Table ofContents

 

 

 

**UNITED STATES SECURITIES ANDEXCHANGE COMMISSION**

**Washington D.C., 20549**

 

**FORM 10-Q**

 

**x****      QuarterlyReport Pursuant to Section 13 or 15(d) of the Securities Exchange Actof 1934**

 

**For the quarterly period ended June 30,2010**

 

**o****         TransitionReport 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 asSpecified in Its Charter)

 

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

 

**301 East Fairhaven Avenue**

**Burlington, Washington  98233**

(Address of PrincipalExecutive Offices) (Zip Code)

 

**(360) 755-0411**

(Registrant’s TelephoneNumber, Including Area Code)

 

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

 

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

 

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

 

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

 

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

 

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

 

The number of shares of the issuer’s Common Stock outstanding at August 4,2010 was 588,390.

 

 

 

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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 June 30, 2010  and December 31, 2009                                                                |   | Page 3 |
|              |                       |                                                                                                                                           |   |   |
|              |                       | Consolidated Statement of Income for the three and six  months ended June 30, 2010 and 2009                                               |   | Page 4 |
|              |                       |                                                                                                                                           |   |   |
|              |                       | Consolidated Statement of Changes in Stockholders’  Equity and Comprehensive Income for the six months ended June 30, 2010  and 2009 |   | Page 5 |
|              |                       |                                                                                                                                           |   |   |
|              |                       | Consolidated Statement of Cash Flows for the six  months ended June 30, 2010 and 2009                                                     |   | Page 6 |
|              |                       |                                                                                                                                           |   |   |
|              |                       | Notes to Consolidated Financial Statements                                                                                                     |   | Pages 7-15 |
|              |                       |                                                                                                                                           |   |   |
|              | Item 2.                    | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                                    |   | Pages 15-26 |
|              |                       |                                                                                                                                           |   |   |
|              | Item 3.                    | Quantitative  and Qualitative Disclosures About Market Risk                                                                                    |   | Page 26-27 |
|              |                       |                                                                                                                                           |   |   |
|              | Item 4T.                   | Controls and  Procedures                                                                                                                       |   | Page 27 |
|              |                       |                                                                                                                                           |   |   |
| **PART II.** | **OTHER INFORMATION**      |                                                                                                                                           |   |
|              |                       |                                                                                                                                           |   |   |
|              | Item 1.                    | Legal Proceedings                                                                                                                              |   | Page 27 |
|              |                       |                                                                                                                                           |   |   |
|              | Item 1 A.                  | Risk Factors                                                                                                                                   |   | Page 27-30 |
|              |                       |                                                                                                                                           |   |   |
|              | Item 2.                    | Unregistered  Sales of Equity Securities and Use of Proceeds                                                                                   |   | Page 30 |
|              |                       |                                                                                                                                           |   |   |
|              | Item 3.                    | Defaults  Upon Senior Securities                                                                                                               |   | Page 30 |
|              |                       |                                                                                                                                           |   |   |
|              | Item 4.                    | Removed and Reserved                                                                                                                           |   | Page 30 |
|              |                       |                                                                                                                                           |   |   |
|              | Item 5.                    | Other Information                                                                                                                              |   | Page 30 |
|              |                       |                                                                                                                                           |   |   |
|              | Item 6.                    | Exhibits                                                                                                                                       |   | Page 31 |
|              |                       |                                                                                                                                           |   |   |
|              |                       | Signatures                                                                                                                                     |   | Pages 32 |

 

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**Item 1.    Financial Statements**

 

**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

**CONSOLIDATEDBALANCE SHEET (Unaudited)**

 
| **(dollars  in thousands except share data)**                                                                                                                             | ** ** | **June 30, 2010** | ** ** | **December 31, 2009** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|----------------------------|------------|
| **ASSETS**                                                                                                                                                                | ** ** | ** **             | ** ** | ** **                 | ** ** |
| ** **                                                                                                                                                                | ** ** | ** **             | ** ** | ** **                 | ** ** |
| **ASSETS**                                                                                                                                                                | ** ** | ** **             | ** ** | ** **                 | ** ** |
| Cash and due from banks                                                                                                                                                   |       | $                      | 13,222     |                       | $          | 14,441 |   |
| Federal funds sold                                                                                                                                                        |       | 77,215                 |       | 62,531                     |       |
| Investment securities                                                                                                                                                     |       |                   |       |                       |       |
| Available-for-sale, at fair value                                                                                                                                         |       | 147,729                |       | 118,561                    |       |
| Held-to-maturity, at amortized cost                                                                                                                                       |       | 39,862                 |       | 40,298                     |       |
| Loans held for sale                                                                                                                                                       |       | 80                     |       | 574                        |       |
| Loans                                                                                                                                                                     |       | 383,436                |       | 393,532                    |       |
| Allowance for loan losses                                                                                                                                                 |       | (7,392                 | )          | (6,883                     | )          |
| Net loans                                                                                                                                                                 |       | 376,044                |       | 386,649                    |       |
| Bank premises and equipment, net                                                                                                                                          |       | 11,266                 |       | 10,944                     |       |
| Other real estate owned                                                                                                                                                   |       | 7,099                  |       | 6,284                      |       |
| Accrued interest receivable                                                                                                                                               |       | 2,352                  |       | 2,531                      |       |
| Other assets                                                                                                                                                              |       | 4,598                  |       | 5,075                      |       |
| **TOTAL ASSETS**                                                                                                                                                          |       | $                      | 679,467    |                       | $          | 647,888 |   |
| ** **                                                                                                                                                                |       |                   |       |                       |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                             |       |                   |       |                       |       |
| ** **                                                                                                                                                                |       |                   |       |                       |       |
| **LIABILITIES**                                                                                                                                                           |       |                   |       |                       |       |
| Deposits                                                                                                                                                                  |       |                   |       |                       |       |
| Interest-bearing                                                                                                                                                          |       | $                      | 504,396    |                       | $          | 471,597 |   |
| Non-interest-bearing                                                                                                                                                      |       | 72,185                 |       | 73,839                     |       |
| Total deposits                                                                                                                                                            |       | 576,581                |       | 545,436                    |       |
| Other borrowings                                                                                                                                                          |       | 35,097                 |       | 38,128                     |       |
| Other liabilities                                                                                                                                                         |       | 1,901                  |       | 1,467                      |       |
| Total liabilities                                                                                                                                                         |       | 613,579                |       | 585,031                    |       |
|                                                                                                                                                                      |       |                   |       |                       |       |
| **STOCKHOLDERS’ EQUITY**                                                                                                                                             |       |                   |       |                       |       |
| Common stock no par value, 5,000,000 shares  authorized, 587,194 and 586,905 shares issued and outstanding at  June 30, 2010 and December 31, 2009 respectively |       | 12,445                 |       | 12,303                     |       |
| Accumulated other comprehensive income, net of tax                                                                                                                        |       | 3,249                  |       | 1,872                      |       |
| Retained earnings                                                                                                                                                         |       | 50,194                 |       | 48,682                     |       |
| Total stockholders’ equity                                                                                                                                           |       | 65,888                 |       | 62,857                     |       |
| **TOTAL LIABILITIES AND  STOCKHOLDERS’ EQUITY**                                                                                                                      |       | $                      | 679,467    |                       | $          | 647,888 |   |

 

*See accompanying notes tothese consolidated financial statements*

 

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**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

**CONSOLIDATED STATEMENT OF INCOME (Unaudited)**

** **
| ** **                                               | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|----------------------------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| **(dollars  in thousands except per share data)**        | ** ** | **2010**                             | ** ** | **2009**                           | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                                               |       |                                 |       |                               |       |   |   |   |   |
| **INTEREST INCOME**                                      |       |                                 |       |                               |       |   |   |   |   |
| Interest and fees on loans                               |       | $                                    | 5,766      |                               | $          | 5,760 |   | $ | 11,406 |   | $ | 11,667 |   |
| Investment securities                                    |       |                                 |       |                               |       |   |   |   |   |
| Taxable                                                  |       | 1,064                                |       | 1,044                              |       | 2,082 |   | 2,114 |   |
| Exempt from federal income tax                           |       | 276                                  |       | 281                                |       | 550 |   | 562 |   |
| Federal funds sold                                       |       | 56                                   |       | 11                                 |       | 105 |   | 12 |   |
| Total interest income                                    |       | 7,162                                |       | 7,096                              |       | 14,143 |   | 14,355 |   |
| **INTEREST EXPENSE**                                     |       |                                 |       |                               |       |   |   |   |   |
| Deposits                                                 |       | 1,456                                |       | 1,743                              |       | 2,976 |   | 3,477 |   |
| Other borrowings                                         |       | 87                                   |       | 64                                 |       | 169 |   | 153 |   |
| Total interest expense                                   |       | 1,543                                |       | 1,807                              |       | 3,145 |   | 3,630 |   |
| **NET INTEREST INCOME**                                  |       | 5,619                                |       | 5,289                              |       | 10,998 |   | 10,725 |   |
| Provision for loan losses                                |       | 370                                  |       | 450                                |       | 920 |   | 900 |   |
| **NET INTEREST INCOME AFTER PROVISION  FOR LOAN LOSSES** |       | 5,249                                |       | 4,839                              |       | 10,078 |   | 9,825 |   |
| **NON-INTEREST INCOME**                                  |       |                                 |       |                               |       |   |   |   |   |
| Service charges on deposits                              |       | 832                                  |       | 781                                |       | 1,545 |   | 1,489 |   |
| Other                                                    |       | 196                                  |       | 179                                |       | 377 |   | 379 |   |
| Gain on sale of loans                                    |       | 45                                   |       | 67                                 |       | 96 |   | 119 |   |
| Total non-interest income                                |       | 1,073                                |       | 1,027                              |       | 2,018 |   | 1,987 |   |
| **NON-INTEREST EXPENSES**                                |       |                                 |       |                               |       |   |   |   |   |
| Salaries                                                 |       | 1,930                                |       | 1,891                              |       | 3,835 |   | 3,872 |   |
| Payroll taxes and employee benefits                      |       | 483                                  |       | 464                                |       | 979 |   | 979 |   |
| Provision for other real estate owned losses             |       | 245                                  |       | 373                                |       | 265 |   | 373 |   |
| Bank premises and equipment                              |       | 230                                  |       | 242                                |       | 458 |   | 484 |   |
| Occupancy                                                |       | 186                                  |       | 189                                |       | 383 |   | 413 |   |
| Loan collection and OREO expenses                        |       | 166                                  |       | 158                                |       | 280 |   | 291 |   |
| Advertising                                              |       | 201                                  |       | 224                                |       | 358 |   | 373 |   |
| Deposit Insurance                                        |       | 263                                  |       | 469                                |       | 493 |   | 762 |   |
| Other                                                    |       | 1,005                                |       | 928                                |       | 2,005 |   | 1,929 |   |
| Total non-interest expenses                              |       | 4,709                                |       | 4,938                              |       | 9,056 |   | 9,476 |   |
| **INCOME BEFORE PROVISION FOR  INCOME TAX**              |       | 1,613                                |       | 928                                |       | 3,040 |   | 2,336 |   |
| **PROVISION FOR INCOME TAX**                             |       |                                 |       |                               |       |   |   |   |   |
| Current                                                  |       | 227                                  |       | 40                                 |       | 445 |   | 250 |   |
| Deferred                                                 |       | 53                                   |       | —                             |       | 53 |   | — |   |
| Total provision for income tax                           |       | 280                                  |       | 40                                 |       | 498 |   | 250 |   |
| **NET INCOME**                                           |       | $                                    | 1,333      |                               | $          | 888 |   | $ | 2,542 |   | $ | 2,086 |   |
| **BASIC EARNINGS PER SHARE**                             |       | $                                    | 2.27       |                               | $          | 1.51 |   | $ | 4.33 |   | $ | 3.56 |   |
| **DILUTED EARNINGS PER SHARE**                           |       | $                                    | 2.27       |                               | $          | 1.50 |   | $ | 4.32 |   | $ | 3.53 |   |
| **DIVIDENDS DECLARED PER SHARE**                         |       | $                                    | 1.75       |                               | $          | 2.25 |   | $ | 1.75 |   | $ | 2.25 |   |

 

*Seeaccompanying notes to these consolidated financial statements*

 

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**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

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

** **

Sixmonths ended June 30, 2010 and 2009

 
| ** **                                                                                            | ** ** | ** **            | ** ** | ** **        | ** ** | **Accum. Other** | ** ** | ** **             | ** ** | **Total**         | ** ** | ** ** | ** ** |
|-------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|-------------------|------------|-----------------------|------------|------------------------|------------|-------------------|------------|------------|------------|
| ** **                                                                                            | ** ** | **Common Stock** | ** ** | **Comprehensive** | ** ** | **Retained**          | ** ** | **Stockholders’** | ** ** | **Comprehensive** | ** ** |
| **(dollars in thousands except share and per share amounts)** | ** ** | **Shares**            | ** ** | **Amount**        | ** ** | **Income**            | ** ** | **Earnings**           | ** ** | **Equity**        | ** ** | **Income** | ** ** |
| **BALANCE,**January 1, 2009                                                                      |       | 586,285               |       | $                 | 12,042     |                  | $          | 2,325                  |       | $                 | 47,434     |       | $          | 61,801 |   |   |   |
| Comprehensive  income:                                                                                |       |                  |       |              |       |                  |       |                   |       |              |       |       |       |
| Net  income                                                                                           |       | —                |       | —            |       | —                |       | 2,086                  |       | 2,086             |       | $          | 2,086      |   |
| Other  comprehensive income:                                                                          |       |                  |       |              |       |                  |       |                   |       |              |       |       |       |
| Unrealized  loss on available-for-sale securities, net of tax benefit of $257                         |       | —                |       | —            |       | (500                  | )          | —                 |       | (500              | )          | (500       | )          |
| Total  other comprehensive income                                                                     |       |                  |       |              |       |                  |       |                   |       |              |       | (500       | )          |
| Comprehensive  income                                                                                 |       |                  |       |              |       |                  |       |                   |       |              |       | $          | 1,586      |   |
| Cash  dividend declared, $2.25 per share                                                              |       | —                |       | —            |       | —                |       | (1,324                 | )          | (1,324            | )          |       |       |
| Stock  options exercised                                                                              |       | 25                    |       | 4                 |       | —                |       | —                 |       | 4                 |       |       |       |
| Stock  compensation expense and restricted stock awards                                               |       | 285                   |       | 128               |       | —                |       | —                 |       | 128               |       |       |       |
| **BALANCE,**June 30, 2009                                                                        |       | 586,595               |       | $                 | 12,174     |                  | $          | 1,825                  |       | $                 | 48,196     |       | $          | 62,195 |   |   |   |
|                                                                                                  |       |                  |       |              |       |                  |       |                   |       |              |       |       |       |
| **BALANCE,**January 1, 2010                                                                      |       | 586,905               |       | $                 | 12,303     |                  | $          | 1,872                  |       | $                 | 48,682     |       | $          | 62,857 |   |   |   |
| Comprehensive  income:                                                                                |       |                  |       |              |       |                  |       |                   |       |              |       |       |       |
| Net  income                                                                                           |       | —                |       | —            |       | —                |       | 2,542                  |       | 2,542             |       | $          | 2,542      |   |
| Other  comprehensive income:                                                                          |       |                  |       |              |       |                  |       |                   |       |              |       |       |       |
| Unrealized  gains on available-for-sale securities, net of tax expense of $709                        |       | —                |       | —            |       | 1,377                 |       | —                 |       | 1,377             |       | 1,377      |       |
| Total  other comprehensive income                                                                     |       |                  |       |              |       |                  |       |                   |       |              |       | 1,377      |       |
| Comprehensive  income                                                                                 |       |                  |       |              |       |                  |       |                   |       |              |       | $          | 3,919      |   |
| Cash  dividend declared, $1.75 per share                                                              |       | —                |       | —            |       | —                |       | (1,030                 | )          | (1,030            | )          |       |       |
| Stock  compensation expense and restricted stock awards                                               |       | 289                   |       | 142               |       | —                |       | —                 |       | 142               |       |       |       |
| **BALANCE,**June 30, 2010                                                                        |       | 587,194               |       | $                 | 12,445     |                  | $          | 3,249                  |       | $                 | 50,194     |       | $          | 65,888 |   |   |   |

 

*See accompanying notes to these consolidated financial statements*

 

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** **

**SKAGITSTATE BANCORP, INC. AND SUBSIDIARY**

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

 
| **(dollars  in thousands)**                                                                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
|-------------------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| **Six  months ended June 30,**                                                                         | ** ** | **2010**   | ** ** | **2009**   | ** ** |
| **CASH FLOWS FROM OPERATING  ACTIVITIES**                                                                   |       |       |       |       |       |
| Net income                                                                                                  |       | $          | 2,542      |       | $          | 2,086 |   |
| *Adjustments to reconcile net  income to net**cash flows  from operating activities*                        |       |       |       |       |       |
| Provision for loan losses                                                                                   |       | 920        |       | 900        |       |
| Provision for other real estate owned losses                                                                |       | 265        |       | 373        |       |
| Depreciation                                                                                                |       | 416        |       | 430        |       |
| Loss on sale of premises and equipment                                                                      |       | —     |       | 8          |       |
| Gains on sale of loans                                                                                      |       | (96        | )          | (119       | )          |
| Amortization of investment security premiums and  discounts, net                                            |       | (45        | )          | (98        | )          |
| Provision for deferred income taxes                                                                         |       | 53         |       | —     |       |
| Stock compensation for employee services                                                                    |       | 142        |       | 128        |       |
| *Changes in operating assets and  liabilities*                                                              |       |       |       |       |       |
| Originations of loans held for sale                                                                         |       | (5,965     | )          | (9,926     | )          |
| Proceeds from sales of loans held for sale                                                                  |       | 6,555      |       | 9,737      |       |
| Decrease in interest receivable                                                                             |       | 179        |       | 53         |       |
| Increase in other assets                                                                                    |       | (284       | )          | (155       | )          |
| (Decrease) increase in other liabilities                                                                    |       | 434        |       | (609       | )          |
| Net cash flows from operating activities                                                                    |       | 5,116      |       | 2,808      |       |
| **CASH FLOWS FROM INVESTING  ACTIVITIES**                                                                   |       |       |       |       |       |
| Proceeds from maturities, calls, and principal  payments of investment securities — available-for-sale |       | 20,549     |       | 10,705     |       |
| Purchases of investment securities —  available-for-sale                                               |       | (47,591    | )          | (7,140     | )          |
| Proceeds from maturities, calls, and principal  payments of investment securities — held-to-maturity   |       | 3,155      |       | 4,528      |       |
| Purchases of investment securities —  held-to-maturity                                                 |       | (2,715     | )          | (4,417     | )          |
| Net increase in federal funds sold                                                                          |       | (14,684    | )          | (31,778    | )          |
| Net decrease in loans                                                                                       |       | 8,266      |       | 6,895      |       |
| Purchase of premises and equipment                                                                          |       | (399       | )          | (121       | )          |
| Capitalized expenditures for improvements to other  real estate owned                                       |       | —     |       | (136       | )          |
| Net cash flows from investing activities                                                                    |       | (33,419    | )          | (21,464    | )          |
| **CASH FLOWS FROM FINANCING  ACTIVITIES**                                                                   |       |       |       |       |       |
| Net increase in demand deposits, money market, NOW  and savings accounts                                    |       | 22,185     |       | 16,376     |       |
| Net increase in time deposits                                                                               |       | 8,960      |       | 18,262     |       |
| Net decrease in other borrowings                                                                            |       | (3,031     | )          | (15,934    | )          |
| Proceeds from exercise of stock options                                                                     |       | —     |       | 4          |       |
| Cash dividends                                                                                              |       | (1,030     | )          | (1,324     | )          |
| Net cash flows from financing activities                                                                    |       | 27,084     |       | 17,384     |       |
| **NET CHANGE IN CASH AND DUE FROM  BANKS**                                                                  |       | (1,219     | )          | (1,272     | )          |
| **CASH AND DUE FROM BANKS,**beginning of  period                                                            |       | 14,441     |       | 11,954     |       |
| **CASH AND DUE FROM BANKS,** end of  period                                                                 |       | $          | 13,222     |       | $          | 10,682 |   |
| **SUPPLEMENTAL DISCLOSURES OF CASH  FLOW INFORMATION**                                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash paid during the period for income taxes                                                                |       | $          | 1,080      |       | $          | 166 |   |
| Cash paid during the period for interest                                                                    |       | $          | 3,221      |       | $          | 3,600 |   |
| **NONCASH FINANCING AND INVESTING  TRANSACTIONS**                                                           |       |       |       |       |       |
| Property taken in settlement of loans                                                                       |       | $          | 1,419      |       | $          | 1,334 |   |

 

*Seeaccompanying notes to these consolidated financial statements*

 

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

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

 

**Note 1:   BASIS OF PRESENTATION**

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

 

**Note 2:   CRITICALACCOUNTING POLICIES AND ESTIMATES**

Bancorp’sfinancial statements are based upon the selection and application ofsignificant accounting policies which by their nature are inherently subject toestimation techniques, valuation assumptions and other subjective assessments.Bancorp considers accounting estimates to be critical to reported financialresults if (i) the accounting estimate requires management to makeassumptions about matters that are highly uncertain and (ii) differentestimates that management reasonably could have used for the accounting estimatein the current period, or changes in the accounting estimate that arereasonably likely to occur from period to period, could have a material impacton Bancorp’s financial statements. Management has identified specificaccounting policies that due to judgments, estimates and assumptions andeconomic assumptions which may prove inaccurate or are subject to variationthat may significantly affect our reported results of operations and financialpositions for the periods presented or in future periods.  These policies relate to the determination ofthe allowance for loan losses, deferred income taxes and the valuation of realestate owned and investment securities. These policies and the judgments,estimates and assumptions are described in the Annual Report on Form 10-Kfor the year ended December 31, 2009.

 

**Note 3:   RECLASSIFICATIONS**

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

 

**Note4:   NEW ACCOUNTING PRONOUNCEMENTS**

InJanuary 2010, the FASB issued ASU 2010-06, an update to ASU 820-10, “FairValue Measurements”. This update adds a new requirement to disclose transfersin and out of level 1 and level 2, along with the reasons for the transfers,and requires a gross presentation of purchases and sales of level 3 activities.Additionally, the update clarifies that entities provide fair value measurementdisclosures for each class of assets and liabilities and that entities provideenhanced disclosures around level 2 valuation techniques and inputs. Bancorpadopted the disclosure requirements for level 1 and level 2 transfers and theexpanded fair value measurement and valuation disclosures effective January 1,2010. The disclosure requirements for level 3 activities are effective forBancorp on January 1, 2011. The adoption of the disclosure requirementsfor level 1 and level 2 transfers and the expanded qualitative disclosures hadno impact on Bancorp’s financial position, results of operations, and earningsper share. Bancorp does not expect the adoption of the level 3 disclosurerequirements to have an impact on its financial position, results ofoperations, and earnings per share.

 

OnJuly 21, 2010, the FASB issued ASU 2010-20 which amends ASU 310 andexpands required disclosures for the Allowance for Loan and Lease Losses.  The objective of these enhanced disclosuresis to improve financial statements users’ understanding of (i) the natureof a company’s credit risk associated with financing receivables and (ii) thecompany’s assessment of risk in estimating its allowance for loan and leaselosses as well as changes in the allowance and the reasons for thosechanges.  For public companies, thisguidance is effective for interim and annual periods beginning on or after December 15,2010.  Bancorp does not anticipate theadoption of this guidance will have a material impact on its consolidatedfinancial statements.

 

**Note 5:   EARNINGS PER SHARE**

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

 

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

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

** **

(dollars in thousands except share and per share amounts)

 
| ** **                                                                       | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|----------------------------------------------------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                                                                       | ** ** | **2010**                             | ** ** | **2009**                           | ** ** | **2010** | ** ** | **2009** | ** ** |
| Numerator:                                                                       |       |                                 |       |                               |       |   |   |   |   |
| Net income                                                                       |       | $                                    | 1,333      |                               | $          | 888 |   | $ | 2,542 |   | $ | 2,086 |   |
| Denominator:                                                                     |       |                                 |       |                               |       |   |   |   |   |
| Denominator for basic earnings per share - Weighted  average shares outstanding  |       | 587,194                              |       | 586,595                            |       | 587,119 |   | 586,519 |   |
| Effect of dilutive securities:                                                   |       |                                 |       |                               |       |   |   |   |   |
| Stock options and unvested restricted stock grants                               |       | 1,312                                |       | 4,399                              |       | 1,391 |   | 4,690 |   |
| Denominator for diluted earning per share - Weighted  average shares outstanding |       | 588,506                              |       | 590,994                            |       | 588,510 |   | 591,209 |   |
| Basic earnings per share                                                         |       | $                                    | 2.27       |                               | $          | 1.51 |   | $ | 4.33 |   | $ | 3.56 |   |
| Diluted earnings per share                                                       |       | $                                    | 2.27       |                               | $          | 1.50 |   | $ | 4.32 |   | $ | 3.53 |   |

 

**Note 6:   STOCK-BASED COMPENSATION**

Bancorphas one share-based payment plan, which is shareholder approved, and permitsthe grant of share-based awards to its employees and directors up to 100,000shares and at June 30, 2010 there were 69,239 common shares available forgrant. Total equity compensation expense was $142,000 for the six months ended June 30,2010 and $128,000 for the like period in 2009.

 

**StockOptions**: No grants of options were awarded for the six months ended June 30,2010.  All options granted during 2009were Incentive Stock Options and were granted at a price equal to the marketvalue of the stock on the grant date, have a term of 10 years and vest over afive year period.  Bancorp measures thefair value of each stock option at the date of the grant, using the BlackScholes option valuation model.  The applicationof this valuation model involves assumptions that are judgmental and sensitivein the determination of compensation expense. The unrecognized share-based compensation cost relating to stock optionexpense at June 30, 2010 was $417,000, which will be recognized over theremaining vesting schedule through 2014.

 

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

 

(dollarsin 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, 2010 |       | 28,761     |       | $                                            | 179.40     |                                                     | 7.58       |                           | $          | — |   |
| Granted                             |       | —     |       |                                         |       |                                                     |       |                           |       |
| Exercised                           |       | —     |       |                                         |       |                                                     |       |                           |       |
| Forfeited                           |       | 450        |       |                                         |       |                                                     |       |                           |       |
| Outstanding at June 30, 2010   |       | 28,311     |       | $                                            | 179.69     |                                                     | 7.10       |                           | $          | — |   |
| Exercisable at June 30, 2010   |       | 11,773     |       | $                                            | 173.49     |                                                     | 6.50       |                           | $          | 18 |   |

 

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

 

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

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

Theunrecognized share-based compensation cost relating to restricted stock awardsexpense at June 30, 2010 was $168,000, which will be recognized over theremaining years of the original five year vesting period of the awards.  There were no awards granted for the sixmonths ended June 30, 2010.   Thetotal intrinsic value of stock awards exercised and vested during the sixmonths ended June 30, 2010 was $45,000.

 

Theaggregate intrinsic value in the table below represents the total pretaxintrinsic value (amount by which the fair value of the underlying stock exceedsthe exercise price of an option or award, times the number of shares).  The following table summarizes the activityrelating to restricted stock awards outstanding for the six months ended June 30,2010.

 

(dollarsin thousands except share and per share amounts)

 
| ** **                          | ** ** | **Shares** | ** ** | **Weighted Average  Remaining  Contractual Terms (in  years)** | ** ** | **Aggregate Intrinsic Value** | ** ** |
|-------------------------------------|------------|------------|------------|----------------------------------------------------------------|------------|-------------------------------|------------|
| Outstanding at January 1, 2010 |       | 1,564      |       | 2.80                                                           |       | $                             | 145        |   |
| Granted                             |       | —     |       |                                                           |       |                          |       |
| Vested                              |       | 289        |       | —                                                         |       | 45                            |       |
| Forfeited                           |       | 79         |       |                                                           |       |                          |       |
| Outstanding at June 30, 2010   |       | 1,196      |       | 2.24                                                           |       | $                             | 209        |   |
| Exercisable at June 30, 2010   |       | —     |       |                                                           |       |                          |       |

 

For additional informationon the stock-based equity compensation plan, refer to Bancorp’s auditedfinancial statements and footnotes for the most recent annual period ended December 31,2009 contained in the Annual Report on Form 10-K.

 

**Note 7:   INVESTMENT SECURITIES**

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

 

**June 30,2010**

** **
| ** **                                                                      | ** ** | **Amortized** | ** ** | **Gross Unrealized** | ** ** | **Estimated** | ** ** |
|---------------------------------------------------------------------------------|------------|---------------|------------|----------------------|------------|---------------|------------|
| **(dollars  in thousands)**                                                     | ** ** | **Cost**      | ** ** | **Gains**            | ** ** | **Losses**    | ** ** | **Fair Value** | ** ** |
| *Available-For-Sale Securities*                                                 |       |          |       |                 |       |          |       |   |   |
| U.S. Treasury and government agencies                                           |       | $             | 63,711     |                 | $          | 593           |       | $ | — |   | $ | 64,304 |   |
| Residential mortgage-backed securities and collateralized  mortgage obligations |       | 69,824        |       | 3,984                |       | —        |       | 73,808 |   |
| State and political subdivisions                                                |       | 9,272         |       | 365                  |       | 20            |       | 9,617 |   |
| Total available-for-sale                                                        |       | 142,807       |       | 4,942                |       | 20            |       | 147,729 |   |
| *Held-To-Maturity Securities*                                                   |       |          |       |                 |       |          |       |   |   |
| State and political subdivisions                                                |       | 39,862        |       | 1,204                |       | 24            |       | 41,042 |   |
| Total held-to-maturity                                                          |       | 39,862        |       | 1,204                |       | 24            |       | 41,042 |   |
| Total investment securities                                                     |       | $             | 182,669    |                 | $          | 6,146         |       | $ | 44 |   | $ | 188,771 |   |

 

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

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

**December 31,2009**

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

 

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

 

**June 30,2010**

** **
| ** **                                                                      | ** ** | **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. Treasury and government agencies                                           |       | $                       | —     |                     | $          | —         |       | $ | — |   | $ | — |   | $ | — |   | $ | — |   |
| Residential mortgage-backed securities and  collateralized mortgage obligations |       | —                  |       | —                   |       | —         |       | — |   | — |   | — |   |
| State and political subdivisions                                                |       | —                  |       | —                   |       | 477            |       | 20 |   | 477 |   | 20 |   |
| Total available-for-sale                                                        |       | —                  |       | —                   |       | 477            |       | 20 |   | 477 |   | 20 |   |
| *Held-To-Maturity Securities*                                                   |       |                    |       |                     |       |           |       |   |   |   |   |   |   |
| State and political subdivisions                                                |       | —                  |       | —                   |       | 2,051          |       | 24 |   | 2,051 |   | 24 |   |
| Total held-to-maturity                                                          |       | —                  |       | —                   |       | 2,051          |       | 24 |   | 2,051 |   | 24 |   |
| Total investment securities                                                     |       | $                       | —     |                     | $          | —         |       | $ | 2,528 |   | $ | 44 |   | $ | 2,528 |   | $ | 44 |   |

 

**December 31,2009**

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

 

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

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

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

 

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

 

AtJune 30, 2010, Bancorp held one security in the available-for-saleportfolio and two securities in the held-to-maturity portfolio that had anunrealized loss for more than one year.

 

Available-for-sale investment securities with a carrying value of$102.4 and $101.3 million as of June 30, 2010 and December 31, 2009,were pledged as collateral for public fund deposits, securities sold underagreement to repurchase, Treasury Tax and Loan payments, and Federal ReserveBank discount window borrowings.

 

**Note 8:   ALLOWANCE FOR LOANLOSSES**

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

 

**Allowance for Loan Losses Activity**

** **
| ** **                                                   | ** ** | **Three months ended,** | ** ** | **Six months ended,** | ** ** |
|--------------------------------------------------------------|------------|-------------------------|------------|-----------------------|------------|
| **(dollars  in thousands)**                                  | ** ** | **2010**                | ** ** | **2009**              | ** ** | **2010** | ** ** | **2009** | ** ** |
| Allowance as of beginning of period                          |       | $                       | 7,280      |                  | $          | 5,637 |   | $ | 6,883 |   | $ | 5,450 |   |
| Provision for loan losses                                    |       | 370                     |       | 450                   |       | 920 |   | 900 |   |
| Charge-offs                                                  |       | (323                    | )          | (496                  | )          | (511 | ) | (810 | ) |
| Recoveries                                                   |       | 65                      |       | 38                    |       | 100 |   | 89 |   |
| Net charge-offs                                              |       | (258                    | )          | (458                  | )          | (411 | ) | (721 | ) |
| Balance at end of period                                     |       | $                       | 7,392      |                  | $          | 5,629 |   | $ | 7,392 |   | $ | 5,629 |   |
| Ratio of net charge-offs to average loans during  the period |       | (0.27                   | )%         | (0.48                 | )%         | (0.21 | )% | (0.37 | )% |
| Ratio of allowance to net loans at end of period             |       | 1.97                    | %          | 1.46                  | %          | 1.97 | % | 1.46 | % |
| Ratio of non-performing loans to allowance                   |       | 124.34                  | %          | 162.96                | %          | 124.34 | % | 162.96 | % |

 

Impairedloans were $15.2 million as of June 30, 2010 compared to $24.4 million asof December 31, 2009.  Impairedloans had specific reserve allocations of $1.1 million and $1.2 million as of June 30,2010 and December 31, 2009, respectively.

 

**Note 9:   COMMITMENTS**

In the ordinary course ofbusiness, Bancorp has entered into off-balance-sheet financial instrumentsconsisting of commitments to extend credit, commitments under credit-cardarrangements, commercial letters of credit, and standby letters of credit. Suchfinancial instruments are recorded in the financial statements when they arefunded or related fees are incurred or received.

 

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

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

 

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

 
| Unfunded commitments to extend credit  |   | $      | 60,117 |   |
|----------------------------------------|--------|--------|--------|--------|
| Credit card arrangements               |   | 11,512 |   |
| Commitments to fund municipal warrants |   | 4,365  |   |
| Standby letters of credit              |   | 1,379  |   |

 

**Note 10: INCOME TAXES**

Bancorp files a consolidatedfederal income tax return.  Bancorpaccounts for income taxes using the liability method and deferred taxes arereflected at currently enacted income tax rates applicable to the period inwhich the deferred tax assets or liabilities are expected to be realized orsettled.  Deferred taxes result from temporarydifferences in the recognition of certain income and expense amounts betweenBancorp’s financial statements and its tax returns. As changes in tax laws orrates are enacted, deferred tax assets and liabilities are adjusted through theprovision for income taxes.

 

FASBASU 740, “Accounting for Uncertainty in Income Taxes” seeks to reduce thediversity in practice associated with certain aspects of measurement andrecognition in accounting for income taxes. ASU 740 provides guidance onde-recognition, classification, interest and penalties and accounting ininterim periods and requires expanded disclosure with respect to uncertainty inincome taxes.  As a result of theimplementation of ASU 740, Bancorp recognized no adjustments for unrecognizedincome tax benefits, all of which would affect Bancorp’s effective income taxrate if recognized.  Our accountingpolicy with respect to interest and penalties arising from income taxsettlements is to recognize them as non-interest expense.

 

**Note11:  FAIR VALUE MEASUREMENTS**

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

 

***Financial Instruments***

Cash, Due From Banks,Federal Funds Sold, Loans Held For Sale, Other Borrowings**andAccrued Interest Receivable and Payable*—*The carryingamount of these financial assets and liabilities approximates fair value.

 

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

 

Loans*—*The fair value of loans is estimated by discounting anticipated future cashflows using interest rates currently being offered for loans with similar termsto borrowers of similar credit quality as of the balance sheet date.  An overall liquidity discount was also usedfor 2010 and 2009 to reflect the decline of loan sales in the marketplace.  Impaired loans were not subjected todiscounted cash flow analysis as they are already considered to be held at fairvalue.

 

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

 

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

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

 

Off-Balance-SheetInstruments*—* Commitments to extend credit andstandby letters of credit represent the principal categories of off-balancefinancial instruments (See Note 9).  Thefair value of these instruments is not considered material since they are forrelatively short periods of time and are subject to customary credit terms,which would not include terms that would expose Bancorp to significant gains orlosses.

 

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

 
| ** **                           | ** ** | **June 30, 2010** | ** ** | **December 31, 2009** | ** ** |
|--------------------------------------|------------|------------------------|------------|----------------------------|------------|
| ** **                           | ** ** | **Carrying**           | ** ** | ** **                 | ** ** | **Carrying** | ** ** | ** ** | ** ** |
| **(dollars in thousands)** | ** ** | **Amount**             | ** ** | **Fair Value**        | ** ** | **Amount** | ** ** | **Fair Value** | ** ** |
| *Financial Assets*                   | * *   | * *               | * *   | * *                   | * *   | * * | * * | * * | * * |
| Cash and due from banks              |       | $                      | 13,222     |                       | $          | 13,222 |   | $ | 14,441 |   | $ | 14,441 |   |
| Federal funds sold                   |       | 77,215                 |       | 77,215                     |       | 62,531 |   | 62,531 |   |
| Investment securities                |       | 187,591                |       | 188,771                    |       | 158,859 |   | 159,122 |   |
| Loans held for sale                  |       | 80                     |       | 80                         |       | 574 |   | 574 |   |
| Net loans                            |       | 376,044                |       | 356,855                    |       | 386,649 |   | 361,780 |   |
| Accrued interest receivable          |       | 2,352                  |       | 2,352                      |       | 2,531 |   | 2,531 |   |
| * *                             |       |                   |       |                       |       |   |   |   |   |
| *Financial Liabilities*              |       |                   |       |                       |       |   |   |   |   |
| Demand and savings deposits          |       | 361,186                |       | 361,186                    |       | 339,001 |   | 339,001 |   |
| Time deposits                        |       | 215,395                |       | 217,314                    |       | 206,435 |   | 208,142 |   |
| Other borrowings                     |       | 35,097                 |       | 35,097                     |       | 38,128 |   | 38,128 |   |
| Accrued interest payable             |       | 290                    |       | 290                        |       | 366 |   | 366 |   |
|                                      |            |                        |            |                            |            |  |  |  |  |  |  |  |  |

 

***Fair Value Hierarchy***

 

FASB ASU 820 establishes ahierarchy that prioritizes the use of fair value inputs used in the valuationmethodologies into the following three levels:

 

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

 

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

 

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

 

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

 

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

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

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

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

 

(dollars in thousands)

 
| ** **                                                                      | ** ** | ** ** | ** ** | **Quoted  Prices in  Active  Markets for** | ** ** | **Significant  Other  Observable  Inputs** | ** ** | **Significant  Unobservable  Inputs** | ** ** |
|---------------------------------------------------------------------------------|------------|------------|------------|--------------------------------------------|------------|--------------------------------------------|------------|---------------------------------------|------------|
| **Description**                                                                 | ** ** | ** ** | ** ** | **(Level 1)**                              | ** ** | **(Level 2)**                              | ** ** | **(Level 3)**                         | ** ** |
| **June 30, 2010**                                                          |       |       |       |                                       |       |                                       |       |                                  |       |
| Available-for-sale securities                                                   |       |       |       |                                       |       |                                       |       |                                  |       |
| U.S. Treasury and government agencies                                           |       | $          | 64,304     |                                       | $          | —                                     |       | $                                     | 64,304     |   | $ | — |   |
| Residential mortgage-backed securities and collateralized  mortgage obligations |       | 73,808     |       | —                                     |       | 73,808                                     |       | $                                     | —     |   |
| State and political subdivisions                                                |       | 9,617      |       | —                                     |       | 9,617                                      |       | $                                     | —     |   |
| Total                                                                           |       | $          | 147,729    |                                       | $          | —                                     |       | $                                     | 147,729    |   | $ | — |   |
|                                                                            |       |       |       |                                       |       |                                       |       |                                  |       |
| **December 31, 2009**                                                      |       |       |       |                                       |       |                                       |       |                                  |       |
| Available-for-sale securities                                                   |       |       |       |                                       |       |                                       |       |                                  |       |
| U.S. government agencies                                                        |       | $          | 39,840     |                                       | $          | —                                     |       | $                                     | 39,840     |   | $ | — |   |
| Residential mortgage-backed-securities                                          |       | 68,996     |       | —                                     |       | 68,996                                     |       | $                                     | —     |   |
| State and political subdivisions                                                |       | 9,725      |       | —                                     |       | 9,725                                      |       | $                                     | —     |   |
| Total                                                                           |       | $          | 118,561    |                                       | $          | —                                     |       | $                                     | 118,561    |   | $ | — |   |

 

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

 

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

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

 

(dollarsin thousands)

 
| ** **                 | ** ** | ** ** | ** ** | **Quoted  Prices in  Active  Markets for** | ** ** | **Significant  Other  Observable  Inputs** | ** ** | **Significant  Unobservable  Inputs** | ** ** |
|----------------------------|------------|------------|------------|--------------------------------------------|------------|--------------------------------------------|------------|---------------------------------------|------------|
| **Description**            | ** ** | ** ** | ** ** | **(Level 1)**                              | ** ** | **(Level 2)**                              | ** ** | **(Level 3)**                         | ** ** |
| **June 30, 2010**     |       |       |       |                                       |       |                                       |       |                                  |       |
| Impaired loans             |       | $          | 14,055     |                                       | $          | —                                     |       | $                                     | —     |   | $ | 14,055 |   |
| Other real estate owned    |       | 7,099      |       | —                                     |       | —                                     |       | 7,099                                 |       |
| Total                      |       | $          | 21,154     |                                       | $          | —                                     |       | $                                     | —     |   | $ | 21,154 |   |
|                       |       |       |       |                                       |       |                                       |       |                                  |       |
| **December 31, 2009** |       |       |       |                                       |       |                                       |       |                                  |       |
| Impaired loans             |       | $          | 23,188     |                                       | $          | —                                     |       | $                                     | —     |   | $ | 23,188 |   |
| Other real estate owned    |       | 6,284      |       | —                                     |       | —                                     |       | 6,284                                 |       |
| Total                      |       | $          | 29,472     |                                       | $          | —                                     |       | $                                     | —     |   | $ | 29,472 |   |

 

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

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

 

*ImpairedLoans* — The recorded net investment in impaired loans, including accruedinterest, is limited to the present value of the expected cash flows of theimpaired loan, the observable fair market value of the loan or the estimated fairvalue of the loan’s collateral.  Impairedloans were written down $235,000 via partial charge-offs and in addition hadspecific reserve allocation decreases of $55,000, which was recorded throughthe****allowance for loan losses for the sixmonths ended June 30, 2010. Impaired loans were written down $1.7 million via partial charge-offsand in addition had specific reserve allocation increases of $1.3 million whichwas recorded through the allowance for loan losses for the twelve months ended December 31,2009.

 

*OtherReal Estate Owned* — Other real estate owned includes propertiesacquired through foreclosure.  Theseproperties are recorded at the lower of the recorded amount of the loan, orestimated fair value less estimated costs to sell based on periodic evaluationsusing Level 3 inputs.  Valuation of theproperty occurs when it is foreclosed upon and annually thereafter.  Write-downs arising from the acquisition ofproperty, in full or partial satisfaction of loans, are charged to theallowance for loan losses.  Subsequentwrite-downs after acquisition, identified through management’s periodicvaluations, are written down through non-interest expenses. Other real estateowned with a carrying amount of $7.4 million, were written down to their fairvalue of $7.1 million, resulting in write-downs of $265,000, which was chargedagainst earnings for the six months ended June 30, 2010.  Other real estate owned with a carryingamount of $7.5 million, were written down to their fair value of $6.3 million,resulting in write-downs of $1.2 million, which was charged against earningsfor the twelve months ended December 31, 2009.

 

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

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

 

**FORWARD LOOKING STATEMENTS**

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

 

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

·              increased loan delinquencyrates;

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

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

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

·              reduced demand for bankingproducts and services;

·              competition from otherfinancial services companies in our markets; and

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

 

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

 

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**BUSINESS**

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

 

**OVERVIEW**

Netincome was $1.3 million and $888,000 for the quarters ended June 30, 2010,and 2009 with diluted earnings per share at $2.27 and $1.50, respectively.  Net income was $2.5 million and $2.1 millionfor the six months ended June 30, 2010, and 2009 with diluted earnings pershare at $4.32 and $3.53, respectively. The increase in net income wasprimarily attributable to a decrease in interest expense and lower depositinsurance premiums. Annualized return on average assets was 0.78 percent and0.77 percent for the quarter and six months ended June 30, 2010, comparedto 0.61 percent and 0.73 percent during the same time periods as 2009.  Annualized return on average equity was 8.22percent and 7.96 percent for the quarter and six months ending June 30,2010 compared to 5.62 percent and 6.63 percent, respectively, for the same timeperiods in 2009.

 

Theprovision for loan losses was $370,000 and $920,000 for the quarter and sixmonths ended June 30, 2010, compared to $450,000 and $900,000 for the sametime periods in 2009. The continued elevated provisions for loan losses areprimarily attributable to the continued effects of a weakened economy, therelated declines in real estate values, and elevated levels of adverselyclassified assets. The provision for loan losses increased Bancorp’s totalallowance for loan losses to 1.97 percent of net loans at June 30, 2010compared to 1.78 percent at December 31, 2009.  For the quarter and six months ended June 30,2010, respectively, net charge-offs were $258,000 and $411,000 down from$458,000 and $721,000 for the same time periods in 2009.

 

Non-interestexpense was $4.7 million and $9.1 million for the quarter and six months ended June 30,2010 compared to $4.9 million and $9.5 million in the like periods in2009.  For the 2010 second quarter andsix months ended compared to the same 2009 periods, the decrease was primarilyattributable to decreases in FDIC deposit insurance premiums and OREOwrite-downs. The 2009 deposit insurance premiums included a one-time assessmentof $260,000.

 

Totalassets increased to $679.5 million at June 30, 2010, compared to $647.9million at December 31, 2009.  Theincrease was primarily due to deposit growth of $31.1 million.  Net loans decreased by $10.6 million or 2.7percent to $376.0 million at June 30, 2010, compared to $386.6 million at December 31,2009.  During 2010 and 2009, Bancorpcontinued to originate and fund loans to credit-worthy customers within ourmarkets.  Decreased loan balances reflectthe current market conditions and the lower demand and lower availability ofquality loans.

 

**RESULTSOF OPERATIONS**

Bancorp’sresults of operations are dependent to a large degree on net interest income,operating efficiency and the level of the provision for loan losses. Bancorp’soperations are sensitive to interest rate changes and the resulting impact onnet interest income. In addition, changes in net interest income are influencedby the volume of assets and liabilities and the rates earned and paidrespectively.  Bancorp generates non-interestincome primarily through fees and service charges on deposit accounts and gainson the sale of mortgage loans. Bancorp’s non-interest expenses consistprimarily of salaries and employee benefits expense, bank premises andequipment expenses and other operating expenses.

 

**NET INTEREST INCOME**                 Net interest income is Bancorp’s principal source ofrevenue and is comprised of interest income on earnings assets (loans andinvestment securities) less interest expense on interest-bearing liabilities(deposits and borrowings). Interest income and expense are affectedsignificantly by general economic conditions, particularly changes in marketinterest rates, and by government policies and the actions of regulatoryauthorities.

 

Netinterest income was $5.6 million and $11.0 million for the quarter and sixmonths ended June 30, 2010 compared to $5.3 million and $10.7 million forthe like periods in 2009.  For thequarter and six months ended June 30, 2010, the net interest margindecreased to 3.49 percent and 3.51 percent compared to 3.88 percent and 3.99percent for the like periods in 2009. The decreases in net interest margin are primarily due to a decrease inthe average yield on securities and the negative impact of the change in theinterest-earning asset composition with lower yielding federal funds soldcomprising a higher percentage of total interest-earning assets.  In addition, the yield on interest-earningassets decreased 75 basis points and 83 basis points for the quarter and sixmonths ended June 30, 2010 compared to the like periods in 2009.  This was partially offset by a decrease inthe cost of funds of 49 basis points and 47 points for the same time periods.

 

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Thefollowing tables present information regarding average balances of assets andliabilities as well as the total amounts of interest income from averageinterest-earning assets and interest expense on average interest-bearingliabilities, resulting yield and cost ratios, interest rate spread and netinterest margin. Tax exempt securities, included in investment securities beloware stated at their contractual interest rate. Loan fees of $252,000 and $426,000 for the quarter and six months ended June 30,2010, and $215,000 and $438,000 for the quarter and six months ended June 30,2009, respectively, are included in interest earned on loans. Non-accruingloans have been included in the computation of average loans.

 

**Condensed Average Balance Sheets**

(dollars in thousands except share data)

 
| ** **                                        | ** ** | **2010**             | ** ** | **2009**     | ** ** |
|---------------------------------------------------|------------|----------------------|------------|--------------|------------|
| **Three  months ended June 30,**             | ** ** | **Average  Balance** | ** ** | **Interest** | ** ** | **Yield  /Cost** | ** ** | **Average  Balance** | ** ** | **Interest** | ** ** | **Yield  /Cost** | ** ** |
| **Assets**                                        |       |                 |       |         |       |   |   |   |   |   |   |   |   |
| Federal funds sold                                |       | $                    | 89,369     |         | $          | 56 |   | 0.25 | % | $ | 24,691 |   | $ | 11 |   | 0.18 | % |
| Taxable investment securities                     |       | 125,262              |       | 1,064        |       | 3.41 |   | 87,958 |   | 1,044 |   | 4.76 |   |
| Tax exempt securities                             |       | 49,510               |       | 276          |       | 2.24 |   | 48,290 |   | 281 |   | 2.33 |   |
| Loans                                             |       | 382,100              |       | 5,766        |       | 6.05 |   | 385,946 |   | 5,760 |   | 5.99 |   |
| Total interest-earning assets                     |       | 646,241              |       | 7,162        |       | 4.45 | % | 546,885 |   | 7,096 |   | 5.20 | % |
| Non-interest earning assets                       |       | 37,453               |       |         |       |   |   | 32,483 |   |   |   |   |   |
| Total assets                                      |       | $                    | 683,694    |         |       |   |   |   | $ | 579,368 |   |   |   |   |   |
|                                              |       |                 |       |         |       |   |   |   |   |   |   |   |   |
| **Liabilities and Stockholders’  Equity**    |       |                 |       |         |       |   |   |   |   |   |   |   |   |
| Interest-bearing demand                           |       | $                    | 110,863    |         | $          | 112 |   | 0.41 | % | $ | 89,073 |   | $ | 78 |   | 0.35 | % |
| Savings and money market                          |       | 177,527              |       | 333          |       | 0.75 |   | 165,560 |   | 410 |   | 0.99 |   |
| Certificates of deposit                           |       | 215,474              |       | 1,011        |       | 1.88 |   | 175,346 |   | 1,255 |   | 2.87 |   |
| Total interest-bearing deposits                   |       | 503,864              |       | 1,456        |       | 1.16 |   | 429,979 |   | 1,743 |   | 1.63 |   |
| Other borrowings                                  |       | 40,569               |       | 87           |       | 0.86 |   | 15,074 |   | 64 |   | 1.70 |   |
| Total interest-bearing deposits & liabilities |       | 544,433              |       | 1,543        |       | 1.14 | % | 445,053 |   | 1,807 |   | 1.63 | % |
| Non interest-bearing demand deposits              |       | 72,381               |       |         |       |   |   | 69,043 |   |   |   |   |   |
| Other non-interest-bearing liabilities            |       | 1,810                |       |         |       |   |   | 1,841 |   |   |   |   |   |
| Total liabilities                                 |       | 618,624              |       |         |       |   |   | 515,937 |   |   |   |   |   |
| Stockholders’ equity                         |       | 65,070               |       |         |       |   |   | 63,431 |   |   |   |   |   |
| Total liabilities and stockholders equity         |       | $                    | 683,694    |         |       |   |   |   | $ | 579,368 |   |   |   |   |   |
| Net interest income                               |       |                 |       | $            | 5,619      |   |   |   |   |   | $ | 5,289 |   |   |   |
| Interest rate spread                              |       |                 |       |         |       | 3.31 | % |   |   |   |   | 3.58 | % |
| Net interest margin                               |       |                 |       |         |       | 3.49 | % |   |   |   |   | 3.88 | % |

 

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**Condensed Average Balance Sheets**

(dollars in thousands except share data)

 
| ** **                                        | ** ** | **2010**    | ** ** | **2009**     | ** ** |
|---------------------------------------------------|------------|-------------|------------|--------------|------------|
| ** **                                        | ** ** | **Average** | ** ** | ** **   | ** ** | **Yield** | ** ** | **Average** | ** ** | ** ** | ** ** | **Yield** | ** ** |
| **Six  months ended June 30,**               | ** ** | **Balance** | ** ** | **Interest** | ** ** | **/Cost** | ** ** | **Balance** | ** ** | **Interest** | ** ** | **/Cost** | ** ** |
| **Assets**                                        |       |        |       |         |       |   |   |   |   |   |   |   |   |
| Federal funds sold                                |       | $           | 83,844     |         | $          | 105 |   | 0.25 | % | $ | 14,041 |   | $ | 12 |   | 0.17 | % |
| Taxable investment securities                     |       | 115,121     |       | 2,082        |       | 3.65 |   | 89,188 |   | 2,114 |   | 4.75 |   |
| Tax exempt securities                             |       | 49,564      |       | 550          |       | 2.24 |   | 48,093 |   | 562 |   | 2.34 |   |
| Loans                                             |       | 383,355     |       | 11,406       |       | 6.00 |   | 388,172 |   | 11,667 |   | 6.03 |   |
| Total interest-earning assets                     |       | 631,884     |       | 14,143       |       | 4.51 | % | 539,494 |   | 14,355 |   | 5.34 | % |
| Non-interest earning assets                       |       | 36,715      |       |         |       |   |   | 32,068 |   |   |   |   |   |
| Total assets                                      |       | $           | 668,599    |         |       |   |   |   | $ | 571,562 |   |   |   |   |   |
|                                              |       |        |       |         |       |   |   |   |   |   |   |   |   |
| **Liabilities and Stockholders’  Equity**    |       |        |       |         |       |   |   |   |   |   |   |   |   |
| Interest-bearing demand                           |       | $           | 106,168    |         | $          | 196 |   | 0.37 | % | $ | 87,899 |   | $ | 149 |   | 0.34 | % |
| Savings and money market                          |       | 172,460     |       | 688          |       | 0.80 |   | 159,396 |   | 787 |   | 0.99 |   |
| Certificates of deposit                           |       | 213,172     |       | 2,092        |       | 1.98 |   | 170,891 |   | 2,541 |   | 2.98 |   |
| Total interest-bearing deposits                   |       | 491,800     |       | 2,976        |       | 1.22 |   | 418,186 |   | 3,477 |   | 1.67 |   |
| Other borrowings                                  |       | 39,013      |       | 169          |       | 0.87 |   | 19,804 |   | 153 |   | 1.55 |   |
| Total interest-bearing deposits & liabilities |       | 530,813     |       | 3,145        |       | 1.19 | % | 437,990 |   | 3,630 |   | 1.66 | % |
| Non interest-bearing demand deposits              |       | 71,688      |       |         |       |   |   | 69,065 |   |   |   |   |   |
| Other non-interest-bearing liabilities            |       | 1,688       |       |         |       |   |   | 1,455 |   |   |   |   |   |
| Total liabilities                                 |       | 604,189     |       |         |       |   |   | 508,510 |   |   |   |   |   |
| Stockholders’ equity                         |       | 64,410      |       |         |       |   |   | 63,052 |   |   |   |   |   |
| Total liabilities and stockholders equity         |       | $           | 668,599    |         |       |   |   |   | $ | 571,562 |   |   |   |   |   |
| Net interest income                               |       |        |       | $            | 10,998     |   |   |   |   |   | $ | 10,725 |   |   |   |
| Interest rate spread                              |       |        |       |         |       | 3.32 | % |   |   |   |   | 3.67 | % |
| Net interest margin                               |       |        |       |         |       | 3.51 | % |   |   |   |   | 3.99 | % |

 

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

 

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

 
| ** **                                                   | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|--------------------------------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                                                   | ** ** | **2010 vs. 2009**                    | ** ** | **2010 vs. 2009**                  | ** ** |
| ** **                                                   | ** ** | **Increase (Decrease) Due to**       | ** ** | **Increase (Decrease) Due to**     | ** ** |
| **(dollars  in thousands)**                                  | ** ** | **Volume**                           | ** ** | **Rate**                           | ** ** | **Total** | ** ** | **Volume** | ** ** | **Rate** | ** ** | **Total** | ** ** |
| **Interest-Earning Assets**                                  | ** ** | ** **                           | ** ** | ** **                         | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |   | ** ** |
| Federal funds sold                                           |       | $                                    | 39         |                               | $          | 6 |   | $ | 45 |   | $ | 85 |   | $ | 8 |   | $ | 93 |   |
| Investment securities                                        |       | 1,472                                |       | (1,457                             | )          | 15 |   | 1,114 |   | (1,158 | ) | (44 | ) |
| Loans                                                        |       | (240                                 | )          | 246                                |       | 6 |   | (190 | ) | (71 | ) | (261 | ) |
| Total net change in income on interest-earning  assets       |       | 1,271                                |       | (1,205                             | )          | 66 |   | 1,009 |   | (1,221 | ) | (212 | ) |
| **Interest-Bearing Liabilities**                             |       |                                 |       |                               |       |   |   |   |   |   |   |   |   |
| Deposits                                                     |       | 1,182                                |       | (1,469                             | )          | (287 | ) | 1,194 |   | (1,695 | ) | (501 | ) |
| Other borrowings                                             |       | 214                                  |       | (191                               | )          | 23 |   | 196 |   | (180 | ) | 16 |   |
| Total net change in expense on interest-bearing  liabilities |       | 1,396                                |       | (1,660                             | )          | (264 | ) | 1,390 |   | (1,875 | ) | (485 | ) |
| Net change in net interest income                            |       | $                                    | (125       | )                                  | $          | 455 |   | $ | 330 |   | $ | (381 | ) | $ | 654 |   | $ | 273 |   |

 

**PROVISIONFOR LOAN LOSSES               **The provisionfor loan losses was $370,000 and $920,000 for the quarter and six months ended June 30,2010 compared to $450,000 and $900,000 provision for loan losses for the likeperiods in 2009. The continued elevated provisions for loan losses areprimarily attributable to the continued effects of a weakened economy, therelated declines in real estate values, and elevated levels of adversely classifiedassets. For the quarter and six months ended June 30, 2010, netcharge-offs were $258,000 and $411,000 compared to $458,000 and $721,000 forthe like periods in 2009.  For the sixmonths ended June 30, 2010, charge-offs on 4 credit relationships were 72percent of total net charge-offs.

 

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

 

**NON-INTERESTINCOME               **Non-interestincome, which consists primarily of fees and service charges on deposits andother income, was relatively unchanged at $1.1 million and $2.0 million for thequarter and six months ended June 30, 2010, and $1.0 million and $2.0million for the like periods in 2009.

 

**NON-INTERESTEXPENSE             **Non-interestexpense was $4.7 million and $9.1 million for the quarter and six months ended June 30,2010 compared to $4.9 million and $9.5 million in the like periods in2009.  For the quarter and six monthsended, the decrease was attributable to a $128,000 and $108,000 decrease inwrite-downs of other real estate owned and a $206,000 and $269,000 decrease inFDIC insurance premiums. The 2009 deposit insurance premiums included aone-time assessment of $260,000.

 

Theefficiency ratio is computed by dividing total operating expenses bynon-interest income and net interest income before provision for loanlosses.  An increase in the efficiencyratio indicates that more resources are being utilized to generate the same orgreater volume of income. The efficiency ratio for the quarter and six monthsended June 30, 2010 was 70.4 percent and 69.6 percent compared to 78.2percent and 74.5 percent for the same time periods in 2009.

** **

**INCOME TAX EXPENSE                 **Income taxexpense for the quarter and six months ended June 30, 2010 was $280,000and $498,000 compared to $40,000 and $250,000 expense for the quarter and sixmonths ended June 30, 2009, respectively. Bancorp’s effective tax rateswere 16.4 percent and 10.7 percent for the six months ended June 30, 2010and 2009, respectively. The effective tax rate is lower than the federalstatutory rate due to tax credits from tax-exempt bonds and tax-exempt interestfrom municipal bonds and loans.  As of June 30,2010, Bancorp had $49.5 million in tax-exempt securities compared to $47.6million as of June 30, 2009.

 

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**REVIEWOF FINANCIAL CONDITION**

Totalassets increased to $679.5 million at June 30, 2010 compared to $647.9million at December 31, 2009.  Thisincrease was primarily due to a $31.1 million increase in deposits to $576.6million. Net loans decreased $10.6 million to $376.0 million during the sametime period.

 

**INVESTMENT SECURITIES AND FEDERAL FUNDS SOLD**Totalinvestment securities, including federal funds sold, increased to $264.8million at June 30, 2010 compared to $221.4 million at December 31,2009. Federal funds sold increased to $77.2 million at June 30, 2010 from$62.5 million as of December 31, 2009. This increase resulted primarilyfrom the growth in deposits.

 

Theavailable-for-sale investment portfolio is comprised of 50.0 percent GovernmentSponsored Agencies and Government Agencies mortgage-backed pass-throughsecurities and collateralized mortgage obligations, 6.5 percent of state andmunicipals and 43.5 percent of U.S Treasury and Government Sponsored Agenciesand Government Agencies securities.  Theheld-to-maturity portfolio is concentrated in municipal securities andQualified Zone Academy Bonds. Security purchases for the quarter and six monthsended June 30, 2010, respectively, were $43.8 million and $50.3million.  Security maturities, calls, andpay-downs were $14.0 million and $23.7 million for the quarter and six monthsended June 30, 2010, respectively.

 

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

 
| ** **                                                                      | ** ** | **2010**               | ** ** |
|---------------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                      | ** ** | **Available-For-Sale** | ** ** | **Held-To-Maturity** | ** ** |
| ** **                                                                      | ** ** | **Amortized**          | ** ** | **Estimated** | ** ** | **Amortized** | ** ** | **Estimated** | ** ** |
| **(dollars  in thousands)**                                                     | ** ** | **Cost**               | ** ** | **Fair Value** | ** ** | **Cost** | ** ** | **Fair Value** | ** ** |
| 0-1 year                                                                        |       | $                      | 8,524      |   | $ | 8,560 |   | $ | 5,032 |   | $ | 5,068 |   |
| 1-5 years                                                                       |       | 57,063                 |       | 57,870 |   | 13,315 |   | 13,703 |   |
| 5-10 years                                                                      |       | 5,895                  |       | 5,989 |   | 10,993 |   | 11,382 |   |
| Over 10 years                                                                   |       | 1,500                  |       | 1,501 |   | 10,522 |   | 10,889 |   |
| Residential mortgage-backed securities and  collateralized mortgage obligations |       | 69,825                 |       | 73,809 |   | — |   | — |   |
| Total investment securities                                                     |       | $                      | 142,807    |   | $ | 147,729 |   | $ | 39,862 |   | $ | 41,042 |   |

 

**LOANS                **Net loansdecreased 2.7 percent to $376.0 million at June 30, 2010 compared to$386.6 million at December 31, 2009. Net loans represented 55.3 percent of total assets at June 30,2010.  During 2010 and 2009, Bancorpcontinued to originate and fund loans to credit-worthy customers within ourmarkets.  Decreased loan balances reflectthe current market conditions and the lower demand and lower availability ofquality loans.

 

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

 

*RealEstate Loans:* Real estate loans comprise the largest category ofloans and our real estate portfolio consists of commercial and residentialloans which are secured by property such as office buildings, retail buildings,owner occupied commercial business properties, farm land, timber land,residential land development properties and residential properties.  Real estate loans compromised 66.6% of totalloans at June 30, 2010.  The primaryrepayment source of these specific loan types are from the cash flows generatedby the occupant business, occupant farm operation, or the sale of properties.While Bancorp has significant balances secured by real estate, Bancorp believesthat its lending policies and concentration policies are sufficient to minimizerisks.  However, economic conditions mayaffect a borrower’s ability to meet the stated repayment terms.

 

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

 

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

 

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

 

**LoanComposition**

** **
| ** **                                           | ** ** | **June 30, 2010** | ** ** | **December 31, 2009** | ** ** |
|------------------------------------------------------|------------|------------------------|------------|----------------------------|------------|
| **(dollars  in thousands)**                          | ** ** | **Amount**             | ** ** | **%**                      | ** ** | **Amount** | ** ** | **%** | ** ** |
| Real estate — residential & commercial |       | $                      | 244,438    |                       | 63.6       | % | $ | 248,658 |   | 63.0 | % |
| Real estate construction                             |       | 11,472                 |       | 3.0                        | %          | 13,261 |   | 3.4 | % |
| Commercial, industrial & agricultural       |       | 74,717                 |       | 19.4                       | %          | 76,716 |   | 19.4 | % |
| Consumer                                             |       | 53,607                 |       | 14.0                       | %          | 55,910 |   | 14.2 | % |
| Total loans                                          |       | 384,234                |       | 100                        | %          | 394,545 |   | 100 | % |
| Less:                                                |       |                   |       |                       |       |   |   |   |   |
| Allowance for loan losses                            |       | 7,392                  |       |                       |       | 6,883 |   |   |   |
| Deferred loan fees                                   |       | 798                    |       |                       |       | 1,013 |   |   |   |
| Net loans                                            |       | $                      | 376,044    |                       |       |   | $ | 386,649 |   |   |   |

 

*Concentrations*

Asshown in the table above, a concentration of loans in commercial andresidential real estate existed as of June 30, 2010.  At June 30,2010, Bancorp’s real estate portfolio included $153.0 million in non-farmnon-residential real estate loans of which $91.1 million is owner occupied.Total loans also included $51.2 million in raw land, land development andconstruction loans and $59.0 million in one-to-four family residential loans.

 

During2006, the FDIC issued guidance entitled “Concentrations in Commercial RealEstate Lending, Sound Risk Management Practices”.  The guidance set forthtwo thresholds to identify institutions with Commercial Real Estate (CRE) loanconcentrations. Financial institutions are deemed to have a CRE concentrationif loans for construction, land development, and other land represent 100percent or more of total capital or if loans for construction, landdevelopment, and other land and loans secured by multifamily and nonfarmnonresidential property(excluding loans secured by owner-occupied properties)represent 300 percent or more of total capital. Bancorp’s construction, landdevelopment, raw land, multifamily and nonfarm nonresidential non-owneroccupied real estate loans outstanding (total commercial real estate) were 172%and 194% of total risk based capital for June 30, 2010 and 2009,respectively. Total reported loans for construction, land development, and rawland were 75% and 88% of total risk based capital for June 30, 2010 and2009, respectively. Bancorp considers both ratios noted above to be withinacceptable levels of concentration risk.

 

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

 

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*CreditRisk Management*

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

 

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

 

**ALLOWANCEFOR LOAN LOSSES**             Theallowance for loan losses was $7.4 million or 1.97 percent of net loans as of June 30,2010 compared to $6.9 million or 1.78 percent of net loans as of December 31,2009. The increase in the allowance for loan losses is primarily due to thecontinued weakness in the economy and declines in real estate values. Additionsto the allowance, in the form of provision, are reflected in current operatingresults, while charge-offs to the allowance are made when a loss is determinedto have occurred. The provision for loan losses was $370,000 and $920,000 forthe quarter and six months ended June 30, 2010, respectively, compared to$450,000 and $900,000 for the like period in 2009. For the quarter and sixmonth ended June 30, 2010, net charge-offs were $258,000 and $411,000compared to $458,000 and $721,000 for the like period in 2009.

 

Theallowance consists of specific, general and unallocated components; (i) aspecific valuation allowance based on a review of classified or non-performingloans for specific weaknesses and evaluation of those loans for impairment andloss exposure; (ii) a general allowance which is based on historical loanloss experience for different loan types and different risk gradings withadjustments for current events and conditions. Bancorp’s process is designed to account for credit deterioration as itoccurs.  The adjustments are a result ofmanagement’s judgment about risks inherent in the portfolio and include suchfactors as loan quality trends, levels of and trends of non-accrual loans, pastdue loans, potential problem loans, criticized loan balances, net charge-offsand current economic and business conditions, among other factors and (iii) unallocatedgeneral allowances determined based on general economic conditions and otherqualitative risk factors.  Theunallocated allowance provides for other credit losses inherent in the loanportfolio that may not have been contemplated in the general and specificcomponents of the allowance. The unallocated amount is reviewed periodicallybased on trends in credit losses, the results of credit reviews and overalleconomic trends. At June 30, 2010 and December 31, 2009, the generalallocated reserve was $5.2 million and $5.0 million, respectively. At June 30,2010 and December 31, 2009, respectively, $1.1 million and $1.2 millionrelated to loans for which there was a specific reserve. The increase in theunallocated portion of the allowance for possible loan losses during 2010 isreflective of continued recessionary economic conditions and the impact tocredit quality. While we strive to carefully monitor credit quality and toidentify loans that may become nonperforming, at any time there are loans inthe portfolio that could result in losses, but that have not been identified asnonperforming or potential problem loans.

 

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

 

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

 
| ** **                                     | ** ** | **June 30,  2010** | ** ** | **December 31, 2009** | ** ** |
|------------------------------------------------|------------|-------------------------|------------|----------------------------|------------|
| Commercial, industrial & agricultural |       | $                       | 1,287      |                       | $          | 1,456 |   |
| Real estate-residential & commercial  |       | 4,380                   |       | 4,013                      |       |
| Consumer                                       |       | 699                     |       | 683                        |       |
| Unallocated                                    |       | 1,026                   |       | 731                        |       |
| Total                                          |       | $                       | 7,392      |                       | $          | 6,883 |   |

 

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

 

**Allowancefor Loan Losses Activity**

** **
| ** **                                                   | ** ** | **Three months ended,** | ** ** | **Six months ended,** | ** ** |
|--------------------------------------------------------------|------------|-------------------------|------------|-----------------------|------------|
| **(dollars  in thousands)**                                  | ** ** | **2010**                | ** ** | **2009**              | ** ** | **2010** | ** ** | **2009** | ** ** |
| Allowance as of beginning of period                          |       | $                       | 7,280      |                  | $          | 5,637 |   | $ | 6,883 |   | $ | 5,450 |   |
| Provision for loan losses                                    |       | 370                     |       | 450                   |       | 920 |   | 900 |   |
| Charge-offs                                                  |       | (323                    | )          | (496                  | )          | (511 | ) | (810 | ) |
| Recoveries                                                   |       | 65                      |       | 38                    |       | 100 |   | 89 |   |
| Net charge-offs                                              |       | (258                    | )          | (458                  | )          | (411 | ) | (721 | ) |
| Balance at end of period                                     |       | $                       | 7,392      |                  | $          | 5,629 |   | $ | 7,392 |   | $ | 5,629 |   |
| Ratio of net charge-offs to average loans during  the period |       | (0.27                   | )%         | (0.48                 | )%         | (0.21 | )% | (0.37 | )% |
| Ratio of allowance to net loans at end of period             |       | 1.97                    | %          | 1.46                  | %          | 1.97 | % | 1.46 | % |
| Ratio of non-performing loans to allowance                   |       | 124.34                  | %          | 162.96                | %          | 124.34 | % | 162.96 | % |

 

***ASSET QUALITY*****    **Non-performing assetsconsist of nonaccrual loans, accruing loans past due 90 days or more, and otherreal estate owned. At June 30, 2010, non-performing assets decreased to$16.3 million or 2.40 percent of total assets compared to $17.0 million or 2.63percent as of December 31, 2009.

 

*Non-accrual*- It is Bancorp’s policy to discontinue the accrualof interest on all loans that are 90 days or more past due or when there areotherwise serious doubts about the collectability of principal or interestwithin the existing terms of the loan and place them on non-accrual.  When a loan is placed on non-accrual status,any accrued but unpaid interest on that date is removed from interestincome.  Non-accruing loans decreased to$9.2 million as of June 30, 2010 compared to $10.7 million as of December 31,2009 with $1.4 million of the December balance transferring into otherreal estate owned during 2010. Raw land, construction, and land developmentloans are the primary components of non-performing loans representing $6.5million or 70.6% of non-performing loans as of June 30, 2010.

 

*Restructured loans* — Loans are consideredrestructured on loans for which concessions, including the reduction ofinterest rates below a rate otherwise available to that borrower or thedeferral or forgiveness, of interest or principal, have been granted due to theborrower’s weakened financial condition. Restructured loans included in impaired loans were $3.5 million as of June 30,2010, of which, $3.2 million was included in non-accrual loans.   Restructured loans included in impairedloans were $945,000 as of December 31, 2009, of which, $555,000 wasincluded in non-accrual loans.

 

*Otherreal estate owned* —   Otherreal estate owned increased to $7.1 million at June 30, 2010 from $6.3million at December 31, 2009. During 2010, Bancorp foreclosed on a non-accrual credit relationship of$1.4 million. In addition, Bancorp transferred the former Boulevard branch witha balance of $339,000 from other real estate owned back into bank premises foruse as the bank’s consumer loan administrative facility. As of June 30,2010, Bancorp held seven properties which represent four separate landdevelopment projects consisting of finished lots with a carrying balance of$4.7 million, two commercial real estate properties with a carrying balance of$2.3 million, and a $136,000 raw land property.

 

Valuationof the property occurs when it is foreclosed upon and annually thereafter.Based on current appraisals received and the decrease in fair market values ofthese real estate properties, Bancorp recorded a write-down on other realestate owned of $245,000 and $265,000 for the quarter and six months ended June 30,2010. Bancorp plans to continue its collection efforts and liquidation ofcollateral, as necessary, to recover as large a portion of the non-accrualassets or other real estate owned as possible.

 

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

** **

**Non-PerformingAssets**

 
| **(dollars  in thousands)**                 | ** ** | **June 30, 2010** | ** ** | **December 31, 2009** | ** ** |
|---------------------------------------------|------------|------------------------|------------|----------------------------|------------|
| Non-accrual loans                           |       | $                      | 9,191      |                       | $          | 10,742 |   |
| Loans past due 90 days or more              |       | —                 |       | —                     |       |
| Total non-performing loans                  |       | 9,191                  |       | 10,742                     |       |
| Other real estate owned                     |       | 7,099                  |       | 6,284                      |       |
| Total non-performing assets                 |       | $                      | 16,290     |                       | $          | 17,026 |   |
| Total non-performing loans to net loans     |       | 2.44                   | %          | 2.78                       | %          |
| Total non-performing loans to total assets  |       | 1.35                   | %          | 1.66                       | %          |
| Total non-performing assets to total assets |       | 2.40                   | %          | 2.63                       | %          |

 

*Impairedloans -*At June 30, 2010, impaired loans decreased to$15.2 million compared to $24.4 million at December 31, 2009.  Four credit relationships of $9.7 million,accounted for 63.8 percent of impaired loans as of June 30, 2010. Impairedloans had specific reserve allocations of $1.1 million and $1.2 million as of June 30,2010 and December 31, 2009, respectively. All material loan restructuringshave been included in impaired loans.

 

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

 

*Potentialproblem loans* —   Potentialproblem loans consist of loans that are currently performing, are not onnonaccrual status, restructured or impaired, but for which management haveidentified as having a well defined weakness or weaknesses and which there aresufficient doubts as to the borrower’s future ability to comply with repaymentterms.  These loans are identifiedthrough our internal risk grading processes and management monitors these loansclosely and reviews their performance on a regular basis. As of June 30,2010 and December 31, 2009, Bancorp had classified $14.6 million and $8.8million, respectively, as other potential problem loans.

 

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

 

Totaldeposits increased to $576.6 million at June 30, 2010 compared to $545.4million at December 31, 2009. Within the total, core deposits increased $22.2 million and timedeposits increased $9.0 million.  Coredeposits, which consist of non-interest and interest bearing demand accounts,money market accounts, and saving accounts, represented 62.6 percent and 62.1percent of total deposits at June 30, 2010 and December 31, 2009,respectively.

 

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

 

**DepositComposition**

** **
| ** **                     | ** ** | **June 30, 2010** | ** ** | **December 31, 2009** | ** ** |
|--------------------------------|------------|------------------------|------------|----------------------------|------------|
| **(dollars  in thousands)**    | ** ** | **Amount**             | ** ** | **% of Total**             | ** ** | **Amount** | ** ** | **% of Total** | ** ** |
| Non-interest bearing demand    |       | $                      | 72,185     |                       | 12.5       | % | $ | 73,839 |   | 13.5 | % |
| Interest bearing demand        |       | 108,358                |       | 18.8                       | %          | 101,504 |   | 18.6 | % |
| Money market                   |       | 84,646                 |       | 14.7                       | %          | 77,288 |   | 14.2 | % |
| Savings                        |       | 95,997                 |       | 16.6                       | %          | 86,370 |   | 15.8 | % |
| Time                           |       | 191,673                |       | 33.2                       | %          | 182,441 |   | 33.4 | % |
| Brokered time deposits (CDARS) |       | 23,722                 |       | 4.2                        | %          | 23,994 |   | 4.5 | % |
| Total deposits                 |       | $                      | 576,581    |                       | 100.0      | % | $ | 545,436 |   | 100.0 | % |

 

**OTHERBORROWINGS  **Securities soldunder agreement to repurchase decreased to $35.1 million at June 30, 2010compared to $38.1 million as of December 31, 2009.  These borrowings are collateralized bysecurities with an estimated fair value exceeding the face value of theborrowings. Investment securities with a carrying amount of $46.7 million,consisting of U.S. government agency debt securities and U.S. government agencyresidential mortgage-backed securities were pledged as collateral forsecurities sold under agreement to repurchase at June 30, 2010.  Securities sold under agreement to repurchaseare overnight funds or borrowings that typically mature within one year.

 

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

 

**CAPITALRESOURCES**    Stockholders’equity increased to $65.9 million at June 30, 2010 from $62.9 million at December 31,2009.  Book value per share at June 30,2010 was $112.21 compared to a book value of $107.10 at December 31, 2009.

 

Bancorphas only one class of stock, which is common stock and at June 30, 2010,there were 777 shareholders of record. Bancorp’s stock is not actively traded or quoted and no broker currentlymakes a market in the stock. However, sales and transfers of the stock dooccur.  Skagit State Bank acts astransfer agent for Bancorp stock.  Tofacilitate trading, the Bank maintains a list of persons interested (known tothe Bank) in either purchasing or selling Bancorp stock.  Purchasers and sellers then negotiate theirown transactions with the Bank acting as transfer agent for those transactions.From time to time, Bancorp repurchases shares of its common stock. The numberof shares of stock that will be repurchased and the price that will be paid isthe result of many factors including market and economic conditions, the numberof shares available, Bancorp’s liquidity and capital needs and regulatoryrequirements. Bancorp repurchased no shares of stock in 2010 or 2009.

 

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

 

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| ** **                      | ** ** | ** ** | ** ** | ** **            | ** ** | ** **            | ** ** | ** **            | ** ** | **To Be Well**        | ** ** |
|---------------------------------|------------|------------|------------|-----------------------|------------|-----------------------|------------|-----------------------|------------|-----------------------|------------|
| ** **                      | ** ** | ** ** | ** ** | ** **            | ** ** | ** **            | ** ** | ** **            | ** ** | **Capitalized Under** | ** ** |
| ** **                      | ** ** | ** ** | ** ** | ** **            | ** ** | **For Capital**       | ** ** | **Prompt Corrective** | ** ** |
| ** **                      | ** ** | **Actual** | ** ** | **Adequacy Purposes** | ** ** | **Action Provisions** | ** ** |
| **(dollars  in thousands)**     | ** ** | **Amount** | ** ** | **Ratio**             | ** ** | **Amount**            | ** ** | **Ratio**             | ** ** | **Amount**            | ** ** | **Ratio** | ** ** |
| As of June 30, 2010        |       |       |       |                  |       |                  |       |                  |       |                  |       |   |   |
| Total Capital                   |       |       |       |                  |       |                  |       |                  |       |                  |       |   |   |
| (to Risk-Weighted Assets)       |       |       |       |                  |       |                  |       |                  |       |                  |       |   |   |
| Skagit State Bank               |       | $          | 68,011     |                  | 15.05      | %                     | $          | 36,156                |       | >  8.00       | %          | $ | 45,196 |   | >  10.00 | % |
| Skagit State Bancorp, Inc. |       | $          | 68,311     |                  | 15.11      | %                     | $          | 36,166                |       | >  8.00       | %          | $ | 45,207 |   | >  10.00 | % |
| Tier I Capital                  |       |       |       |                  |       |                  |       |                  |       |                  |       |   |   |
| (to Risk-Weighted Assets)       |       |       |       |                  |       |                  |       |                  |       |                  |       |   |   |
| Skagit State Bank               |       | $          | 62,340     |                  | 13.79      | %                     | $          | 18,078                |       | >  4.00       | %          | $ | 27,117 |   | >  6.00 | % |
| Skagit State Bancorp, Inc. |       | $          | 62,639     |                  | 13.86      | %                     | $          | 18,083                |       | >  4.00       | %          | $ | 27,124 |   | >  6.00 | % |
| Tier I Capital                  |       |       |       |                  |       |                  |       |                  |       |                  |       |   |   |
| (to Average Assets)             |       |       |       |                  |       |                  |       |                  |       |                  |       |   |   |
| Skagit State Bank               |       | $          | 62,340     |                  | 9.14       | %                     | $          | 27,293                |       | >  4.00       | %          | $ | 34,117 |   | >  5.00 | % |
| Skagit State Bancorp, Inc. |       | $          | 62,639     |                  | 9.18       | %                     | $          | 27,293                |       | >  4.00       | %          | $ | 34,117 |   | >  5.00 | % |
|                            |       |       |       |                  |       |                  |       |                  |       |                  |       |   |   |
| As of December 31, 2009    |       |       |       |                  |       |                  |       |                  |       |                  |       |   |   |
| Total Capital                   |       |       |       |                  |       |                  |       |                  |       |                  |       |   |   |
| (to Risk-Weighted Assets)       |       |       |       |                  |       |                  |       |                  |       |                  |       |   |   |
| Skagit State Bank               |       | $          | 66,563     |                  | 14.39      | %                     | $          | 37,002                |       | >  8.00       | %          | $ | 46,252 |   | >10.00 | % |
| Skagit State Bancorp, Inc. |       | $          | 66,783     |                  | 14.43      | %                     | $          | 37,021                |       | >  8.00       | %          | $ | 46,276 |   | >10.00 | % |
| Tier I Capital                  |       |       |       |                  |       |                  |       |                  |       |                  |       |   |   |
| (to Risk-Weighted Assets)       |       |       |       |                  |       |                  |       |                  |       |                  |       |   |   |
| Skagit State Bank               |       | $          | 60,768     |                  | 13.14      | %                     | $          | 18,501                |       | >  4.00       | %          | $ | 27,751 |   | >  6.00 | % |
| Skagit State Bancorp, Inc. |       | $          | 60,985     |                  | 13.18      | %                     | $          | 18,510                |       | >  4.00       | %          | $ | 27,765 |   | >  6.00 | % |
| Tier I Capital                  |       |       |       |                  |       |                  |       |                  |       |                  |       |   |   |
| (to Average Assets)             |       |       |       |                  |       |                  |       |                  |       |                  |       |   |   |
| Skagit State Bank               |       | $          | 60,768     |                  | 9.74       | %                     | $          | 24,959                |       | >  4.00       | %          | $ | 31,199 |   | >  5.00 | % |
| Skagit State Bancorp, Inc. |       | $          | 60,985     |                  | 9.77       | %                     | $          | 24,959                |       | >  4.00       | %          | $ | 31,199 |   | >  5.00 | % |

 

**LIQUIDITY**

Themajority of our funding comes from customer deposits within the Bank’s marketarea. In addition, funding needs are met through loan repayments, investmentsecurities repayments, earnings and other borrowings through pre-approvedcredit lines. As of June 30, 2010 Bancorp had approximately $47.0 millionin approved unsecured credit lines from various financial institutions and hadsecurities with a market value of $43.4 million pledged as collateral forborrowing at the Federal Reserve Discount Window.

 

Becausethe Bank’s primary sources and uses of funds are deposits and loans, therelationship between net loans and total deposits provides one measure of theBank’s liquidity.  The Bank’s loan todeposit ratio decreased to 65.2 percent at June 30, 2010 compared to 70.9percent at December 31, 2009, as a result of the increase in deposits andthe decrease in loans.

 

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

 

**Item 3.    QUANTITATIVE ANDQUALITATIVE DISCLOSURES ABOUT MARKET RISK**

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

 

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

 

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

 

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

Evaluationof Disclosure Controls and Procedures

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

 

Changesin Internal Controls

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

 

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

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

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

 

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

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

 

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

 

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

 

**Bancorp’sconcentration in real estate loans could adversely affect Bancorp’s earnings inan economic downturn.**

 

Realestate related loans, including those loans that are collateralized by realestate, comprise the largest category of loans, representing 75.9 percent ofBancorp’s total loans.  Our real estate portfolio consists of commercial and residential lending. These loans are secured by property such as office buildings, commercialbusiness properties, healthcare buildings, agricultural land, timber land andresidential properties.  Commercial and commercial real estate loansgenerally are viewed as having more risk of default than residential realestate loans or certain other types of loans or investments.  Typically,these types of loans are larger than residential real estate loans and other 

 

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loans.  Because the loan portfolio contains anumber of commercial real estate loans with relatively large balances, thedeterioration of one or a few of these loans may cause a significant increasein nonperforming loans.  An increase in nonperforming loans could resultin a loss of earnings from these loans, an increase in the provision for loanlosses or an increase in loan charge-offs, which could have an adverse impacton our results of operations and financial condition.

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Reputation risk is the risk to liquidity, earnings andcapital arising from negative publicity regarding the financial servicesindustry.  The financial services industry continues to be featured innegative headlines about the global and national credit crisis and theresulting stabilization legislation enacted by the U.S. federalgovernment.  These reports can be damaging to the industry’s image andpotentially erode consumer confidence in insured financial 

 

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institutions, such as our banking subsidiary.  Inaddition, our ability to engage in routine funding and other transactions couldbe adversely affected by the actions and financial condition of other financialinstitutions. Financial services institutions are interrelated as a result oftrading, clearing, counterparty or other relationships. As a result, defaultsby, or even rumors or questions about, one or more financial servicesinstitutions, or the financial services industry generally, could lead tomarket-wide liquidity problems, losses of depositor, creditor and counterpartyconfidence 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 orindirect result of other banks’ difficulties or failure, which could affect theamount of capital we need.

 

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

 

The FDIC adopted a final rule revising itsrisk-based assessment system, effective April 1, 2009.  The changesto the assessment system involve adjustments to the risk-based calculation ofan institution’s unsecured debt, secured liabilities and brokereddeposits.  The potential increase in FDIC insurance premiums could have asignificant impact on Bancorp.

 

The FDIC also has recently required insuredinstitutions to prepay estimated quarterly risk-based assessments for thefourth quarter of 2009 and for 2010, 2011 and 2012, and increased the regularassessment rate by three basis points effective January 1, 2011, as ameans of replenishing the deposit insurance fund.  The prepayment wascollected on December 30, 2009, and was accounted for as a prepaid expenseamortized over the prepayment period.

 

The FDIC imposed a special deposit insuranceassessment of five basis points on all insured institutions.  Thisemergency assessment was calculated based on the insured institution’s assetsat June 30, 2009, and collected on September 30, 2009.  Based onour June 30, 2009 assets subject to the FDIC assessment, the specialassessment was approximately $260,000.  This special assessment was inaddition to the regular quarterly risk-based assessment.

 

The FDIC deposit insurance fund may suffer additionallosses in the future due to bank failures.  There can be no assurance thatthere will not be additional significant deposit insurance premium increases,special assessments or prepayments in order to restore the insurance fund’sreserve ratio.  Any significant premiumincreases, special assessments or prepayment requirements could have a materialadverse effect on our financial condition and results of operations.

 

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

 

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

 

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

 

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

 

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

None

 

**Item 3.                    Defaults Upon Senior Securities**

None

 

**Item 4.                    Removed and Reserved**

None

 

**Item 5.                    Other Information**

None

 

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**Item 6.****                                                        ****Exhibits**

 

(a)                                  Exhibits.

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

 

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**SIGNATURES**

 

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

 
|   |                  | SKAGIT  STATE BANCORP, INC.       |
|--------|-----------------------|----------------------------------------|
|   |                  | (Registrant)                           |
|   |                  |                                   |
|   |                  |                                   |
| Dated: | August 10,  2010 |                                   | /s/  Cheryl R. Bishop |
|   |                  | Cheryl  R. Bishop                      |
|   |                  | President  and Chief Executive Officer |
|   |                  |                                   |
|   |                  |                                   |
| Dated: | August 10,  2010 |                                   | /s/  Carla F. Tucker |
|   |                  | Carla  F. Tucker                       |
|   |                  | Executive  Vice-President              |
|   |                  | Chief  Financial Officer               |

 

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