioned. Special mention loans do not expose Bancorp to sufficient risk to warrant an adverse classification to substandard.

 

*Substandard:* These loans have a well defined weakness that jeopardizes the orderly liquidation of the loan and are inadequately protected by the sound worth and paying capacity of the borrower or the collateral pledged, if any. Normal repayment from the borrower is in jeopardy, although no loss is envisioned at this time. Substandard commercial loans are characterized by the distinct possibility that the Bank will sustain some loss if the identified weaknesses are not corrected. Loss potential, while existing in the aggregate amount of all substandard commercial loans, does not have to exist in an individual loan risk rated substandard.

 

The four risk ratings for consumer loans are as follows:

 

*Risk Ratings A-D:* Consumer loan risk rating categories are based on two factors; charge off expectation and bankruptcy expectation. The Bank utilizes a credit reporting agency to provide scores for charge off expectation and bankruptcy expectation for each consumer borrower at loan origination. The loan is then assigned a risk rating, with the lowest level of risk (A) to the highest level of risk (D).

 

*No Rating:* This category includes small performing commercial loans that were originated prior to the Bank’s implementation of the current risk rating system and consumer credit cards. Each consumer credit card is risk rated at loan origination based on the consumer loan risk rating categories, however Bancorp outsources the processing and servicing of its credit card portfolio and their system does not provide for credit card portfolio risk rating identification. Bancorp believes the risk rating mix for credit cards is similar to the risk rating mix for its consumer loan portfolio.

 

Two additional risk ratings are available for both consumer and commercial loans:

 

*Doubtful:* These loans have all the weaknesses inherent in those classified substandard with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently known facts, highly questionable or improbable. A doubtful classification may be appropriate in cases where significant risk exposures are perceived, but loss cannot be determined because of specific reasonable factors which may strengthen the credit in the near term.

 

*Loss:*These loans have balances in excess of the calculated current fair value which are considered uncollectible. There is little or no prospect for near term improvement and no realistic strengthening action of significance pending.

 

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The following tables present Bancorp’s risk rating loan balances by class as of the dates indicated:

** **

**March 31, 2011**

 
| ** **                                         | ** ** | ** ** | ** ** | **Commercial Credit Indicator** | ** ** | ** **            | ** ** |
|----------------------------------------------------|------------|------------|------------|-------------------------------------------|------------|-----------------------|------------|
| **(dollars in thousands)**               | ** ** | **Pass**   | ** ** | **Watch**                                 | ** ** | **Special   Mention** | ** ** | **Substandard** | ** ** | **Non-Rated** | ** ** | **Total** | ** ** |
| Commercial                                         |       | $          | 51,412     |                                      | $          | 5,305                 |       | $ | 2,551 |   | $ | 5,934 |   | $ | — |   | $ | 65,202 |   |
| Commercial real estate                             |       |       |       |                                      |       |                  |       |   |   |   |   |   |   |
| Raw land and land development                      |       | 24,821     |       | 69                                        |       | 1,330                 |       | 10,672 |   | 45 |   | 36,937 |   |
| Other commercial real estate                       |       | 59,408     |       | —                                    |       | 2,491                 |       | 3,168 |   | 15 |   | 65,082 |   |
| Other real estate                                  |       |       |       |                                      |       |                  |       |   |   |   |   |   |   |
| Residential                                        |       | 16,394     |       | 450                                       |       | 692                   |       | 2,124 |   | 494 |   | 20,154 |   |
| Farmland and owner occupied nonfarm nonresidential |       | 88,098     |       | 8,179                                     |       | 5,610                 |       | 11,264 |   | 261 |   | 113,412 |   |
| Real estate construction                           |       |       |       |                                      |       |                  |       |   |   |   |   |   |   |
| Commercial                                         |       | 564        |       | —                                    |       | —                |       | 328 |   | — |   | 892 |   |
| Residential                                        |       | 1,687      |       | —                                    |       | —                |       | 1,113 |   | — |   | 2,800 |   |
| Consumer                                           |       |       |       |                                      |       |                  |       |   |   |   |   |   |   |
| Home equity                                        |       | 1,802      |       | —                                    |       | 490                   |       | 243 |   | — |   | 2,535 |   |
| Credit cards and other consumer                    |       | —     |       | —                                    |       | —                |       | 45 |   | — |   | 45 |   |
| Total                                              |       | $          | 244,186    |                                      | $          | 14,003                |       | $ | 13,164 |   | $ | 34,891 |   | $ | 815 |   | $ | 307,059 |   |

 
| ** **                                         | ** ** | ** ** | ** ** | **Consumer Credit Indicator** | ** ** | ** ** | ** ** |
|----------------------------------------------------|------------|------------|------------|-----------------------------------------|------------|------------|------------|
| ** **                                         | ** ** | **A**      | ** ** | **B**                                   | ** ** | **C**      | ** ** | **D** | ** ** | **Non-Rated** | ** ** | **Total** | ** ** |
| Commercial                                         |       | $          | —     |                                    | $          | —     |       | $ | — |   | $ | — |   | $ | — |   | $ | — |   |
| Commercial real estate                             |       |       |       |                                    |       |       |       |   |   |   |   |   |   |
| Raw land and land development                      |       | 531        |       | 324                                     |       | 92         |       | — |   | — |   | 947 |   |
| Other commercial real estate                       |       | —     |       | —                                  |       | —     |       | — |   | — |   | — |   |
| Other real estate                                  |       |       |       |                                    |       |       |       |   |   |   |   |   |   |
| Residential                                        |       | 8,903      |       | 2,492                                   |       | 855        |       | 814 |   | — |   | 13,064 |   |
| Farmland and owner occupied nonfarm nonresidential |       | 240        |       | —                                  |       | —     |       | — |   | — |   | 240 |   |
| Real estate construction                           |       |       |       |                                    |       |       |       |   |   |   |   |   |   |
| Commercial                                         |       | —     |       | —                                  |       | —     |       | — |   | — |   | — |   |
| Residential                                        |       | 31         |       | 285                                     |       | —     |       | 338 |   | — |   | 654 |   |
| Consumer                                           |       |       |       |                                    |       |       |       |   |   |   |   |   |   |
| Home equity                                        |       | 16,240     |       | 3,062                                   |       | 1,498      |       | 932 |   | 53 |   | 21,785 |   |
| Credit cards and other consumer                    |       | 7,387      |       | 1,591                                   |       | 719        |       | 584 |   | 5,630 |   | 15,911 |   |
| Total                                              |       | $          | 33,332     |                                    | $          | 7,754      |       | $ | 3,164 |   | $ | 2,668 |   | $ | 5,683 |   | $ | 52,601 |   |

 

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**December 31, 2010**

 
| ** **                                         | ** ** | ** ** | ** ** | **Commercial Credit Indicator** | ** ** | ** **            | ** ** |
|----------------------------------------------------|------------|------------|------------|-------------------------------------------|------------|-----------------------|------------|
| **(dollars in thousands)**               | ** ** | **Pass**   | ** ** | **Watch**                                 | ** ** | **Special   Mention** | ** ** | **Substandard** | ** ** | **Non-Rated** | ** ** | **Total** | ** ** |
| Commercial                                         |       | $          | 54,940     |                                      | $          | 6,744                 |       | $ | 1,136 |   | $ | 6,352 |   | $ | 5 |   | $ | 69,177 |   |
| Commercial real estate                             |       |       |       |                                      |       |                  |       |   |   |   |   |   |   |
| Raw land and land development                      |       | 23,174     |       | 800                                       |       | 2,029                 |       | 10,599 |   | 47 |   | 36,649 |   |
| Other commercial real estate                       |       | 57,342     |       | 358                                       |       | 5,548                 |       | 2,253 |   | 15 |   | 65,516 |   |
| Other real estate                                  |       |       |       |                                      |       |                  |       |   |   |   |   |   |   |
| Residential                                        |       | 17,091     |       | 452                                       |       | 559                   |       | 1,952 |   | 505 |   | 20,559 |   |
| Farmland and owner occupied nonfarm nonresidential |       | 88,266     |       | 8,263                                     |       | 4,426                 |       | 13,756 |   | 320 |   | 115,031 |   |
| Real estate construction                           |       |       |       |                                      |       |                  |       |   |   |   |   |   |   |
| Commercial                                         |       | 498        |       | —                                    |       | —                |       | 328 |   | — |   | 826 |   |
| Residential                                        |       | 1,741      |       | —                                    |       | —                |       | 968 |   | — |   | 2,709 |   |
| Consumer                                           |       |       |       |                                      |       |                  |       |   |   |   |   |   |   |
| Home equity                                        |       | 1,367      |       | —                                    |       | 500                   |       | 245 |   | — |   | 2,112 |   |
| Credit cards and other consumer                    |       | —     |       | —                                    |       | —                |       | 63 |   | — |   | 63 |   |
| Total                                              |       | $          | 244,419    |                                      | $          | 16,617                |       | $ | 14,198 |   | $ | 36,516 |   | $ | 892 |   | $ | 312,642 |   |

 
| ** **                                         | ** ** | ** ** | ** ** | **Consumer Credit Indicator** | ** ** | ** ** | ** ** |
|----------------------------------------------------|------------|------------|------------|-----------------------------------------|------------|------------|------------|
| ** **                                         | ** ** | **A**      | ** ** | **B**                                   | ** ** | **C**      | ** ** | **D** | ** ** | **Non-Rated** | ** ** | **Total** | ** ** |
| Commercial                                         |       | $          | —     |                                    | $          | —     |       | $ | — |   | $ | — |   | $ | — |   | $ | — |   |
| Commercial real estate                             |       |       |       |                                    |       |       |       |   |   |   |   |   |   |
| Raw land and land development                      |       | 164        |       | 326                                     |       | 94         |       | — |   | — |   | 584 |   |
| Other commercial real estate                       |       | —     |       | —                                  |       | —     |       | — |   | — |   | — |   |
| Other real estate                                  |       |       |       |                                    |       |       |       |   |   |   |   |   |   |
| Residential                                        |       | 9,715      |       | 2,485                                   |       | 1,129      |       | 793 |   | — |   | 14,122 |   |
| Farmland and owner occupied nonfarm nonresidential |       | 260        |       | —                                  |       | —     |       | — |   | — |   | 260 |   |
| Real estate construction                           |       |       |       |                                    |       |       |       |   |   |   |   |   |   |
| Commercial                                         |       | —     |       | —                                  |       | —     |       | — |   | — |   | — |   |
| Residential                                        |       | 215        |       | 155                                     |       | —     |       | 131 |   | — |   | 501 |   |
| Consumer                                           |       |       |       |                                    |       |       |       |   |   |   |   |   |   |
| Home equity                                        |       | 16,195     |       | 2,677                                   |       | 1,537      |       | 949 |   | 52 |   | 21,410 |   |
| Credit cards and other consumer                    |       | 7,586      |       | 1,663                                   |       | 754        |       | 581 |   | 5,975 |   | 16,559 |   |
| Total                                              |       | $          | 34,135     |                                    | $          | 7,306      |       | $ | 3,514 |   | $ | 2,454 |   | $ | 6,027 |   | $ | 53,436 |   |

 

**Note 7:****        ****ALLOWANCE FOR LOAN LOSSES**

 

The allowance for loan losses represents management’s best estimate of losses inherent in the portfolio and is evaluated on a regular basis and reviewed by the Board of Directors. The allowance for possible loan losses include allowance allocations in accordance with Accounting Standards Codification (ASC) Topic 310, Receivables and allowance allocations calculated in accordance with ASC Topic 450, “Contingencies.”  In analyzing the adequacy of the allowance for loan losses, we utilize a comprehensive loan grading system to determine the risk potential in the portfolio and also consider the results of independent third party credit reviews. Bancorp’s process is designed to account for credit deterioration as it occurs.  The allowance is based upon Bancorp’s evaluation of the pertinent factors underlying the quality and composition of the loan portfolio, levels and trends in losses and delinquencies, current economic conditions, specific industry conditions and estimated value of any underlying collateral. These evaluations are inherently subjective and it requires management to make numerous assumptions, estimates and judgments that are susceptible to significant revision as more information becomes available.

 

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While Bancorp believes that it uses the best information available to determine the allowance for loan losses and that our processes adequately address the various components that could potentially result in credit losses, the processes and the various components include features that may be susceptible to significant change. There are numerous components that enter into the evaluation of the allowance for loan losses. Some are quantitative while others require Bancorp to make qualitative judgments. Unforeseen market conditions and unfavorable differences between the actual outcome of credit-related events and our estimates and projections could require an additional provision for credit losses, which would negatively impact Bancorp’s results of operations in future periods. Also, growth of the loan portfolio and a further decline in the performance of the economy, in general, or a further decline in real estate values in our market areas, in particular, could have an adverse impact on collectability, increase the level of non-performing loans or have other adverse effects which alone or in aggregate could have a material adverse effect on our business, financial condition, results of operation and cash flows which may require additional provisions to our allowance for loan losses. The ultimate recovery of loans is susceptible to future market factors beyond Bancorp’s control. Additionally, loans are subject to examinations b**y** regulators, who, based upon their judgment, may require Bancorp to make additional provisions or adjustments to its allowance for loan losses. The allowance consists of specific, general and unallocated components.

 

*Specific Valuation Allowance:* A specific valuation allowance is established based on a review of impaired loans for specific weaknesses, impairment and loss exposure.  A loan is considered impaired when management determines that it is probable that Bancorp will be unable to collect all contractual amounts of principal and interest as scheduled in the loan agreement. Factors considered by management in determining impairment include payment status and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired.

 

The assessment for impairment occurs when and while loans are designated as substandard per Bancorp’s internal risk rating system or when and while such loans are on non-accrual.  Generally, substandard or non-accrual loans are reviewed for impairment and are analyzed individually on a quarterly basis. Smaller balance loans, including commercial loans under the threshold or consumer and credit card loans, may be grouped with other loans in its product type and risk grade category for reserve purposes. In general, the specific allocation for a loan is equal to the impairment measured by ASC 310.  If the loan is collateral dependent, a specific reserve is established when the value of the loan collateral is less than Bancorp’s recorded investment in the loan.  If the loan is not collateral dependent, a specific allocation is established when the discounted cash flow is less than Bancorp’s recorded investment in the loan.

 

*General Allowance:* The general allowance is based on historical loan loss experience for different loan types and different risk gradings with adjustments for current events and conditions.  Bancorp’s loan portfolio is broken into different loan types and different risk ratings.  For real estate and commercial loans, Bancorp uses historical loss experience factors by loan category, adjusted for changes in trends and conditions, to help determine an indicated allowance for each category based on individual risk ratings. In addition, other factors are considered in the analysis including volumes and trends of delinquencies, levels of nonaccrual loans, repossessions and bankruptcies, trends in criticized and classified loans, and expected losses on loans secured by real estate, new policies, economic conditions, concentrations of credit risk, management’s judgment about risks inherent in the portfolio and the experience and abilities of lending personnel are also taken into consideration. Historical loss rates for commercial and real estate types loans are established by examining historical charge-off data for each pool of loans, typically over the last 5 years (although the period may be shortened based on current and expected trends and conditions). Bancorp’s process is designed to account for credit deterioration as it occurs. Loss factor rates for consumer loans are based on West Coast consumer loan loss statistics from Equifax and the loss factors for Credit Cards are based on Federal Reserve Statistical loss rates.

* *

*Unallocated General Allowance:* An unallocated general allowances is established based on an additional review of the adequacy of the allowance on the loan portfolio in its entirety, as well as our judgmental consideration of any adjustments necessary for subjective factors such as economic uncertainties and concentration risks. The unallocated allowance also provides for other credit losses inherent in the loan portfolio that may not have been contemplated in the general and specific components of the allowance.

 

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The following is an analysis of the changes in the allowance for loan losses as of March 31, 2011, and 2010:

 

(dollars in thousands)

**Allowance for loan losses:**

 
| **March 31, 2011**                            | ** ** | **Commercial** | ** ** | **Commercial   Real Estate** | ** ** | **Other Real   Estate** | ** ** | **Real Estate   Construction** | ** ** | **Consumer** | ** ** | **Unallocated** | ** ** | **Total** | ** ** |
|---------------------------------------------------------|------------|----------------|------------|-----------------------------------|------------|------------------------------|------------|-------------------------------------|------------|--------------|------------|-----------------|------------|-----------|------------|
| Balance, beginning of year                              |       | $              | 1,494      |                              | $          | 2,564                        |       | $                                   | 1,400      |         | $          | 67              |       | $         | 855        |   | $ | 699 |   | $ | 7,079 |   |
| Loans charged off                                       |       | —         |       | —                            |       | —                       |       | —                              |       | (92          | )          | —          |       | (92       | )          |
| Recoveries                                              |       | 3              |       | —                            |       | —                       |       | —                              |       | 31           |       | —          |       | 34        |       |
| Provision (benefit)                                     |       | 659            |       | (243                              | )          | (125                         | )          | 23                                  |       | 10           |       | 1               |       | 325       |       |
| Balance, end of period                                  |       | $              | 2,156      |                              | $          | 2,321                        |       | $                                   | 1,275      |         | $          | 90              |       | $         | 804        |   | $ | 700 |   | $ | 7,346 |   |
|                                                    |       |           |       |                              |       |                         |       |                                |       |         |       |            |       |      |       |
| Ending balance: individually evaluated for   impairment |       | $              | 1,260      |                              | $          | 445                          |       | $                                   | 39         |         | $          | —          |       | $         | 25         |   | $ | — |   | $ | 1,769 |   |
| Ending balance: collectively evaluated for   impairment |       | $              | 896        |                              | $          | 1,876                        |       | $                                   | 1,236      |         | $          | 90              |       | $         | 779        |   | $ | 700 |   | $ | 5,577 |   |
|                                                    |       |           |       |                              |       |                         |       |                                |       |         |       |            |       |      |       |
| **Loans Receivables:**                                  |       |           |       |                              |       |                         |       |                                |       |         |       |            |       |      |       |
| Ending balance                                          |       | $              | 65,202     |                              | $          | 102,966                      |       | $                                   | 146,870    |         | $          | 4,346           |       | $         | 40,276     |   |   |   | $ | 359,660 |   |
| Ending balance: individually evaluated for   impairment |       | $              | 3,801      |                              | $          | 6,938                        |       | $                                   | 7,460      |         | $          | 1,032           |       | $         | 149        |   |   |   | $ | 19,380 |   |
| Ending balance: collectively evaluated for   impairment |       | $              | 61,401     |                              | $          | 96,028                       |       | $                                   | 139,410    |         | $          | 3,314           |       | $         | 40,127     |   |   |   | $ | 340,280 |   |

** **
| **(dollars in thousands)**                           | ** ** | ** ** | ** ** |
|----------------------------------------------------------------|------------|------------|------------|
| **Three months ended March 31, 2010** | ** ** | ** ** | ** ** |
| Allowance as of beginning of period                            |       | $          | 6,883      |   |
| Provision for loan losses                                      |       | 550        |       |
| Charge-offs                                                    |       | (188       | )          |
| Recoveries                                                     |       | 35         |       |
| Net charge-offs                                                |       | (153       | )          |
| Balance at end of period                                       |       | $          | 7,280      |   |

 

**Note 8:****        ****COMMITMENTS**

 

Bancorp is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to originate loans, provide funds under existing lines of credit, standby letters of credit and municipal warrants. Those instruments involve, to varying degrees, elements of credit and interest-rate risk in excess of the amount recognized in the balance sheet. Bancorp uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments.

 

Commitments to originate loans or provide funds under existing lines of credit or to fund municipal warrants are agreements to lend to a customer as long as there is no violation of conditions established in the loan documents. Commitments generally have fixed expiration dates or other termination clauses. Total commitment amounts may not necessarily represent future cash-flow requirements. Standby letters of credit are conditional commitments issued by Bancorp to guarantee the performance of a customer to a third party. Commercial and standby letters of credit are granted primarily to commercial borrowers and are primarily issued to support public and private borrowing arrangements.  The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Bancorp has not incurred any losses on its letter of credit commitments in 2011 or 2010.

 

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The following is a summary of the off-balance-sheet financial instruments or contracts outstanding as of March 31, 2011: (dollars in thousands)

 
| Unfunded   commitments to extend credit  |   | $      | 66,907 |
|------------------------------------------|--------|--------|--------|
| Credit   card arrangements               |   | 11,538 |
| Commitments   to fund municipal warrants |   | 4,924  |
| Standby   letters of credit              |   | 1,864  |

 

**Note 9:****        ****INCOME TAXES**

 

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

 

The effective tax rate is lower than the statutory rate due to tax credits from tax-exempt bonds and due to nontaxable income generated from tax-exempt municipal bonds and warrants. As of March 31, 2011, Bancorp had $257,000 in tax-exempt income from $26.6 million of tax-exempt bonds and warrants. In addition, Bancorp had $20.7 million in Qualified Zone Academy Bonds as of March 31, 2011. In lieu of receiving periodic interest payments on Qualified Zone Academy Bonds, Bancorp receives an annual income tax credit until maturity of the bond.  The tax credits are available one year after the bond is issued and each successive one year period thereafter until maturity.

** **

**Note 10:****           ****FAIR VALUE MEASUREMENTS**

 

Disclosures regarding the fair value of financial asset and liabilities, including those financial assets and liabilities that are not measured and reported at fair value on a recurring basis or non-recurring basis are required disclosures.  The estimated fair values have been determined by Bancorp using available market information and appropriate valuation methodologies and considerable judgment is necessary to interpret market data in the development of the estimates of fair value.  The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts. In that regard, the fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in immediate settlement on the instrument. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of Bancorp.

 

***Financial Instruments***

 

Disclosures regarding the fair value of financial asset and liabilities, including those financial assets and liabilities that are not measured and reported at fair value on a recurring basis or non-recurring basis are required disclosures.  The estimated fair values have been determined by Bancorp using available market information and appropriate valuation methodologies and considerable judgment is necessary to interpret market data in the development of the estimates of fair value.  The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts. In that regard, the fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in immediate settlement on the instrument. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of Bancorp.

* *

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

* *

*Investment Securities* — The securities classified as available for sale are reported at fair value utilizing quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, or other inputs that are observable or can be derived from or corroborated by observable market data by correlation or other means. The fair values for held-to-maturity securities including fixed rate warrants and qualified zone academy bonds are estimated using discounted cash flow analysis using interest rates currently being offered for warrants of similar terms or the current qualified zone academy bond interest rates.

* *

*Loans —* The fair value of loans is estimated by discounting anticipated future cash flows using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality as of the balance sheet date.  An overall liquidity discount was also used for 2011 and 2010 to reflect the decline of loan sales in the marketplace.  Collateral dependent impaired loans were not subjected to discounted cash flow analysis as they are already considered to be held at fair value.

* *

*Loans held for sale—* The fair value of loans held for sale are equal to, or approximate, their carrying amounts.

 

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

 

*Off-Balance-Sheet Instruments —* Commitments to extend credit and standby letters of credit represent the principal categories of off-balance financial instruments.  The fair value of these instruments is not considered material since they are for relatively short periods of time and are subject to customary credit terms, which would not include terms that would expose Bancorp to significant gains or losses.

 

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

 
| ** **                           | ** ** | **March 31, 2011** | ** ** | **December 31, 2010** | ** ** |
|--------------------------------------|------------|------------------------------|------------|---------------------------------|------------|
| ** **                           | ** ** | **Carrying**                 | ** ** | ** **                      | ** ** | **Carrying** | ** ** | ** ** | ** ** |
| **(dollars in thousands)** | ** ** | **Amount**                   | ** ** | **Fair Value**             | ** ** | **Amount** | ** ** | **Fair Value** | ** ** |
| *Financial Assets*                   | * *   | * *                     | * *   | * *                        | * *   | * * | * * | * * | * * |
| Cash and due from banks              |       | $                            | 10,759     |                            | $          | 10,759 |   | $ | 10,461 |   | $ | 10,461 |   |
| Federal funds sold                   |       | 71,167                       |       | 71,167                          |       | 80,413 |   | 80,413 |   |
| Investment securities                |       | 252,824                      |       | 253,653                         |       | 219,338 |   | 219,833 |   |
| Loans held for sale                  |       | —                       |       | —                          |       | 78 |   | 78 |   |
| Net loans                            |       | 351,622                      |       | 332,383                         |       | 358,240 |   | 338,704 |   |
| Accrued interest receivable          |       | 2,400                        |       | 2,400                           |       | 2,521 |   | 2,521 |   |
| * *                             |       |                         |       |                            |       |   |   |   |   |
| *Financial Liabilities*              |       |                         |       |                            |       |   |   |   |   |
| Demand and savings deposits          |       | 396,087                      |       | 396,087                         |       | 375,541 |   | 375,541 |   |
| Time deposits                        |       | 210,241                      |       | 211,535                         |       | 215,340 |   | 216,736 |   |
| Other borrowings                     |       | 34,464                       |       | 34,464                          |       | 34,118 |   | 34,118 |   |
| Accrued interest payable             |       | 215                          |       | 215                             |       | 234 |   | 234 |   |
|                                      |            |                              |            |                                 |            |  |  |  |  |  |  |  |  |

 

***Fair Value Hierarchy***

 

The methodologies for estimating the fair value of financial assets and liabilities that are measured at fair value on a recurring or non-recurring basis are discussed below.  The methodologies for other financial assets and liabilities are discussed above. ASC 820 establishes a hierarchy that prioritizes the use of fair value inputs used in the valuation methodologies into the following three levels:

 

Level 1 — Quoted prices for identical instruments in active markets that Bancorp has the ability to access at the measurement date.

 

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

 

Level 3 — Significant unobservable inputs that reflect the Bancorp’s own assumption about the assumptions that market participants would use in pricing an asset or liability.

 

In general, Bancorp determines fair value based upon quoted prices when available or through the use of alternative approaches, such as matrix or model pricing, when market quotes are not readily accessible or available. The valuation techniques used are based on observable and unobservable inputs.  Valuation adjustments may be made to ensure that financial instruments are recorded at fair value.  While management believes Bancorp’s valuation methodologies are appropriate and consistent with other market participants, the use of different methodologies or assumptions used to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date. There were no transfers between levels during 2011.

 

*Investment Securities Available for Sale* — Securities classified as available for sale are reported at fair value utilizing Level 2 inputs. For these securities, Bancorp obtains fair value measurements from an independent pricing service.  The fair value measurements includes considerable observable data that may include dealer quotes, market spreads, cash flows, the treasury yield curve, yield/spread relationships, consensus prepayment rates, and the bonds terms and conditions,  among other things.

 

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*Impaired Loans* — The recorded net investment in impaired loans, including accrued interest, is limited to the present value of the expected cash flows of the impaired loan, the observable fair market value of the loan or the estimated fair value of the loan’s collateral.

 

*Other Real Estate Owned* — Other real estate owned includes properties acquired through foreclosure and other properties owned but no longer used for banking purposes.  These properties are recorded at the lower of the recorded amount of the loan, or estimated fair value less estimated costs to sell based on periodic evaluations using Level 3 inputs.  Valuation of the property occurs when it is foreclosed upon and annually thereafter.  Write-downs arising from the acquisition of property, in full or partial satisfaction of loans, are charged to the allowance for loan losses.  Subsequent write-downs after acquisition, identified through management’s periodic valuations, are written down through non-interest expenses.

 

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

 
| **(dollars in thousands)**                                             | ** ** | ** ** | ** ** | **Quoted Prices   in Active   Markets for   Identical   Assets** | ** ** | **Significant   Other   Observable   Inputs** | ** ** | **Significant   Unobservable   Inputs** | ** ** |
|----------------------------------------------------------------------------------|------------|------------|------------|---------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|-----------------------------------------|------------|
| **Description**                                                                  | ** ** | **Total**  | ** ** | **(Level 1)**                                                              | ** ** | **(Level 2)**                            | ** ** | **(Level 3)**                      | ** ** |
| **March 31, 2011**                                                               |       |       |       |                                                                            |       |                                          |       |                                    |       |
|                                                                             |       |       |       |                                                                            |       |                                          |       |                                    |       |
| Available-for-sale securities                                                    |       |       |       |                                                                            |       |                                          |       |                                    |       |
| U.S. Treasury and government agencies                                            |       | $          | 119,775    |                                                                            | $          | —                                        |       | $                                       | 119,775    |   | $ | — |   |
| Residential mortgage-backed securities and collateralized   mortgage obligations |       | 85,752     |       | —                                                                          |       | 85,752                                        |       | —                                  |       |
| State and political subdivisions                                                 |       | 8,989      |       | —                                                                          |       | 8,989                                         |       | —                                  |       |
| Total                                                                            |       | $          | 214,516    |                                                                            | $          | —                                        |       | $                                       | 214,516    |   | $ | — |   |
|                                                                             |       |       |       |                                                                            |       |                                          |       |                                    |       |
| **December 31, 2010**                                                       |       |       |       |                                                                            |       |                                          |       |                                    |       |
|                                                                             |       |       |       |                                                                            |       |                                          |       |                                    |       |
| Available-for-sale securities                                                    |       |       |       |                                                                            |       |                                          |       |                                    |       |
| U.S. Treasury and government agencies                                            |       | $          | 85,775     |                                                                            | $          | —                                        |       | $                                       | 85,775     |   | $ | — |   |
| Residential mortgage-backed securities and collateralized   mortgage obligations |       | 86,431     |       | —                                                                          |       | 86,431                                        |       | —                                  |       |
| State and political subdivisions                                                 |       | 8,765      |       | —                                                                          |       | 8,765                                         |       | —                                  |       |
| Total                                                                            |       | $          | 180,971    |                                                                            | $          | —                                        |       | $                                       | 180,971    |   | $ | — |   |

 

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The table below shows assets measured at fair value on a non-recurring basis as of the dates indicated.

 

(dollars in thousands)

 
| ** **               | ** ** | ** ** | ** ** | **Quoted Prices   in Active   Markets for   Identical   Assets** | ** ** | **Significant   Other   Observable   Inputs** | ** ** | **Significant   Unobservable   Inputs** | ** ** | **Total   Gains/(Losses) for   the Three Months** | ** ** |
|--------------------------|------------|------------|------------|---------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|-----------------------------------------|------------|-------------------------------------------------------------|------------|
| **Description**          | ** ** | **Total**  | ** ** | **(Level 1)**                                                              | ** ** | **(Level 2)**                            | ** ** | **(Level 3)**                      | ** ** | **Ended**                                                   | ** ** |
| **March 31, 2011**  |       |       |       |                                                                            |       |                                          |       |                                    |       |                                                        |       |
| Impaired loans           |       |       |       |                                                                            |       |                                          |       |                                    |       |                                                        |       |
| Commercial               |       | $          | 2,541      |                                                                            | $          | —                                        |       | $                                       | —     |                                                        | $          | 2,541 |   | $ | (721 | ) |
| Commercial real estate   |       | 6,493      |       | —                                                                          |       | —                                        |       | 6,493                                   |       | (94                                                         | )          |
| Other real estate        |       | 7,421      |       | —                                                                          |       | —                                        |       | 7,421                                   |       | (37                                                         | )          |
| Real estate construction |       | 1,032      |       | —                                                                          |       | —                                        |       | 1,032                                   |       | —                                                      |       |
| Consumer                 |       | 124        |       | —                                                                          |       | —                                        |       | 124                                     |       | (21                                                         | )          |
| Other real estate owned  |       | 4,334      |       | —                                                                          |       | —                                        |       | 4,334                                   |       | (213                                                        | )          |
| Total                    |       | $          | 21,945     |                                                                            | $          | —                                        |       | $                                       | —     |                                                        | $          | 21,945 |   | $ | (1,086 | ) |

 
| ** **                 | ** ** | ** ** | ** ** | **Quoted Prices   in Active   Markets for   Identical   Assets** | ** ** | **Significant   Other   Observable   Inputs** | ** ** | **Significant   Unobservable   Inputs** | ** ** | **Total   Gains/(Losses) for   the Twelve** | ** ** |
|----------------------------|------------|------------|------------|---------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|-----------------------------------------|------------|-------------------------------------------------------|------------|
| **Description**            | ** ** | **Total**  | ** ** | **(Level 1)**                                                              | ** ** | **(Level 2)**                            | ** ** | **(Level 3)**                      | ** ** | **Months Ended**                                 | ** ** |
| ** **                 |       |       |       |                                                                            |       |                                          |       |                                    |       |                                                  |       |
| **December 31, 2010** |       |       |       |                                                                            |       |                                          |       |                                    |       |                                                  |       |
| Impaired loans             |       |       |       |                                                                            |       |                                          |       |                                    |       |                                                  |       |
| Commercial                 |       | $          | 3,159      |                                                                            | $          | —                                        |       | $                                       | —     |                                                  | $          | 3,159 |   | $ | (1,065 | ) |
| Commercial real estate     |       | 5,353      |       | —                                                                          |       | —                                        |       | 5,353                                   |       | 578                                                   |       |
| Other real estate          |       | 7,331      |       | —                                                                          |       | —                                        |       | 7,331                                   |       | (241                                                  | )          |
| Real estate construction   |       | 969        |       | —                                                                          |       | —                                        |       | 969                                     |       | (114                                                  | )          |
| Consumer                   |       | 153        |       | —                                                                          |       | —                                        |       | 153                                     |       | (29                                                   | )          |
| Other real estate owned    |       | 5,813      |       | —                                                                          |       | —                                        |       | 5,813                                   |       | (473                                                  | )          |
| Total                      |       | $          | 22,778     |                                                                            | $          | —                                        |       | $                                       | —     |                                                  | $          | 22,778 |   | $ | (1,344 | ) |

 

Gains and losses on impaired loans in the table above are the result of charge-offs and/or changes to specific valuation allowances recorded to the allowance for loan losses for the period specified.

 

Gains and losses on other real estate owned in the table above are the result of increases, and/or decreases, to the provision for other real estate losses which are charged against earnings for the period specified.

 

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

** **

*The following discussion should be read in conjunction with the consolidated financial statements and notes thereto presented elsewhere in this report.  For additional information, refer to the financial statements and footnotes for the year ended December 31, 2010 in the Annual Report on Form 10-K.*

 

**FORWARD LOOKING STATEMENTS**

 

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

 

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·              the risks associated with lending and potential adverse changes in the credit quality of loans in our portfolio, including as a result of declines in the housing and real estate markets in our market areas;

·              increased loan delinquency rates;

·              the risks presented by a continued economic downturn, which could adversely affect credit quality, loan collateral values, investment values, liquidity levels, and loan originations;

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

·              legislative or regulatory changes that adversely affect our business or our ability to complete pending or prospective future acquisitions;

·              reduced demand for banking products and services;

·              competition from other financial services companies in our markets; and

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

 

Additional factors that could cause actual results to differ materially from those expressed in the forward-looking statements are discussed in Risk Factors in Item 1A. Please take into account that forward-looking statements speak only as of the date of this Form 10-Q or documents incorporated by reference. Bancorp does not undertake any obligation to publicly correct or update any forward-looking statement if we later become aware that actual results are likely to differ materially from these expressed in such forward looking statement.

 

**BUSINESS**

 

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

 

**RESULTS OF OPERATIONS**

** **

Net income decreased to $975,000 or $1.66 per diluted earnings per share for the quarter ended March 31, 2011 compared to $1.2 million or $2.05 per diluted earnings per share for the quarter ended March 31, 2010. Return on average assets and return on average equity was 0.57 percent and 5.98 percent, respectively, for the three months ended March 31, 2011 compared to 0.75 percent and 7.69 percent, respectively, for the three months ended March 31, 2010. The decrease in net income was primarily due to a decrease in interest income which was partially offset by decreases in interest expense and provision for loan losses.

 

Bancorp’s results of operations are dependent to a large degree on net interest income, operating efficiency and the level of the provision for loan losses. Bancorp’s operations are sensitive to interest rate changes and the resulting impact on net interest income. In addition, changes in net interest income are influenced by the volume of assets and liabilities and the rates earned and paid respectively.  Bancorp generates non-interest income primarily through fees and service charges on deposit accounts and gains on the sale of mortgage loans. Bancorp’s non-interest expenses consist primarily of salaries and employee benefits expense, bank premises and equipment expenses and other operating expenses.

 

**NET INTEREST INCOME**        Net interest income is Bancorp’s principal source of revenue and is comprised of interest income on earnings assets (loans and investment securities) less interest expense on interest-bearing liabilities (deposits and borrowings). Interest income and expense are affected significantly by i) general economic conditions, particularly changes in market interest rates, ii) volume of non-interest earning assets, iii) asset quality and, iv) the pricing, volume and mix of interest-earning assets and interest-bearing liabilities as well as by government policies and the actions of regulatory authorities.

 

Bancorp’s net interest income decreased to $5.1 million for the three months ended March 31, 2011 from $5.4 million for the like period in 2010.  The net interest margin is net interest income expressed as a percent of average interest-earning assets. The decrease was primarily a result of the decrease in average loan balances and yields on loans from 2010 to 2011.  The net interest margin decreased to 3.08 percent for the three months ended March 31, 2011 from 3.53 percent for the like quarter in 2010.

 

*Interest-earning assets:*The largest component of interest income is interest earned on loans.  Total loan interest income decreased by $735,000 for three months ended March 31, 2011 to $4.9 million compared to $5.6 million for the three months ended March 31, 2010.  The decrease was primarily the result of the both the decrease in average loan balances from 2010 to 2011 and the decrease in yield which decreased to 5.64 percent for three months ended March 31, 2011 from 5.95 percent in 2010. Interest earned on investments and federal funds sold were $1.4 million and $1.3 million, respectively, for the quarters ended March 31, 2011 and 2010. This decrease was impacted by a reduction in the yield which was partially offset by an $80.6 million increase in average balances.

 

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*Interest- bearing liabilities:*Interest expense decreased $348,000 to $1.3 million for the three months ended March 3, 2011 compared to $1.6 million for the three months ended March 31, 2010. This reduction was the primarily the result of a 65 basis point decrease in the cost of funds for time deposits and a 41 basis point decrease in the cost of funds for savings accounts.  This reduction was partially offset by the $ 42.1 million increase in average deposit balances.

 

The following tables present information regarding average balances of assets and liabilities as well as the total amounts of interest income from average interest-earning assets and interest expense on average interest-bearing liabilities, resulting yield and cost ratios, interest rate spread and net interest margin. Tax exempt securities, included in investment securities below are stated at their contractual interest rate.  Loan fees of $143,000 for the quarter ended March 31, 2011 and $174,000 for the quarter ended March 31, 2010 are included in interest earned on loans. Non-accruing loans have been included in the computation of average loans.

 

**Condensed Average Balance Sheets**

(dollars in thousands except share data)

 
| ** **                                           | ** ** | **2011**              | ** ** | ** **   | ** ** | **2010**          | ** ** | ** **            | ** ** |
|------------------------------------------------------|------------|-----------------------|------------|--------------|------------|-------------------|------------|-----------------------|------------|
| **Three months ended March 31,** | ** ** | **Average   Balance** | ** ** | **Interest** | ** ** | **Yield   /Cost** | ** ** | **Average   Balance** | ** ** | **Interest** | ** ** | **Yield   /Cost** | ** ** |
| **Assets**                                           |       |                  |       |         |       |              |       |                  |       |   |   |   |   |
| Federal funds sold                                   |       | $                     | 82,491     |         | $          | 52                |       | 0.26                  | %          | $ | 78,298 |   | $ | 49 |   | 0.25 | % |
| Taxable investment securities                        |       | 183,916               |       | 1,108        |       | 2.44              |       | 104,867               |       | 1,018 |   | 3.94 |   |
| Tax exempt securities                                |       | 46,960                |       | 257          |       | 2.22              |       | 49,614                |       | 274 |   | 2.24 |   |
| Loans                                                |       | 352,932               |       | 4,905        |       | 5.64              |       | 384,601               |       | 5,640 |   | 5.95 |   |
| Total interest-earning assets                        |       | 666,299               |       | 6,322        |       | 3.85              | %          | 617,380               |       | 6,981 |   | 4.59 | % |
| Non-interest earning assets                          |       | 32,748                |       |         |       |              |       | 35,957                |       |   |   |   |   |
| Total assets                                         |       | $                     | 699,047    |         |       |              |       |                  | $          | 653,337 |   |   |   |   |   |
|                                                 |       |                  |       |         |       |              |       |                  |       |   |   |   |   |
| **Liabilities and Stockholders’   Equity**      |       |                  |       |         |       |              |       |                  |       |   |   |   |   |
| Interest-bearing demand                              |       | $                     | 108,782    |         | $          | 125               |       | 0.47                  | %          | $ | 101,409 |   | $ | 84 |   | 0.34 | % |
| Savings and money market                             |       | 197,296               |       | 297          |       | 0.61              |       | 167,364               |       | 355 |   | 0.86 |   |
| Certificates of deposit                              |       | 215,606               |       | 758          |       | 1.43              |       | 210,840               |       | 1,081 |   | 2.08 |   |
| Total interest-bearing deposits                      |       | 521,684               |       | 1,180        |       | 0.92              |       | 479,613               |       | 1,520 |   | 1.29 |   |
| Other borrowings                                     |       | 34,655                |       | 74           |       | 0.87              |       | 37,465                |       | 82 |   | 0.89 |   |
| Total interest-bearing deposits & liabilities    |       | 556,339               |       | 1,254        |       | 0.91              | %          | 517,078               |       | 1,602 |   | 1.26 | % |
| Non interest-bearing demand deposits                 |       | 75,242                |       |         |       |              |       | 71,007                |       |   |   |   |   |
| Other non-interest-bearing liabilities               |       | 1,331                 |       |         |       |              |       | 1,510                 |       |   |   |   |   |
| Total liabilities                                    |       | 632,912               |       |         |       |              |       | 589,595               |       |   |   |   |   |
| Stockholders’ equity                            |       | 66,135                |       |         |       |              |       | 63,742                |       |   |   |   |   |
| Total liabilities and stockholders equity            |       | $                     | 699,047    |         |       |              |       |                  | $          | 653,337 |   |   |   |   |   |
| Net interest income                                  |       |                  |       | $            | 5,068      |              |       |                  |       |   | $ | 5,379 |   |   |   |
| Interest rate spread                                 |       |                  |       |         |       | 2.93              | %          |                  |       |   |   | 3.33 | % |
| Net interest margin                                  |       |                  |       |         |       | 3.08              | %          |                  |       |   |   | 3.53 | % |

 

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

 

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**Analysis of Changes in Interest Income and Expense Due to Changes in Volume and Rate**

 
| ** **                                                        | ** ** | **Three months ended March 31,** | ** ** |
|-------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                        | ** ** | **2011 vs. 2010**                          | ** ** |
| ** **                                                        | ** ** | **Increase (Decrease) Due to**        | ** ** |
| ** (dollars in thousands)**                        | ** ** | **Volume**                                           | ** ** | **Rate** | ** ** | **Total** | ** ** |
| **Interest-Earning Assets**                                       | ** ** | ** **                                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Federal funds sold                                                |       | $                                                    | 3          |   | $ | — |   | $ | 3 |   |
| Investment securities                                             |       | 2,129                                                |       | (2,056 | ) | 73 |   |
| Loans                                                             |       | (450                                                 | )          | (285 | ) | (735 | ) |
| Total net change in income on interest-earning   assets           |       | 1,682                                                |       | (2,341 | ) | (659 | ) |
| **Interest-Bearing Liabilities**                                  |       |                                                 |       |   |   |   |   |
| Deposits                                                          |       | 564                                                  |       | (904 | ) | (340 | ) |
| Other borrowings                                                  |       | (6                                                   | )          | (2 | ) | (8 | ) |
| Total net change in expense on  interest-bearing liabilities |       | 558                                                  |       | (906 | ) | (348 | ) |
| Net change in net interest income                                 |       | $                                                    | 1,124      |   | $ | (1,435 | ) | $ | (311 | ) |

 

**PROVISION FOR LOAN LOSSES               **The provision for loan losses was $325,000 for the three months ended March 31, 2011 compared to $550,000 for the like period in 2010. The decrease in provision resulted from decreased net charge-offs and the decline in loan balances.  For the three months ended March 31, 2011 and 2010, net charge-offs were $58,000 and $153,000, respectively.

 

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

 

**NON-INTEREST INCOME     **Non-interest income, which consists primarily of fees and service charges on deposits and other income, was relatively unchanged at $1.0 million for the quarters ended March 31, 2011 and 2010.

 

**NON-INTEREST EXPENSE    **Non-interest expenses increased to $4.6 million for the quarter ended March 31, 2011 compared to $4.3 for the quarter ended March 31, 2010. The increase was primarily a result of a $193,000 increase in the provisions for other real estate losses.  These provisions were a result of updated appraisals received and the decrease in fair market values of these real estate properties. Valuation of the other real estate owned property occurs when it is foreclosed upon and annually thereafter.

 

The efficiency ratio is computed by dividing total non-interest expenses by non-interest income and net interest income before any provision for loan losses.  Bancorp’s efficiency ratio was 75.2 percent and 68.7 percent for the quarters ended March 31, 2011 and 2010, respectively.

 

**INCOME TAX EXPENSE        **Income tax expense remained relatively unchanged at $216,000 and $218,000, respectively, for the quarters ended March 31, 2011 and 2010 with effective tax rates of 18.1 percent and 15.3 percent.

 

The effective tax rate is lower than the statutory rate due to tax credits from tax-exempt bonds and due to nontaxable income generated from tax-exempt municipal bonds and warrants. As of March 31, 2011, Bancorp had $257,000 in tax-exempt income from $26.6 million of tax-exempt bonds and warrants. In addition, Bancorp had $20.7 million in Qualified Zone Academy Bonds as of March 31, 2011. In lieu of receiving periodic interest payments on Qualified Zone Academy Bonds, Bancorp receives an annual income tax credit until maturity of the bond.  The tax credits are available one year after the bond is issued and each successive one year period thereafter until maturity.

 

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**REVIEW OF FINANCIAL CONDITION**

 

Total assets increased to $709.1 million at March 31, 2011 compared to $692.9 million at December 31, 2010.  This increase was primarily due to a $15.4 million increase in deposits.

 

**INVESTMENT SECURITIES AND FEDERAL FUNDS SOLD**Investment securities and federal funds sold increased $24.2 million to $324.0 million at March 31, 2011 and within the total, federal funds sold decreased to $71.2 million at March 31, 2011 compared to $80.4 million at December 31, 2010.  Total investment securities, including federal funds sold as a percentage of total assets increased to 46% at March 31, 2011, compared to 43% as of December 31, 2010.

 

Securities classified as available for sale are reported at estimated fair value, with unrealized gains and losses (net of income taxes) reported as accumulated other comprehensive income, a separate component of stockholders’ equity.   At March 31, 2011, the available-for-sale investment portfolio was comprised of 40.0 percent Government Sponsored Agency and Government Agency residential mortgage-backed pass-through securities and collateralized mortgage obligations, 4.2 percent of state and municipals and 55.8 percent of Government Sponsored Agencies and Government Agencies securities.  The held-to-maturity portfolio was concentrated in municipal securities and Qualified Zone Academy Bonds. Security purchases totaled $47.3 million for the three months ended March 31, 2011, while maturities, security calls and principal pay downs totaled $13.5 million.

 

The following table presents the carrying value of the portfolio of investments securities as of the dates indicated.

 
| ** **                                                                       | ** ** | **March 31, 2011** | ** ** | **December 31, 2010** | ** ** |
|----------------------------------------------------------------------------------|------------|------------------------------|------------|---------------------------------|------------|
| **Held-To-Maturity**                                                             |       |                         |       |                            |       |
| State and political subdivisions                                                 |       | $                            | 38,308     |                            | $          | 38,367 |   |
| Total                                                                            |       | $                            | 38,308     |                            | $          | 38,367 |   |
| **Available-For-Sale**                                                           |       |                         |       |                            |       |
| U.S. government agencies                                                         |       | $                            | 119,775    |                            | $          | 85,775 |   |
| Residential mortgage-backed securities and   collateralized mortgage obligations |       | 85,752                       |       | 86,431                          |       |
| State and political subdivisions                                                 |       | 8,989                        |       | 8,765                           |       |
| Total                                                                            |       | $                            | 214,516    |                            | $          | 180,971 |   |

 

**LOANS                **Net loans decreased $6.6 million to $351.6 million at March 31, 2011 from $358.2 million at December 31, 2010.  Net loans represented 49.6 percent of total assets at March 31, 2011.   Bancorp continues to originate and fund loans to credit-worthy customers within our markets.  However, decreased loan balances reflect the current market conditions and the lower demand and lower availability of quality loans.  Bancorp’s primary lending activities includes real estate loans, commercial loans which include agriculture production loans and consumer purpose loans.

 

*Commercial Loans*:  These loans were 18% of our portfolio as of March 31, 2011 compared to 19.0% at December 31, 2010.  Commercial loans, secured and unsecured, are made primarily for commercial and industrial purposes to small and medium-sized businesses including farms operating within Skagit, Snohomish and Whatcom Counties.  These loans are available for general operating purposes, acquisition of fixed assets, purchases of equipment and machinery, financing of inventory and accounts receivable, and other business purposes.  Bancorp originates Small Business Administration (SBA) loans, including 504 and 7A loans.

 

*Commercial Real Estate:*Commercial real estate loans were 29% of our portfolio as of March 31, 2011 compared to 28% at December 31, 2010. Commercial real estate loans consist of real estate secured loans advanced for non-owner occupied commercial real estate which includes, but is not limited to, office buildings, retail centers, multifamily and warehouses. These loans are typically term loans and are made to purchase or refinance non-owner occupied commercial real estate.  Commercial real estate loans also include real estate secured raw land loans and land development loans which are made to acquire land or finance development preparatory to erecting residential or commercial structures.

 

*Other Real Estate Loans:* Other real estate loans compromised 41% of our portfolio as of March 31, 2011 compared to 40% at December 31, 2010. Other real estate loans are typically made for, the purchase of or refinance of, residential real estate, real estate used for agricultural purposes including timberland, and owner-occupied real estate utilized by small to medium sized businesses and individuals for their business operations. They are typically term loans secured by the property being purchased or refinanced.

 

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*Real Estate Constructio*n:  These loans compromised 1% of our portfolio as of March 31, 2011 and December 31, 2010. Real Estate construction loans are short term loans made for the construction period required for both commercial construction projects and residential construction projects. These loans are generally secured by the real estate project being constructed. Commercial construction loans are available for owner-occupied real estate utilized by small to**medium sized businesses and individuals for their business operations and for non-owner occupied real estate.

 

*Consumer Loans:* Consumer loans compromises 11% of our portfolio as of March 31, 2011 compared to 12% at December 31, 2010.Bancorp makes secured and unsecured consumer loans including loans to individuals, primarily customers of Bancorp, for various purposes, including home equity loans, purchases of automobiles, mobile homes, boats and other recreational vehicles, home improvement loans and loans for education and personal investments.

 

*Concentrations:* While Bancorp has a diversification of loan types and type of security, Bancorp does have a concentration of loans in commercial and residential real estate and as such we are not immune to either the current economic conditions or how these economic conditions may affect a borrower’s ability to meet the stated repayment terms.  Loans secured by real estate compose 77% of the total loan portfolio and 39% of total assets as of March 31, 2011.  Further declines in the performance of the economy, in general, or further declines in real estate values in our market areas, in particular, could have an adverse impact on collectability, increase the level of real estate non-performing loans or have other adverse effects which alone or in aggregate could have a material adverse effect on our business, financial condition, results of operation and cash flows.  In addition, Bancorp has a high concentration of loans to a relatively small group of large borrowers, which could adversely affect Bancorp’s earnings if some of those customers cease doing business with us or certain of those larger loans incur problems. Approximately 47% of our loan portfolio as of March 31, 2011 was comprised of loans to a group of approximately 43 customers.  Also, most of Bancorp’s business activity is with customers located within Skagit, Snohomish and Whatcom Counties. While Bancorp has these concentrations, Bancorp believes that its lending policies and concentration policies are sufficient to minimize risks.  Management employs risk management practices, including board and management oversight and strategic planning, development of underwriting standards, risk assessment and monitoring through stress testing.

 

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

 

**Loan Composition**

 
| **(dollars in thousands)**               | ** ** | **March 31, 2011** | ** ** | **December 31, 2010** | ** ** |
|----------------------------------------------------|------------|------------------------------|------------|---------------------------------|------------|
| Commercial                                         |       | $                            | 65,202     |                            | $          | 69,177 |   |
| Commercial real estate                             |       |                         |       |                            |       |
| Raw land and land development                      |       | 37,884                       |       | 37,233                          |       |
| Other commercial real estate                       |       | 65,082                       |       | 65,516                          |       |
| Other real estate                                  |       |                         |       |                            |       |
| Residential                                        |       | 33,218                       |       | 34,681                          |       |
| Farmland and owner occupied nonfarm nonresidential |       | 113,652                      |       | 115,291                         |       |
| Real estate construction                           |       |                         |       |                            |       |
| Commercial                                         |       | 892                          |       | 826                             |       |
| Residential                                        |       | 3,454                        |       | 3,210                           |       |
| Consumer                                           |       |                         |       |                            |       |
| Home equity                                        |       | 24,320                       |       | 23,522                          |       |
| Credit cards and other consumer                    |       | 15,956                       |       | 16,622                          |       |
|                                               |       | $                            | 359,660    |                            | $          | 366,078 |   |
| Less deferred loan fees                            |       | (692                         | )          | (759                            | )          |
| Total Loans                                        |       | $                            | 358,968    |                            | $          | 365,319 |   |

 

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

 

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**ALLOWANCE FOR LOAN LOSSES**             The allowance for loan losses was $7.3 million or 2.09 percent of net loans as of March 31, 2011 compared to $7.1 million or 1.98 percent of net loans as of December 31, 2010.  Additions to the allowance, in the form of provision, are reflected in current operating results, while charge-offs to the allowance are made when a loss is determined to have occurred. The provision for loan losses was $325,000 for the three months ended March 31, 2011 compared to $550,000 for the like period in 2010. For the three months ended March 31, 2011 and 2011, net charge-offs were $58,000 and $153,000, respectively. Net charge-offs have an impact on the historical loss factors used in Bancorp’s allowance for loan losses computation.

 

The allowance for loan losses (“ALLL”) represents management’s best estimate of losses inherent in the portfolio, consists of specific, general and unallocated components. The allowance consists of specific, general and unallocated components; (i) a specific valuation allowance based on a review of substandard or non-accrual loans for specific weaknesses and evaluation of those loans for impairment and loss exposure; (ii) a general allowance which is based on historical loan loss experience for different loan types and different risk gradings with adjustments for current events and conditions.  Bancorp’s process is designed to account for credit deterioration as it occurs.  The adjustments are a result of management’s judgment about risks inherent in the portfolio and include such factors as loan quality trends, levels of and trends of non-accrual loans, past due loans, potential problem loans, criticized loan balances, net charge-offs and current economic and business conditions, among other factors and (iii) unallocated general allowances determined based on general economic conditions and other qualitative risk factors.  The unallocated allowance provides for other credit losses inherent in the loan portfolio that may not have been contemplated in the general and specific components of the allowance. The unallocated amount is reviewed periodically based on trends in credit losses, the results of credit reviews and overall economic trends. Further information regarding Bancorp’s policies and methodology used to estimate the allowance for possible loan losses is presented in Note 7 — Allowance for Loan Losses in the accompanying notes to the consolidated financial statements found elsewhere in this report.

 

The following table presents Bancorp’s allocation of the allowance for loan losses by loan category as of the dates indicated.  (dollars in thousands)

 
| ** **               | ** ** | **March 31, 2011** | ** ** | **December 31, 2010** | ** ** |
|--------------------------|------------|------------------------------|------------|---------------------------------|------------|
| Commercial               |       | $                            | 2,156      |                            | $          | 1,494 |   |
| Commercial real estate   |       | 2,321                        |       | 2,564                           |       |
| Other real estate        |       | 1,275                        |       | 1,400                           |       |
| Real estate construction |       | 90                           |       | 67                              |       |
| Consumer                 |       | 804                          |       | 855                             |       |
| Unallocated              |       | 700                          |       | 699                             |       |
| Total                    |       | $                            | 7,346      |                            | $          | 7,079 |   |

 

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

 

**Allowance for Loan Losses Activity**

 
| ** **                                                    | ** ** | **Three months ended,** | ** ** |
|---------------------------------------------------------------|------------|-----------------------------------|------------|
| **(dollars in thousands)**                          | ** ** | **2011**                          | ** ** | **2010** | ** ** |
| Allowance as of beginning of period                           |       | $                                 | 7,079      |   | $ | 6,883 |   |
| Provision for loan losses                                     |       | 325                               |       | 550 |   |
| Charge-offs                                                   |       | (92                               | )          | (188 | ) |
| Recoveries                                                    |       | 34                                |       | 35 |   |
| Net charge-offs                                               |       | (58                               | )          | (153 | ) |
| Balance at end of period                                      |       | $                                 | 7,346      |   | $ | 7,280 |   |
| Ratio of net charge-offs to average loans during   the period |       | 0.07                              | %          | 0.16 | % |
| Ratio of allowance to net loans at end of period              |       | 2.09                              | %          | 1.90 | % |
| Ratio of non-performing loans to allowance                    |       | 249.77                            | %          | 139.22 | % |

 

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* *

*Credit Risk Management*

 

The extension of credit to individuals and businesses is a significant portion of Bancorp’s principal business activity and requires ongoing portfolio and credit management.  Bancorp has established lending policies and procedures to manage and monitor risk. These lending policies and procedures include guidelines for concentrations of credit, loan terms, loan-to-value ratios, collateral appraisals, borrower lending limits and loan approval limits. In addition, Bancorp monitors its loan portfolio for potential risk of loss according to an internal risk-grading system and monitors its credit quality to identify potential problem credits and any loss exposure in a timely manner.  Bancorp has assessed and will continue to assess on an on-going basis, the impact of the economy on the credit risk in the loan portfolio.

 

***ASSET QUALITY*****        **Non-performing assets consist of nonaccrual loans, accruing loans past due 90 days or more, and other real estate owned. At March 31, 2011, non-performing assets increased to $22.7 million or 3.20 percent of total assets compared to $18.6 million or 2.69 percent as of December 31, 2010.  The increase was mainly the result of one loan relationship, with an aggregate balance of $5.0 million, moving into non-accrual status during the three months ended March 31, 2011.

 

*Non-accrual loans* - It is Bancorp’s policy to discontinue the accrual of interest on all loans that are 90 days or more past due or when there are otherwise serious doubts about the collectability of principal or interest within 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 interest income. Non-accruing loans were $18.3 million as of March 31, 2011 compared to $12.8 million as of December 31, 2010.

* *

*Troubled Debt Restructurings* — Loans are considered troubled debt restructures on loans for which concessions, including the reduction of interest rates below a rate otherwise available to that borrower or the deferral or forgiveness, of interest or principal, have been granted due to the borrower’s weakened financial condition.  Restructured loans included in impaired loans were $5.7 million as of March 31, 2011 of which, $5.7 million was included in non-accrual loans. Restructured loans included in impaired loans were $5.4 million as of December 31, 2010, of which, $5.4 million was included in non-accrual loans.

* *

*Other real estate owned* — At March 31, 2011 and December 31, 2010, Bancorp held six properties which represent three separate land development projects consisting of finished lots with a carrying balance of $ 3.2 million and $3.4, respectively.  Valuation of the property occurs when it is foreclosed upon and annually thereafter.  Based on current appraisals received for the three months ended March 31, 2011 and 2010 and the decrease in fair market values of these real estate properties, Bancorp recorded a write-down on other real estate owned of $213,000 and $20,000, respectively. It is Bancorp’s plan to continue its collection efforts and liquidation of collateral, as necessary, to recover as large a portion of other real estate owned as possible.

 

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

 

**Non-Performing Assets**

 
| **(dollars in thousands)**        | ** ** | **March 31, 2011** | ** ** | **December 31, 2010** | ** ** |
|---------------------------------------------|------------|------------------------------|------------|---------------------------------|------------|
| Non-accrual loans                           |       | $                            | 18,348     |                            | $          | 12,794 |   |
| Loans past due 90 days or more              |       | —                       |       | —                          |       |
| Total non-performing loans                  |       | 18,348                       |       | 12,794                          |       |
| Other real estate owned                     |       | 4,334                        |       | 5,813                           |       |
| Total non-performing assets                 |       | $                            | 22,682     |                            | $          | 18,607 |   |
| Total non-performing loans to net loans     |       | 5.22                         | %          | 3.57                            | %          |
| Total non-performing loans to total assets  |       | 2.59                         | %          | 1.85                            | %          |
| Total non-performing assets to total assets |       | 3.20                         | %          | 2.69                            | %          |

 

*Impaired loans -*At March 31, 2011, impaired loans increased to $19.4 million compared to $17.9 million at December 31, 2010.  Four credit relationships totaling $13.4 million, accounted for 69.0 percent of impaired loans as of March 31, 2011.

 

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A loan is considered impaired when management determines that it is probable that Bancorp will be unable to collect all amounts of principal and interest according to contractual terms. Factors considered by management in determining impairment include payment status, and the probability of collecting scheduled principal and interest payments when due. Impaired loans include loans in nonaccrual status, troubled debt restructures and other loans that management considers to be impaired. Other loans include loans that management has reviewed for impairment and has determined to be impaired even though the loan may be current and performing in accordance with the contractual loan terms.   As a result, these other impaired loans continue to remain on accrual status and are not considered non-performing assets.  Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired.

* *

*Other potential problem loans* —   Potential problem loans consist of loans that are currently performing, are not on nonaccrual status, restructured or impaired, but for which management have identified as having a well defined weakness or weaknesses and which there are sufficient doubts as to the borrower’s future ability to comply with repayment terms.  These loans are identified through our internal risk grading processes and management monitors these loans closely and reviews their performance on a regular basis.  As of March 31, 2011 and December 31, 2010, Bancorp had classified $15.5 million and $18.6 million, respectively, as potential problem loans.

 

*Risk Rating System:* An effective risk rating system provides information for use in determining the overall level of the Allowance for Loan Loss. Accurate and timely risk rating recognition is a primary component of an effective risk rating system. Risk ratings are reviewed through various channels including the loan approval process, the loan reporting process for approved loans, an external loan review process and through the regulatory review process. The Bank risk rates the commercial loan portfolio on a nine scale system, while the Bank’s consumer loans are risk rated on a four scale system. Risk ratings in both scales are based on levels of risk as defined by the internal risk rating guidance within the Bank’s Loan Policy.  A commercial loan’s risk rating may change as risk factors change throughout the life of the loan, while with consumer loans the original risk rating assigned at loan origination remains for the life of the loan except when a consumer loan is moved to nonaccrual at which time it is risk rated a substandard loan. For risk-rating purposes, commercial, commercial real estate, other real estate and real estate construction segments are typically graded using the commercial risk ratings.

 

**DEPOSITS**           Bancorp offers a 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 of deposit are tailored to Bancorp’s primary market area at rates competitive with those offered in the area. Bancorp offers both interest and non-interest bearing checking accounts.

 

Total deposits increased $15.4 million to $606.3 million at March 31, 2011 compared to $590.9 million at December 31, 2010. Within the total, the increase came from core deposits which increased $20.5 million. This increase was partially offset by a $5.1 million decrease in time deposits. As a result, core deposits as a percentage of total deposits increased to 65.3% at March 31, 2011 compared to 63.6% at December 31, 2010.   Core deposits consist of non- interest and interest bearing demand accounts, money market accounts, and saving accounts.

 

In December 2008, Bancorp initiated service through the Certificate of Deposit Account Registry Service (CDARS).  Bancorp uses CDARS to offer existing customers the ability to obtain additional FDIC insurance coverage. Although all CDARS deposits represent direct customer relationships with Bancorp, for regulatory purposes they are required to be classified as brokered deposits. CDARS deposits were $14.5 million and $19.5 million at March 31, 2011 and December 31, 2010.

 

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

 

**Deposit Composition**

 
| ** **                           | ** ** | **March 31, 2011** | ** ** | **December 31, 2010** | ** ** |
|--------------------------------------|------------|------------------------------|------------|---------------------------------|------------|
| **(dollars in thousands)** | ** ** | **Amount**                   | ** ** | **% of Total**        | ** ** | **Amount** | ** ** | **% of Total** | ** ** |
| Non-interest bearing demand          |       | $                            | 78,372     |                            | 12.9       | % | $ | 79,099 |   | 13.4 | % |
| Interest bearing demand              |       | 110,081                      |       | 18.2                            | %          | 109,085 |   | 18.5 | % |
| Money market                         |       | 100,439                      |       | 16.6                            | %          | 87,289 |   | 14.8 | % |
| Savings                              |       | 107,195                      |       | 17.7                            | %          | 100,068 |   | 16.9 | % |
| Time                                 |       | 195,710                      |       | 32.3                            | %          | 195,800 |   | 33.1 | % |
| Brokered time deposits (CDARS)       |       | 14,531                       |       | 2.3                             | %          | 19,540 |   | 3.3 | % |
| Total deposits                       |       | $                            | 606,328    |                            | 100.0      | % | $ | 590,881 |   | 100.0 | % |

 

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**OTHER BORROWINGS **Borrowings consist of federal funds purchased, discount window borrowings from the Federal Reserve Bank of San Francisco and securities sold under agreements to repurchase.  At March 31, 2011 and December 31, 2010, securities sold under agreements to repurchase were $34.5 million and $34.1 million, respectively. These borrowings decrease or increase primarily based on the availability of funds and the current competitive interest rate offered.  These borrowings are collateralized by securities with an estimated fair value exceeding the face value of the borrowings. Periodically, Bancorp uses federal funds purchased and Federal Reserve borrowings as a funding source. Bancorp had no Federal Reserve borrowings at March 31, 2011 and December 31, 2010.

** **

**CAPITAL RESOURCES**    Stockholders’ equity increased to $66.9 million at March 31, 2011 from $66.0 million at December 31, 2010.  Book value per share at March 31, 2011 was $113.78 compared to $112.32 at December 31, 2010.

 

Bancorp has only one class of stock, which is common stock and at March 31, 2011, there were 781 shareholders of record.  Bancorp’s stock is not actively traded or quoted and no broker currently makes a market in the stock. However, sales and transfers of the stock do occur.  Skagit State Bank acts as transfer agent for Bancorp stock.  To facilitate trading, the Bank maintains a list of persons interested (known to the Bank) in either purchasing or selling Bancorp stock.  Purchasers and sellers then negotiate their own transactions with the Bank acting as transfer agent for those transactions. From time to time, Bancorp repurchases shares of its common stock. The number of shares of stock that will be repurchased and the price that will be paid is the result of many factors including market and economic conditions, the number of shares available, Bancorp’s liquidity and capital needs and regulatory requirements. Bancorp did not repurchase any shares in for the three months ended March 31, 2011 and 2010.

 

Skagit State Bancorp and Skagit State Bank are both subject to various regulatory capital requirements administered by the Federal Reserve and the FDIC under which risk percentages are assigned to various categories of asset and off-balance sheet items to calculate a risk-adjusted capital ratio.  The federal regulations set forth the qualifications necessary for bank holding companies and banks to be classified as “well capitalized”. Failure to be well —capitalized can impact a bank’s insurance premium rates, can negatively impact a bank’s ability to expand and engage in certain activities. At March 31, 2011, Skagit State Bancorp and the Bank both exceeded regulatory capital requirements and were “well-capitalized” pursuant to such regulations.

 

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| ** **                           | ** ** | ** ** | ** ** | ** **                 | ** ** | ** **                 | ** ** | ** **                 | ** ** | **To Be Well**   | ** ** |
|--------------------------------------|------------|------------|------------|----------------------------|------------|----------------------------|------------|----------------------------|------------|----------------------------|------------|
| ** **                           | ** ** | ** ** | ** ** | ** **                 | ** ** | ** **                 | ** ** | ** **                 | ** ** | **Capitalized Under** | ** ** |
| ** **                           | ** ** | ** ** | ** ** | ** **                 | ** ** | **For Capital**       | ** ** | **Prompt Corrective** | ** ** |
| ** **                           | ** ** | **Actual** | ** ** | **Adequacy Purposes** | ** ** | **Action Provisions** | ** ** |
| **(dollars in thousands)** | ** ** | **Amount** | ** ** | **Ratio**                  | ** ** | **Amount**                 | ** ** | **Ratio**                  | ** ** | **Amount**                 | ** ** | **Ratio** | ** ** |
| As of March 31, 2011            |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| Total Capital                        |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| (to Risk-Weighted Assets)            |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| Skagit State Bank                    |       | $          | 70,742     |                       | 16.07      | %                          | $          | 35,217                     |       | >8.00                   | %          | $ | 44,021 |   | >10.00 | % |
| Skagit State Bancorp, Inc.      |       | $          | 70,895     |                       | 16.10      | %                          | $          | 35,229                     |       | >8.00                   | %          | $ | 44,036 |   | >10.00 | % |
| Tier I Capital                       |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| (to Risk-Weighted Assets)            |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| Skagit State Bank                    |       | $          | 65,217     |                       | 14.81      | %                          | $          | 17,608                     |       | >4.00                   | %          | $ | 26,413 |   | >6.00 | % |
| Skagit State Bancorp, Inc.      |       | $          | 65,368     |                       | 14.84      | %                          | $          | 17,614                     |       | >4.00                   | %          | $ | 26,421 |   | >6.00 | % |
| Tier I Capital                       |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| (to Average Assets)                  |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| Skagit State Bank                    |       | $          | 65,217     |                       | 9.36       | %                          | $          | 27,869                     |       | >4.00                   | %          | $ | 34,836 |   | >5.00 | % |
| Skagit State Bancorp, Inc.      |       | $          | 65,368     |                       | 9.38       | %                          | $          | 27,869                     |       | >4.00                   | %          | $ | 34,836 |   | >5.00 | % |
|                                 |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| As of December 31, 2010         |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| Total Capital                        |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| (to Risk-Weighted Assets)            |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| Skagit State Bank                    |       | $          | 69,658     |                       | 15.75      | %                          | $          | 35,378                     |       | >8.00                   | %          | $ | 44,222 |   | >10.00 | % |
| Skagit State Bancorp, Inc.      |       | $          | 69,882     |                       | 15.80      | %                          | $          | 35,389                     |       | >8.00                   | %          | $ | 44,237 |   | >10.00 | % |
| Tier I Capital                       |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| (to Risk-Weighted Assets)            |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| Skagit State Bank                    |       | $          | 64,111     |                       | 14.50      | %                          | $          | 17,689                     |       | >4.00                   | %          | $ | 26,533 |   | >6.00 | % |
| Skagit State Bancorp, Inc.      |       | $          | 64,333     |                       | 14.54      | %                          | $          | 17,695                     |       | >4.00                   | %          | $ | 26,542 |   | >6.00 | % |
| Tier I Capital                       |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| (to Average Assets)                  |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| Skagit State Bank                    |       | $          | 64,111     |                       | 9.27       | %                          | $          | 27,673                     |       | >4.00                   | %          | $ | 34,592 |   | >5.00 | % |
| Skagit State Bancorp, Inc.      |       | $          | 64,333     |                       | 9.30       | %                          | $          | 27,673                     |       | >4.00                   | %          | $ | 34,592 |   | >5.00 | % |

 

**LIQUIDITY**

 

Bancorp has a formal liquidity policy that establishes liquidity guidelines and the maintenance of contingency liquidity plans that provide for actions and timely responses to liquidity stress situations and that are in accordance with regulatory guidance. The objective of liquidity risk management is to ensure that Bancorp has the continuing ability to maintain cash flows that are adequate to fund operations including day to day cash flow requirements of either its depositors wanting to withdraw funds or to provide for customers credit needs. The majority of our funding comes from customer deposits within the Bank’s market area. In addition, funding needs are met through loan repayments, investment securities repayments and earnings. Liquidity may also be obtained by borrowing through pre-approved credit lines and by marketable securities that can be readily converted to cash or pledged as collateral for additional borrowings. For the future there can be no guarantee that these unsecured lines of credit will remain available or that securities can be converted to cash with or without loss. Bancorp uses deposits to fund loans and investments that are typically longer in term.

 

As of March 31, 2011 Bancorp had approximately $27.0 million in approved unsecured credit lines from various financial institutions and had securities with a market value of $31.7 million pledged as collateral for borrowing at the Federal Reserve Discount Window, and unpledged marketable securities with a market value of $122.8 million available for funding needs. Because the Bank’s primary sources and uses of funds are deposits and loans, the relationship between net loans and total deposits provides one measure of the Bank’s liquidity.  The Bank’s loan to deposit ratio decreased to 58.0 percent at March 31, 2011 compared to 60.6 percent at December 31, 2010, as a result of the increase in deposits and the decrease in loans.

 

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The analysis of liquidity also includes a review of the statement of cash flows.  The cash flows detail Bancorp’s operating, investing and financing activities during the year. Cash flows from operations contribute to liquidity as well as proceeds from the maturities of securities, loan repayments and increasing customer deposits. As indicated in the statement of cash flows, in the Consolidated Statement of Cash Flows, net cash flows from operating and financing activities contributed $1.5 million and $15.8 million to liquidity, respectively, for the three months ended March 31, 2011. The net use of cash from investing activities of $17.0 million was primarily for the net purchase of $47.3 million in investment securities.

 

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

 

**Item 3.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

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

 

*Asset Liability Management:* Bancorp maintains an asset/liability management program which is the responsibility of the Asset Liability Committee.  The objective of asset liability management is to manage, protect and stabilize Bancorp’s net interest income from undue interest rate risk through various interest rate cycles within the constraints of credit quality, interest rate risk policies, levels of capital and adequate levels of liquidity.  The committee meets to monitor the composition of the balance sheet, to review projected earnings trends, and to formulate strategies consistent with these objectives for liquidity, interest rate risk, and capital adequacy. Bancorp believes that there have not been any material changes about Bancorp’s market risk from the information that was provided in the Form 10-K for the year ended December 31, 2010.

** **

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

 

Evaluation of Disclosure Controls and Procedures

 

Bancorp’s Chief Executive Officer and Chief Financial Officer have reviewed and evaluated the effectiveness of our disclosure controls and procedures, required by Exchange Act Rules 13(a) - 15(b), as of the end of the period covered by this quarterly report.  Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that Bancorp’s current disclosure controls and procedures are effective and timely, providing them with material information relating to Bancorp required to be disclosed in the reports we file or submit under the Exchange Act.

 

Changes in Internal Controls

 

There have not been any significant changes in our internal controls or in other factors that could significantly affect these controls subsequent to the date of their evaluation.  Bancorp did not identify nor implement any corrective actions with regard to any significant deficiencies or material weaknesses in its internal controls.

 

**PART II -****             ****OTHER INFORMATION**

 

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

 

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

 

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

 

There are certain risks inherent to Bancorp’s business.  The material risks and uncertainties that management believes affect Bancorp are described below.  Although we have risk management policies, procedures and verification procedures in place, additional risks and uncertainties that management is not aware of or focused on or that management currently 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 and adversely affected.

 

**The continued challenging economic environment could have a material adverse effect on our future results of operations or trading price of our stock.**

 

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The national economy, and the financial services sector in particular, are still facing significant challenges.   Substantially all of our loans are to businesses and individuals in Skagit, Snohomish or Whatcom Counties, Washington, markets facing many of the same challenges as the national economy, including continued unemployment and declines in commercial and residential real estate.  Although some economic indicators are improving both nationally and in the markets we serve, unemployment remains high and there remains substantial uncertainty regarding when and how strongly a sustained economic recovery will occur.  A further deterioration in economic conditions in the nation as a whole or in the markets we serve or a protracted recovery period could result in the following consequences, any of which could have an adverse impact, which may be material, on our business, financial condition, results of operations and prospects, and could also cause the market price of our stock to decline:

 

·                  economic conditions may worsen, increasing the likelihood of credit defaults by borrowers;

 

·                  loan collateral values, especially as they relate to commercial and residential real estate, may decline further, thereby increasing the severity of loss in the event of loan defaults;

 

·                  demand for banking products and services may decline, including services for low cost and non-interest-bearing deposits; and

 

·                  changes and volatility in interest rates may negatively impact the yields on earning assets and the cost of interest-bearing liabilities.

 

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

 

Real estate related loans, including those loans that are collateralized by real estate, comprise the largest category of loans, representing 77 percent of Bancorp’s total loans.  Our real estate portfolio consists of commercial and residential lending.  These loans are secured by property such as office buildings, commercial business properties, healthcare buildings, agricultural land, timber land and residential properties.  Commercial and commercial real estate loans generally are viewed as having more risk of default than residential real estate loans or certain other types of loans or investments.  Typically, these types of loans are larger than residential real estate loans and other loans.  Because the loan portfolio contains a number of commercial real estate loans with relatively large balances, the deterioration of one or a few of these loans may cause a significant increase in nonperforming loans.  An increase in nonperforming loans could result in a loss of earnings from these loans, an increase in the provision for loan losses or an increase in loan charge-offs, which could have an adverse impact on our results of operations and financial condition.

 

The Bank has a high concentration of loans to a relatively small group of large borrowers, which could adversely affect Bancorp’s earnings if some of those customers cease doing business with us or certain of those larger loans incur problems. Approximately 47% of our loan portfolio as of March 31, 2011 was comprised of loans to a group of approximately 43 customers.  If any material portion of those customers ceased doing business with the Bank, it could have a materially adverse effect on Bancorp’s earnings and financial condition.

 

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

 

Bancorp maintains an allowance for loan losses in an amount that we believe is adequate to provide for losses inherent in the loan portfolio.  While we strive to carefully manage and monitor credit quality and to identify loans that may become nonperforming, at any time there are loans included in the portfolio that will result in losses, but that have not been identified as nonperforming or potential problem loans.  By closely monitoring our credit quality, we attempt to identify deteriorating loans before they become nonperforming assets and adjust the loan loss reserve accordingly.  However, because future events are uncertain, and if the economy continues to deteriorate, there may be loans that deteriorate to a nonperforming status in an accelerated time frame.  As a result, future additions to the allowance may be necessary.  Because the loan portfolio contains a number of loans with relatively large balances, the deterioration of one or a few of these loans may cause a significant increase in nonperforming loans, requiring an increase to the loan loss allowance.  As a result, future additions to the allowance at elevated levels may be required based on changes in the mix of loans comprising the portfolio, changes in the financial condition of borrowers, such as may result from changes in economic conditions, or as a result of actual events being different from assumptions used by management in determining the allowance.  Additionally, banking regulators, as an integral part of their supervisory function, periodically review our loan portfolio and the adequacy of our allowance for loan losses.  These regulatory agencies may require us to recognize further loan loss provisions or charge-offs based upon their judgments, which may be different from ours.  Any increase in the allowance for loan losses could have a negative effect on our financial condition and results of operation.

 

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**A continued tightening of the credit markets may make it difficult to obtain adequate funding for loan growth, which could adversely affect our earnings.**

 

A continued tightening of the credit markets and the inability to obtain or retain adequate funds for continued loan growth at an acceptable cost may negatively affect our asset growth and liquidity position and, therefore, our earnings capability.  In addition to core deposit growth, maturity of investment securities and loan payments, Bancorp also relies on alternative funding sources through correspondent banking, and borrowing lines with the Federal Reserve Bank to fund loans.  In the event the current economic downturn continues, particularly in the housing market, these resources could be negatively affected, both as to price and availability, which would limit and or raise the cost of the funds available to Bancorp.

 

**Fluctuating interest rates can adversely affect Bancorp’s profitability.**

 

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

 

**Competition in our market area may limit Bancorp’s future success.**

 

Commercial banking is a highly competitive business.  Bancorp competes with other commercial banks, savings and loan associations, credit unions and finance companies operating in our market area.  We are subject to substantial competition for loans and deposits from other financial institutions.  Some of our competitors are not subject to the same degree of regulation and restriction as we are.  Some of our competitors have greater financial resources than we do.  We compete for funds with other financial institutions that, in most cases, are larger and able to provide a greater variety of services than we do and thus may obtain deposits at lower rates of interest.  If we are unable to effectively compete in our market area, our business and results of operations could be adversely affected.

 

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

 

Bancorp is subject to extensive regulation, supervision and examination by federal and state banking authorities. In addition, as a publicly reporting company, Bancorp is subject to regulation by the Securities and Exchange Commission. Any change in applicable regulations or federal, state or local legislation or in policies or interpretations or regulatory approaches to compliance and enforcement, income tax laws and accounting principles could have a substantial impact on Bancorp and its operations. Changes in laws and regulations may also increase Bancorp’s expenses by imposing additional fees or taxes or restrictions on its operations. Additional legislation and regulations that could significantly affect Bancorp’s powers, authority and operations may be enacted or adopted in the future, which could have a material adverse effect on Bancorp’s financial condition and results of operations. Failure to appropriately comply with any such laws, regulations or principles could result in sanctions by regulatory agencies or damage to Bancorp’s reputation, all of which could adversely affect our business, financial condition or results of operations.

 

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

 

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Further, regulators have significant discretion and authority to prevent or remedy unsafe or unsound practices or violations of laws or regulations by financial institutions and holding companies in the performance of their supervisory and enforcement duties. Recently, these powers have been utilized more frequently due to the serious national, regional and local economic conditions we continue to face. The exercise of regulatory authority may have a negative impact on Bancorp’s financial condition and results of operations. Additionally, Bancorp’s business is affected significantly by the fiscal and monetary policies of the U.S. federal government and its agencies, including the Federal Reserve Board.

 

Bancorp cannot accurately predict the full effects of recent legislation or the various other governmental, regulatory, monetary and fiscal 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 the failure of these actions to help stabilize the financial markets, asset prices, market liquidity and a continuation or worsening of current financial market and economic conditions could materially and adversely affect our business, financial condition, results of operations, and the trading price of our common stock.

 

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

 

Reputation risk is the risk to liquidity, earnings and capital arising from negative publicity regarding the financial services industry.  The financial services industry continues to be featured in negative headlines about the global and national credit crisis and the resulting stabilization legislation enacted by the U.S. federal government.  These reports can be damaging to the industry’s image and potentially erode consumer confidence in insured financial institutions, such as our banking subsidiary.  In addition, our ability to engage in routine funding and other transactions could be adversely affected by the actions and financial condition of other financial institutions.

 

Financial services institutions are interrelated as a result of trading, clearing, counterparty or other relationships. As a result, defaults by, or even rumors or questions about, one or more financial services institutions, or the financial services industry generally, could lead to market-wide liquidity problems, losses of depositors, creditor and counterparty confidence and could lead to losses or defaults by us or by other institutions. We could experience material changes in the level of deposits as a direct or indirect result of other banks’ difficulties or failure, which could affect the amount of capital we need.

 

**The FDIC has increased insurance premiums to restore and maintain the federal deposit insurance fund, and there may be additional future premium increases and special assessments.**

 

In 2009, the FDIC imposed a special deposit insurance assessment of five basis points on all insured institutions, and also required insured institutions to prepay estimated quarterly risk-based assessments through 2012.

The Dodd-Frank Act established 1.35% as the minimum deposit insurance fund reserve ratio. The FDIC has determined that the fund reserve ratio should be 2.0% and has adopted a plan under which it will meet the statutory minimum fund reserve ratio of 1.35% by the statutory deadline of September 30, 2020. The Dodd-Frank Act requires the FDIC to offset the effect on institutions with assets less than $10 billion of the increase in the statutory minimum fund reserve ratio to 1.35% from the former statutory minimum of 1.15%.  The FDIC has not announced how it will implement this offset or how larger institutions will be affected by it.

 

Despite the FDIC’s actions to restore the deposit insurance fund, the fund will suffer additional losses in the future due to failures of insured institutions.  There can be no assurance that there will not be additional significant deposit insurance premium increases, special assessments or prepayments in order to restore the insurance fund’s reserve ratio.  Any significant premium increases or special assessments could have a material adverse effect on the Company’s financial condition and results of operations.

 

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

 

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

 

**There are restrictions on changes in control of Bancorp that could decrease our shareholders’ chance to realize a premium on their shares.**

 

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

 

**Item 2.                    Unregistered Sales of Equity Securities and Use of Proceeds**

None

 

**Item 3.                    Defaults Upon Senior Securities**

None

**Item 4.                    Removed and Reserved**

None

 

**Item 5.                    Other Information**

None

 

**Item 6.                    Exhibits**

(a)                        Exhibits.

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

 

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**SIGNATURES**

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

 
|   |                |   | SKAGIT   STATE BANCORP, INC.       |
|--------|---------------------|--------|-----------------------------------------|
|   |                |   | (Registrant)                            |
|   |                |   |                                    |
|   |                |   |                                    |
| Dated: | May 10,   2011 |   | /s/   Cheryl R. Bishop                  |
|   |                |   | Cheryl   R. Bishop                      |
|   |                |   | President   and Chief Executive Officer |
|   |                |   |                                    |
|   |                |   |                                    |
| Dated: | May 10,   2011 |   | /s/   Carla F. Tucker                   |
|   |                |   | Carla   F. Tucker                       |
|   |                |   | Executive   Vice-President              |
|   |                |   | Chief   Financial Officer               |

 

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