**UNITEDSTATES SECURITIES AND EXCHANGE COMMISSON**

**Washington D.C., 20549**

**FORM 10-Q**
| **x**      | ** ** | **Quarterly Report  Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934**                                                                                                                                             |
|------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       |       |                                                                                                                                                                                                                                     |
|       |       | **For the quarterly period ended June 30, 2007**                                                                                                                                                                                         |
|       |       |                                                                                                                                                                                                                                     |
| **o**      | ** ** | **Transition Report Under  Section 13 or 15(d) of the Exchange Act**                                                                                                                                                                     |
| ** ** | ** ** | ** **                                                                                                                                                                                                                               |
| ** ** | ** ** | **For the transition period from                                    to** |

 

**Commission File Number  000-52096**

**SKAGITSTATE BANCORP, INC.**

(Exact Name ofRegistrant as Specified in Its Charter)

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

 

**301 East Fairhaven Avenue**

**Burlington, Washington  98233**

(Address ofPrincipal Executive Offices) (Zip Code)

**(360) 755-0411**

(Registrant’sTelephone Number, Including Area Code)

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

Yes          x                 No       o

Indicate by check mark whether the registrant is a large acceleratedfiler, an accelerate filer, or a non-accelerate.

Large accelerated filer     o                Acceleratedfiler      o         Non-accelerated filer     x

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act.

Yes          o                 No       x

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

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

 

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**SKAGITSTATE BANCORP, INC.**

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

 

2

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**Item 1.    FinancialStatements**

**SKAGIT STATEBANCORP, INC. AND SUBSIDIARY**

**CONSOLIDATEDBALANCE SHEET (Unaudited)**
| **(dollars in thousands except share data)**                                                                                            | ** ** | **June 30, 2007** | ** ** | **December 31, 2006** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|---------------------------------|------------|
| **ASSETS**                                                                                                                                                       |       |                        |       |                            |       |
| ** **                                                                                                                                                       |       |                        |       |                            |       |
| **ASSETS**                                                                                                                                                       |       |                        |       |                            |       |
| Cash and due  from banks                                                                                                                                         |       | $                           | 17,302     |                            | $          | 21,535 |   |
| Federal funds  sold                                                                                                                                              |       | 34,840                      |       | 25,700                          |       |
| Investment  securities                                                                                                                                           |       |                        |       |                            |       |
| Available-for-sale,  at fair value                                                                                                                               |       | 114,448                     |       | 113,941                         |       |
| Held-to-maturity,  at amortized cost                                                                                                                             |       | 37,315                      |       | 35,034                          |       |
| Loans                                                                                                                                                            |       | 339,835                     |       | 325,744                         |       |
| Allowance for  loan losses                                                                                                                                       |       | (4,866                      | )          | (5,176                          | )          |
| Net loans                                                                                                                                                        |       | 334,969                     |       | 320,568                         |       |
| Bank premises  and equipment, net                                                                                                                                |       | 11,203                      |       | 11,289                          |       |
| Accrued interest  receivable                                                                                                                                     |       | 3,782                       |       | 3,414                           |       |
| Other assets                                                                                                                                                     |       | 3,701                       |       | 1,307                           |       |
| **TOTAL ASSETS**                                                                                                                                                 |       | $                           | 557,560    |                            | $          | 532,788 |   |
|                                                                                                                                                             |       |                        |       |                            |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                   |       |                        |       |                            |       |
| ** **                                                                                                                                                       |       |                        |       |                            |       |
| **LIABILITIES**                                                                                                                                                  |       |                        |       |                            |       |
| Deposits                                                                                                                                                         |       |                        |       |                            |       |
| Interest-bearing                                                                                                                                                 |       | $                           | 397,113    |                            | $          | 368,093 |   |
| Non-interest-bearing                                                                                                                                             |       | 70,829                      |       | 81,250                          |       |
| Total deposits                                                                                                                                                   |       | 467,942                     |       | 449,343                         |       |
| Securities sold  under agreements to repurchase                                                                                                                  |       | 17,914                      |       | 14,102                          |       |
| Other liabilities                                                                                                                                                |       | 3,319                       |       | 2,799                           |       |
| Total  liabilities                                                                                                                                               |       | 489,175                     |       | 466,244                         |       |
|                                                                                                                                                             |       |                        |       |                            |       |
| **STOCKHOLDERS’ EQUITY**                                                                                                                                    |       |                        |       |                            |       |
| Common stock, no  par value, 5,000,000 shares authorized 671,444 and 673,532 shares issued and  outstanding at June 30, 2007 and December 31, 2006, respectively |       | 13,635                      |       | 13,935                          |       |
| Retained  earnings                                                                                                                                               |       | 55,664                      |       | 52,878                          |       |
| Accumulated  other comprehensive loss, net of tax                                                                                                                |       | (914                        | )          | (269                            | )          |
| Total  stockholders’ equity                                                                                                                                 |       | 68,385                      |       | 66,544                          |       |
| **TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                              |       | $                           | 557,560    |                            | $          | 532,788 |   |

 

*Seeaccompanying notes to these consolidated financial statements*

3

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**SKAGIT STATEBANCORP, INC. AND SUBSIDIARY**

**CONSOLIDATEDSTATEMENT OF INCOME (Unaudited)**
| ** **                                                            | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|-----------------------------------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| **(dollars in thousands except share data)** | ** ** | **2007**                                            | ** ** | **2006**                                          | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                                                  |       |                                                |       |                                              |       |   |   |   |   |
| **INTEREST INCOME**                                                   |       |                                                |       |                                              |       |   |   |   |   |
| Interest and  fees on loans                                           |       | $                                                   | 6,857      |                                              | $          | 6,106 |   | $ | 14,076 |   | $ | 12,240 |   |
| Investment  securities                                                |       |                                                |       |                                              |       |   |   |   |   |
| Taxable                                                               |       | 1,296                                               |       | 1,077                                             |       | 2,606 |   | 1,859 |   |
| Exempt from  federal income tax                                       |       | 255                                                 |       | 191                                               |       | 476 |   | 376 |   |
| Federal funds  sold                                                   |       | 542                                                 |       | 644                                               |       | 962 |   | 1,618 |   |
| Total interest  income                                                |       | 8,950                                               |       | 8,018                                             |       | 18,120 |   | 16,093 |   |
| **INTEREST EXPENSE**                                                  |       |                                                |       |                                              |       |   |   |   |   |
| Deposits                                                              |       | 3,127                                               |       | 2,280                                             |       | 5,969 |   | 4,407 |   |
| Securities sold  under agreements to repurchase                       |       | 153                                                 |       | 117                                               |       | 285 |   | 220 |   |
| Total interest  expense                                               |       | 3,280                                               |       | 2,397                                             |       | 6,254 |   | 4,627 |   |
| **NET INTEREST INCOME**                                               |       | 5,670                                               |       | 5,621                                             |       | 11,866 |   | 11,466 |   |
| Provision  (benefit) for loan losses                                  |       | —                                              |       | —                                            |       | (150 | ) | — |   |
| **NET INTEREST INCOME AFTER PROVISION  (BENEFIT) FOR LOAN LOSSES**    |       | 5,670                                               |       | 5,621                                             |       | 12,016 |   | 11,466 |   |
| **NON-INTEREST INCOME**                                               |       |                                                |       |                                              |       |   |   |   |   |
| Service charges  on deposits                                          |       | 630                                                 |       | 556                                               |       | 1,178 |   | 1,067 |   |
| Gain on sale of  assets                                               |       | 3                                                   |       | 9                                                 |       | 6 |   | 10 |   |
| Other                                                                 |       | 219                                                 |       | 227                                               |       | 430 |   | 396 |   |
| Total  non-interest income                                            |       | 852                                                 |       | 792                                               |       | 1,614 |   | 1,473 |   |
| **NON-INTEREST EXPENSES**                                             |       |                                                |       |                                              |       |   |   |   |   |
| Salaries                                                              |       | 1,821                                               |       | 1,691                                             |       | 3,609 |   | 3,345 |   |
| Payroll taxes  and employee benefits                                  |       | 468                                                 |       | 400                                               |       | 995 |   | 796 |   |
| Bank premises  and equipment                                          |       | 331                                                 |       | 326                                               |       | 649 |   | 619 |   |
| Occupancy                                                             |       | 165                                                 |       | 159                                               |       | 355 |   | 335 |   |
| State business  taxes                                                 |       | 119                                                 |       | 112                                               |       | 230 |   | 224 |   |
| Advertising                                                           |       | 257                                                 |       | 180                                               |       | 417 |   | 326 |   |
| Other                                                                 |       | 887                                                 |       | 713                                               |       | 1,737 |   | 1,421 |   |
| Total  non-interest expenses                                          |       | 4,048                                               |       | 3,581                                             |       | 7,992 |   | 7,066 |   |
| **INCOME BEFORE PROVISION FOR  INCOME TAX**                           |       | 2,474                                               |       | 2,832                                             |       | 5,638 |   | 5,873 |   |
| **PROVISION FOR INCOME TAX**                                          |       |                                                |       |                                              |       |   |   |   |   |
| Current                                                               |       | 570                                                 |       | 686                                               |       | 1,335 |   | 1,556 |   |
| Deferred                                                              |       | —                                              |       | 51                                                |       | — |   | 51 |   |
| Total provision  for income tax                                       |       | 570                                                 |       | 737                                               |       | 1,335 |   | 1,607 |   |
| **NET INCOME**                                                        |       | $                                                   | 1,904      |                                              | $          | 2,095 |   | $ | 4,303 |   | $ | 4,266 |   |
| **BASIC EARNINGS PER SHARE**                                          |       | $                                                   | 2.84       |                                              | $          | 3.07 |   | $ | 6.40 |   | $ | 6.14 |   |
| **DILUTED EARNINGS PER SHARE**                                        |       | $                                                   | 2.82       |                                              | $          | 3.06 |   | $ | 6.38 |   | $ | 6.13 |   |

 

*See accompanying notes to theseconsolidated financial statements*

4

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**SKAGIT STATEBANCORP, INC. AND SUBSIDIARY**

**CONSOLIDATEDSTATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY (Unaudited)**
| ** **                                                                                            | ** ** | ** **            | ** ** | ** **   | ** ** | ** **                           | ** ** | ** **                    | ** ** | ** **        | ** ** | ** ** | ** ** |
|-------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|--------------|------------|--------------------------------------|------------|-------------------------------|------------|-------------------|------------|------------|------------|
| **(dollars in thousands except share and per share amounts)** | ** ** | **Common Stock** | ** ** | **Retained** | ** ** | **Accum. Other  Comprehensive** | ** ** | **Total  Stockholders’** | ** ** | **Comprehensive** | ** ** |
| ** **                                                                                            | ** ** | **Shares**            | ** ** | **Amount**   | ** ** | **Earnings**                         | ** ** | **Income (Loss)**        | ** ** | **Equity**        | ** ** | **Income** | ** ** |
|                                                                                                  |       |                  |       |         |       |                                 |       |                          |       |              |       |       |       |
| **BALANCE,**January 1, 2006                                                                           |       | 707,237               |       | $            | 14,604     |                                 | $          | 51,139                        |       | $            | (370)      |       | $          | 65,373 |   |   |   |
| Comprehensive income:                                                                                 |       |                  |       |         |       |                                 |       |                          |       |              |       |       |       |
| Net income                                                                                            |       | —                |       | —       |       | 4,266                                |       | —                        |       | 4,266             |       | $          | 4,266      |   |
| Other  comprehensive income:                                                                          |       |                  |       |         |       |                                 |       |                          |       |              |       |       |       |
| Unrealized gains  on available-for-sale securities, net of taxes of $90                               |       | —                |       | —       |       | —                               |       | 175                           |       | 175               |       | 175        |       |
| Unrealized loss  on available-for-sale securities, net of tax benefit of $340                         |       | —                |       | —       |       | —                               |       | (659                          | )          | (659              | )          | (659       | )          |
| Total other  comprehensive loss                                                                       |       |                  |       |         |       |                                 |       |                          |       |              |       | (484       | )          |
| Comprehensive income                                                                                  |       |                  |       |         |       |                                 |       |                          |       |              |       | $          | 3,782      |   |
| Cash dividend declared,  $1.25 per share                                                              |       | —                |       | —       |       | (849                                 | )          | —                        |       | (849              | )          |       |       |
| Common stock redemption                                                                               |       | (31,307               | )          | (313         | )          | (4,922                               | )          | —                        |       | (5,235            | )          |       |       |
| **BALANCE,**June 30, 2006                                                                             |       | 675,930               |       | $            | 14,291     |                                 | $          | 49,634                        |       | $            | (854)      |       | $          | 63,071 |   |   |   |
|                                                                                                  |       |                  |       |         |       |                                 |       |                          |       |              |       |       |       |
| **BALANCE,**January 1, 2007                                                                           |       | 673,532               |       | $            | 13,935     |                                 | $          | 52,878                        |       | $            | (269)      |       | $          | 66,544 |   |   |   |
| Comprehensive income:                                                                                 |       |                  |       |         |       |                                 |       |                          |       |              |       |       |       |
| Net income                                                                                            |       | —                |       | —       |       | 4,303                                |       | —                        |       | 4,303             |       | $          | 4,303      |   |
| Other  comprehensive income:                                                                          |       |                  |       |         |       |                                 |       |                          |       |              |       |       |       |
| Unrealized gains  on available-for-sale securities, net of taxes of $166                              |       | —                |       | —       |       | —                               |       | 322                           |       | 322               |       | 322        |       |
| Unrealized loss  on available-for-sale securities, net of tax benefit of $498                         |       | —                |       | —       |       | —                               |       | (967                          | )          | (967              | )          | (967       | )          |
| Total other  comprehensive loss                                                                       |       |                  |       |         |       |                                 |       |                          |       |              |       | (645       | )          |
| Comprehensive income                                                                                  |       |                  |       |         |       |                                 |       |                          |       |              |       | $          | 3,658      |   |
| Cash dividend declared,  $2.25 per share                                                              |       | —                |       | —       |       | (1,517                               | )          | —                        |       | (1,517            | )          |       |       |
| Common stock redemption                                                                               |       | (2,088                | )          | (368         | )          | —                               |       | —                        |       | (368              | )          |       |       |
| Common stock issued                                                                                   |       | —                |       | 68           |       | —                               |       | —                        |       | 68                |       |       |       |
| **BALANCE,**June 30, 2007                                                                             |       | 671,444               |       | 13,635       |       | 55,664                               |       | (914)                         |       | $                 | 68,385     |       |       |   |

 

*Seeaccompanying notes to these consolidated financial statements*

5

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**SKAGIT STATE BANCORP, INC. ANDSUBSIDIARY**

**STATEMENT OFCASH FLOWS (Unaudited**)
| **(dollars in thousands)**                                                                         | ** ** | ** ** | ** ** | ** ** | ** ** |
|--------------------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| **Six months ended June 30,**                                                            | ** ** | **2007**   | ** ** | **2006**   | ** ** |
| **CASH FLOWS FROM OPERATING  ACTIVITIES**                                                                    |       |       |       |       |       |
| Net income                                                                                                   |       | $          | 4,303      |       | $          | 4,266 |   |
| *Adjustments to reconcile net  income to net cash flows from operating activities*                           |       |       |       |       |       |
| Provision  (benefit) for loan losses                                                                         |       | (150       | )          | —     |       |
| Depreciation                                                                                                 |       | 440        |       | 413        |       |
| Gain on sale of  assets                                                                                      |       | (6         | )          | (10        | )          |
| Amortization of  investment security premiums and discounts, net                                             |       | (100       | )          | (30        | )          |
| Provision for  deferred income taxes                                                                         |       | —     |       | 51         |       |
| Stock  compensation for employee services                                                                    |       | 68         |       | —     |       |
| *Changes in operating assets and  liabilities*                                                               |       |       |       |       |       |
| Increase in  interest receivable                                                                             |       | (368       | )          | (889       | )          |
| Increase in  other assets                                                                                    |       | (2,061     | )          | (763       | )          |
| Decrease in  other liabilities                                                                               |       | 520        |       | 402        |       |
| Net cash flows  from operating activities                                                                    |       | 2,646      |       | 3,440      |       |
| **CASH FLOWS FROM INVESTING  ACTIVITIES**                                                                    |       |       |       |       |       |
| Proceeds from  maturities, calls, and principal payments of investment securities –  available-for-sale |       | 25,539     |       | 14,508     |       |
| Purchases of  investment securities – available-for-sale                                                |       | (26,924    | )          | (40,983    | )          |
| Proceeds from  maturities and principal payments of investment securities – held-to-maturity            |       | 2,962      |       | 2,304      |       |
| Purchases of  investment securities – held-to-maturity                                                  |       | (5,243     | )          | (5,226     | )          |
| Net decrease  (increase) in federal funds sold                                                               |       | (9,140     | )          | 40,925     |       |
| Net (increase)  in loans                                                                                     |       | (14,251    | )          | (3,358     | )          |
| Purchase of  premises and equipment                                                                          |       | (354       | )          | (565       | )          |
| Proceeds from  sale of assets                                                                                |       | 6          |       | 10         |       |
| Net cash flows  from investing activities                                                                    |       | (27,405    | )          | 7,615      |       |
| **CASH FLOWS FROM FINANCING  ACTIVITIES**                                                                    |       |       |       |       |       |
| Net decrease in  demand deposits, money market, NOW and savings accounts                                     |       | (7,248     | )          | (15,353    | )          |
| Net increase in  time deposits                                                                               |       | 25,847     |       | 6,236      |       |
| Net increase in  securities sold under agreements to repurchase                                              |       | 3,812      |       | 219        |       |
| Amount paid for  redemption of common stock                                                                  |       | (368       | )          | (5,235     | )          |
| Cash dividends                                                                                               |       | (1,517     | )          | (849       | )          |
| Net cash flows  from financing activities                                                                    |       | 20,526     |       | (14,982    | )          |
| **NET CHANGE IN CASH AND DUE FROM  BANKS**                                                                   |       | (4,233     | )          | (3,927     | )          |
| **CASH AND DUE FROM BANKS,**  beginning of year                                                              |       | 21,535     |       | 24,975     |       |
| **CASH AND DUE FROM BANKS,**  end of period                                                                  |       | $          | 17,302     |       | $          | 21,048 |   |
| **SUPPLEMENTAL DISCLOSURES OF  CASH FLOW INFORMATION**                                                       |       |       |       |       |       |
| Cash paid during  the year for income taxes                                                                  |       | $          | 1,720      |       | $          | 1,702 |   |
| Cash paid during  the year for interest                                                                      |       | 6,163      |       | 4,597      |       |
| **NONCASH FINANCING AND INVESTING  TRANSACTIONS**                                                            |       |       |       |       |       |
| Net unrealized  loss on available-for-sale securities                                                        |       | 645        |       | 484        |       |

 

*See accompanying notes to theseconsolidated financial statements*

6

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**SKAGIT STATE BANCORP, INC. ANDSUBSIDIARY**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**Note 1:   BASIS OF PRESENTATION**

The accompanying consolidatedfinancial statements include the accounts of Skagit State Bancorp, Inc. and itssubsidiary Skagit State Bank, (collectively, “Company” or “Bancorp). Allsignificant inter-company accounts and transactions have been eliminated. Theconsolidated financial statements have been prepared in conformity withaccounting principles generally accepted in the United States of America forinterim financial information and with instructions to Form 10-Q. Accordinglythey do not include all of the information and footnotes required by accountingprinciples generally accepted in the United States of America for completefinancial statements. In the opinion of management, all adjustments (consistingof normal recurring accruals) considered necessary for a fair presentation havebeen included. Operating results for the six months ended June 30, 2007, arenot necessarily indicative of the results anticipated for the year endingDecember 31, 2007. For additional information, refer to the audited financialstatements and footnotes for the most recent annual period ended December 31,2006 contained in the Annual Report on Form 10-K.

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

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

In preparing the financial statements, management isrequired to make estimates and assumptions that affect the reported amounts ofrevenues and expenses for the periods presented, and assets and liabilities asof the date of the balance sheet. Material estimates that are particularlysusceptible to significant change in the near term relate to the determinationof the allowance for loan losses, the valuation of real estate acquired inconnection with foreclosures or in satisfaction of loans and deferred incometaxes. Uncertainties with respect to such estimates and assumptions areinherent in the preparation of Bancorp’s financial statements; Accordingly, itis possible that actual results could differ from these estimates orassumptions, which could have a material effect on the reported amounts of theconsolidated financial position and results of operation. These policies are described in more detail inthe Annual Report on Form 10-K for the year ended December 31, 2006.

**Note 3:   RECLASSIFICATIONS**

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

**Note 4:   EARNINGSPER SHARE**

Basic earnings per shareamounts are computed based on the weighted average number of sharesoutstanding. Diluted earnings per share is calculated by dividing net income bydiluted weighted average shares outstanding, which includes common stockequivalents outstanding using the treasury stock method.
| ** **                                                                                            | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|-------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| **(dollars in thousands except share and per share amounts)** | ** ** | **2007**                                            | ** ** | **2006**                                          | ** ** | **2007** | ** ** | **2006** | ** ** |
| Numerator:                                                                                            |       |                                                |       |                                              |       |   |   |   |   |
| Net income                                                                                            |       | $                                                   | 1,904      |                                              | $          | 2,095 |   | $ | 4,303 |   | $ | 4,266 |   |
| Denominator:                                                                                          |       |                                                |       |                                              |       |   |   |   |   |
| Denominator for  basic earnings per share - Weighted average shares outstanding                       |       | 672,612                                             |       | 683,604                                           |       | 672,914 |   | 694,930 |   |
| Effect of  diluted earnings per share- Stock options and restricted stock grants                      |       | 1,467                                               |       | 400                                               |       | 1,486 |   | 400 |   |
| Denominator for  diluted earnings per share - Weighted average shares outstanding                     |       | 674,079                                             |       | 684,004                                           |       | 674,400 |   | 695,330 |   |
| Basic earnings  per share                                                                             |       | $                                                   | 2.84       |                                              | $          | 3.07 |   | $ | 6.40 |   | $ | 6.14 |   |
| Diluted earnings per  share                                                                           |       | $                                                   | 2.82       |                                              | $          | 3.06 |   | $ | 6.38 |   | $ | 6.13 |   |

 

7

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**Note 5:   ALLOWANCE FOR LOAN LOSSES**

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

Additions to the allowance, in the form of provisions,are reflected in current operating results, while charge-offs to the allowanceare made when a loss is determined to have occurred.  The ultimate recovery ofloans is susceptible to future market factors beyond Bancorp’s control. Thesefactors may result in losses or recoveries differing significantly from thoseprovided in Bancorp’s financial statements. Bancorp’s periodic evaluation of the allowance forloan losses is inherently subjective as it requires estimates that aresusceptible to significant revision as more information becomes available. Inaddition, regulatory agencies, as an integralpart of their examinationprocess, periodically review the estimated losses onloans.  Such agencies may require Bancorpto recognize additional provisions or adjustments to its allowance for loanlosses based on their judgment using information available to them at the timeof their examination.

**Note 6:   STOCK-BASEDCOMPENSATION**

Bancorp has a stock-based equity compensationplan.  Under this plan, Bancorp isauthorized to grant options or restricted stock up to 100,000 shares.  No grants of options or restricted stock wereawarded for the six months ended June 30, 2007. For additional information on the stock-based equity compensation plan,refer to Bancorp’s audited financial statements and footnotes for the mostrecent annual period ended December 31, 2006 contained in the Annual Report onForm 10-K.

**Note 7:   INCOMETAXES**

In 2006, the FASBissued FASB Interpretation 48, “Accounting for Uncertainty in Income Taxes – aninterpretation of FASB Statement No. 109”. FIN 48 seeks to reduce the diversity in practice associated with certainaspects of measurement and recognition in accounting for income taxes. FIN 48provides guidance on de-recognition, classification, interest and penalties andaccounting in interim periods and requires expanded disclosure with respect touncertainty in income taxes.  Bancorpadopted FIN 48 on January 1, 2007. As a result of the implementation of FIN 48,Bancorp recognized no material adjustments for unrecognized income taxbenefits, all of which would affect Bancorp’s effective income tax rate ifrecognized.  Our accounting policy withrespect to interest and penalties arising from income tax settlements is torecognize them as non-interest expense.

Bancorp is nolonger subject to U.S. federal income tax examinations by tax authorities fortax years before 2003.  The State ofWashington is currently examining Bancorp’s business and occupation tax returnsfor 2003, 2004 and 2006.  It isanticipated that this examination and report will be completed during August2007 and that any adjustments will not have a significant impact on Bancorp’sfinancial statements.

**Note 8:   FINANCIALINSTRUMENTS**

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

8

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The following is a summary of the off-balance-sheet financialinstruments or contracts outstanding as of June 30, 2007: (dollars inthousands)
| Unfunded commitments to  extend credit  |   | $     | 68,175 |   |
|-----------------------------------------|--------|-------|--------|--------|
| Credit card  arrangements               |   | 7,237 |   |
| Commitments to  fund municipal warrants |   | 1,773 |   |
| Standby letters of  credit              |   | 3,078 |   |

 

**Note 9:   NEW ACCOUNTING PRONOUNCEMENTS**

In September 2006,the FASB issued SFAS No. 157, “Fair Value Measures”. This statement definesfair value, establishes a framework for measuring fair value in generallyaccepted accounting principles and expands disclosures about fair valuemeasurements.  SFAS No. 157 is effectivefor financial statements issued for fiscal years beginning after November 15,2007 and interim periods within those fiscal years.  Bancorp does not anticipate the adoption ofSFAS No. 157 will have a material impact on its consolidated financialstatements.

In September 2006,the FASB issued SFAS No. 158, “Employers’ Accounting for Defined BenefitPension and Other Postretirement Plans”, an amendment of SFAS No. 87, 88, 106and 132(R).  This statement requires anemployer to recognize the over-funded or under-funded status of a definedbenefit postretirement plan as an asset or liability in its statement offinancial position and to recognize changes in that funded status in the yearin which the changes occur through comprehensive income.  This statement also requires an employer tomeasure the funded status of a plan as of the date of its year-end statement offinancial position. This Statement is effective for Bancorp as of January 1,2008.  Bancorp does not anticipate the adoptionof SFAS No. 158 will have a material impact on its consolidated financialstatements.

In February 2007,the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets andFinancial Liabilities, including an amendment of SFAS No. 115”. This statementpermits companies to choose to measure selected financial instruments at fairvalue. Following the initial fair value measurement date, ongoing unrealizedgains and losses on items for which fair value reporting has been elected arereported in earnings.  SFAS No. 159 iseffective for financial statements issued for fiscal years beginning afterNovember 15, 2007. Early adoption of this statement is permitted only asallowed in paragraph 30 of the statement. Bancorp has not elected earlyadoption of this standard and does not anticipate the adoption of SFASNo. 159 on its effective date will have a material impact on itsconsolidated financial statements.

**Item 2.****                                                           MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIALCONDITION 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, 2006 in theAnnual Report on Form 10-K.*

**FORWARD LOOKING STATEMENTS**

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

9

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**OVERVIEW**

Skagit State Bank,a wholly-owned subsidiary of Skagit State Bancorp, Inc., began operations in1958 and is headquartered in Burlington (Skagit County), Washington.  The Bank provides a full range of bankingservices and products to both businesses and individuals through 13 fullservice banking offices located in Skagit, Snohomish and Whatcom counties.

Net income was$1.9 million and $2.1 million for the quarters ended June 30, 2007 and 2006with basic earnings per share at $2.84 and $3.07, respectively. Net income was$4.3 million for the six months ended June 30, 2007 and 2006 with basicearnings per share at $6.40 and $6.14, respectively. The decrease in net incomewas primarily attributable to increases in non-interest expenses and interestexpenses in 2007, which were partially offset by increases in interest incomeresulting from an increase in the average balance of interest-earning assets in2007. In addition, for the six months ended June 30, 2007, Bancorp reported a$495,000 interest recovery on one loan relationship and a $150,000 benefit forloan losses compared to no provision or benefit for loan losses in 2006.

Annualized returnon average assets was 1.38 percent and 1.59 percent for the quarter and sixmonths ending June 30, 2007 compared to 1.62 percent and 1.65 percent duringthe same time periods in 2006. Annualized return on average equity was 11.06 percent and 12.63 percentfor the quarter and six months ending June 30, 2007 compared to 13.09 percentand 13.15 percent, respectively, for the same time periods in 2006.

Total assetsincreased to $557.6 million at June 30, 2007 compared to $532.8 million atDecember 31, 2006.  The increase wasprimarily due to a $18.6 million increase in total deposits. Net loansincreased by $14.4 million to $335.0 million compared to $320.6 million atDecember 31, 2006.

**RESULTSOF OPERATIONS**

Bancorp’s resultsof operations are dependent to a large degree on net interest income, operatingefficiency and the level of the provision for loan losses. Bancorp’s operationsare sensitive to interest rate changes and the resulting impact on net interestincome.   Bancorp generates non-interestincome primarily through service charges and fees.  Bancorp’s non-interest expenses consistprimarily of salaries and employee benefits expense, and occupancy expense.

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

Net interestincome was $5.7 million and $11.9 million for the quarter and six months endedJune 30, 2007 compared to $5.6 million and $11.5 for the like periods in2006.  These increases from 2006 to 2007were primarily due to increases in the balance of average interest-earningassets and an increase in yield on interest earnings assets   which were partially offset by an increasein the cost of funds on interest-bearing liabilities and an increase in theaverage balance of interest-bearing liabilities.  In addition, for the six months ended June30, 2007, Bancorp recorded a $495,000 interest recovery on one loanrelationship.

The net interestmargin is net interest income expressed as a percent of averageinterest-earning assets. Net interest margin is influenced by the level andrelative mix of interest-earning assets and interest-bearing liabilities aswell as levels of non-interest bearing liabilities.  Opportunities to increase Bancorp’s netinterest margin are available through replacing non-earning or low earningassets with higher earning assets; i.e., specifically, through the reduction innon-accruing loans and Federal Funds sold or increasing Bancorp’s loan todeposit ratio or reducing interest costs. For the quarter and six months endedJune 30, 2007, the net interest margin decreased to 4.39 percent and 4.71percent from 4.69 percent and 4.82 percent for the like periods in 2006.  These decreases were primarily a result ofthe more rapid increase in the cost of funds than the yield on interest-earningassets. For the quarter ended June 30, 2007 compared to the like period in2006, cost of funds increased 66 basis points while the interest-earning assetyield increased 23 basis points.  For thesix months ended June 30, 2007 compared to the like period in 2006, the yieldon interest-earning assets increased 44 basis points compared to a 68 basispoint increase in the cost of funds.

The volume ororigination of fixed or variable rate loans, the interest rate sensitivity ofdeposits, the overall level of interest rates and general economic conditionscan have a significant effect on Bancorp’s performance in a changing 

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interest rateenvironment. During 2007, due primarily to the current market interest rateenvironment and competition among financial institutions for quality loans, thepercentage of variable rate loans in the loan portfolio decreased from 66percent at December 31, 2005 to 44 percent as of December 31, 2006 and to 42percent as of June 30, 2007. Starting in 2004 and continuing in 2005 and 2006,as interest rates began to increase, time deposits became more attractive toinvestors.  Time deposits increased to36.3 percent of deposits at June 30, 2007 compared to 32.1 percent of depositsat December 31, 2006 and 27.2 percent of deposits at December 31, 2005.

The followingtables present information regarding average balances of assets andliabilities  as well as the total amountsof interest income from average interest-earning assets and interest expense onaverage interest- bearing liabilities, resulting yield and cost ratios,interest rate spread and net interest margin. Tax exempt securities, includedin investment securities below are stated at their contractual interest rate.Loan fees of $283,000 and $533,000 for the quarter and six months ended June30, 2007, and $210,000 and $578,000 for the quarter and six months ended June30, 2006 are included in interest earned on loans.

**Condensed Average Balance Sheets**

** **

(dollars in thousands except share data)

 
| ** **                                          | ** ** | **2007**    | ** ** | **2006**                           | ** ** |
|-----------------------------------------------------|------------|-------------|------------|------------------------------------|------------|
| ** **                                          | ** ** | **Average** | ** ** | ** **                         | ** ** | ** ** | ** ** | **Average** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Three months ended June 30,** | ** ** | **Balance** | ** ** | **Interest Yield /Cost** | ** ** | **Balance** | ** ** | **Interest Yield /Cost** | ** ** |
| **Assets**                                          |       |        |       |                               |       |   |   |   |   |   |   |   |   |
| Federal funds  sold                                 |       | $           | 43,978     |                               | $          | 542 |   | 4.94 | % | $ | 57,041 |   | $ | 644 |   | 4.53 | % |
| Taxable  investment securities                      |       | 101,881     |       | 1,296                              |       | 5.10 |   | 92,343 |   | 1,077 |   | 4.68 |   |
| Tax exempt  securities                              |       | 42,717      |       | 255                                |       | 2.39 |   | 34,880 |   | 191 |   | 2.20 |   |
| Loans                                               |       | 329,322     |       | 6,857                              |       | 8.35 |   | 296,002 |   | 6,106 |   | 8.27 |   |
| Total  interest-earning assets                      |       | 517,898     |       | 8,950                              |       | 6.93 | % | 480,266 |   | 8,018 |   | 6.70 | % |
| Non-interest  earning assets                        |       | 34,633      |       |                               |       |   |   | 37,583 |   |   |   |   |   |
| Total assets                                        |       | $           | 552,531    |                               |       |   |   |   | $ | 517,849 |   |   |   |   |   |
|                                                |       |        |       |                               |       |   |   |   |   |   |   |   |   |
| **Liabilities  and Stockholders’ Equity**      |       |        |       |                               |       |   |   |   |   |   |   |   |   |
| Interest-bearing  demand                            |       | $           | 84,960     |                               | $          | 272 |   | 1.28 | % | $ | 89,314 |   | $ | 285 |   | 1.28 | % |
| Savings and  money market                           |       | 142,077     |       | 789                                |       | 2.23 |   | 149,790 |   | 771 |   | 2.06 |   |
| Certificates of  deposit                            |       | 165,991     |       | 2,066                              |       | 4.99 |   | 123,290 |   | 1,224 |   | 3.98 |   |
| Total  interest-bearing deposits                    |       | 393,028     |       | 3,127                              |       | 3.19 |   | 362,394 |   | 2,280 |   | 2.52 |   |
| Securities sold  under agreement to repurchase      |       | 15,470      |       | 153                                |       | 3.97 |   | 13,266 |   | 117 |   | 3.54 |   |
| Total  interest-bearing deposits & liabilities  |       | 408,498     |       | 3,280                              |       | 3.22 | % | 375,660 |   | 2,397 |   | 2.56 | % |
| Non  interest-bearing demand deposits               |       | 71,352      |       |                               |       |   |   | 74,997 |   |   |   |   |   |
| Other  non-interest-bearing liabilities             |       | 3,794       |       |                               |       |   |   | 3,151 |   |   |   |   |   |
| Total  liabilities                                  |       | 483,644     |       |                               |       |   |   | 453,808 |   |   |   |   |   |
| Stockholders’  equity                          |       | 68,887      |       |                               |       |   |   | 64,041 |   |   |   |   |   |
| Total  liabilities and stockholders’ equity    |       | $           | 552,531    |                               |       |   |   |   | $ | 517,849 |   |   |   |   |   |
| Net interest  income                                |       |        |       | $                                  | 5,670      |   |   |   |   |   | $ | 5,621 |   |   |   |
| Interest rate  spread                               |       |        |       |                               |       | 3.71 | % |   |   |   |   | 4.14 | % |
| Net interest margin                                 |       |        |       |                               |       | 4.39 | % |   |   |   |   | 4.69 | % |

 

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| ** **                                         | ** ** | **2007**    | ** ** | **2006**                           | ** ** |
|----------------------------------------------------|------------|-------------|------------|------------------------------------|------------|
| ** **                                         | ** ** | **Average** | ** ** | ** **                         | ** ** | ** ** | ** ** | **Average** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Six months ended June 30,**  | ** ** | **Balance** | ** ** | **Interest Yield /Cost** | ** ** | **Balance** | ** ** | **Interest Yield /Cost** | ** ** |
| **Assets**                                         |       |        |       |                               |       |   |   |   |   |   |   |   |   |
| Federal funds  sold                                |       | $           | 37,323     |                               | $          | 962 |   | 5.20 | % | $ | 69,619 |   | $ | 1,618 |   | 4.69 | % |
| Taxable  investment securities                     |       | 103,636     |       | 2,606                              |       | 5.07 |   | 83,882 |   | 1,859 |   | 4.47 |   |
| Tax exempt  securities                             |       | 41,169      |       | 476                                |       | 2.33 |   | 34,036 |   | 376 |   | 2.23 |   |
| Loans                                              |       | 325,625     |       | 14,076                             |       | 8.72 |   | 292,443 |   | 12,240 |   | 8.44 |   |
| Total  interest-earning assets                     |       | 507,753     |       | 18,120                             |       | 7.20 | % | 479,980 |   | 16,093 |   | 6.76 | % |
| Non-interest  earning assets                       |       | 35,062      |       |                               |       |   |   | 38,385 |   |   |   |   |   |
| Total assets                                       |       | $           | 542,815    |                               |       |   |   |   | $ | 518,365 |   |   |   |   |   |
|                                               |       |        |       |                               |       |   |   |   |   |   |   |   |   |
| **Liabilities  and Stockholders’ Equity**     |       |        |       |                               |       |   |   |   |   |   |   |   |   |
| Interest-bearing  demand                           |       | $           | 83,635     |                               | $          | 540 |   | 1.30 | % | $ | 89,592 |   | $ | 573 |   | 1.29 | % |
| Savings and  money market                          |       | 140,993     |       | 1,533                              |       | 2.19 |   | 151,577 |   | 1,505 |   | 2.00 |   |
| Certificates of  deposit                           |       | 159,463     |       | 3,896                              |       | 4.93 |   | 122,457 |   | 2,329 |   | 3.84 |   |
| Total  interest-bearing deposits                   |       | 384,091     |       | 5,969                              |       | 3.13 |   | 363,626 |   | 4,407 |   | 2.44 |   |
| Securities sold  under agreement to repurchase     |       | 14,923      |       | 285                                |       | 3.85 |   | 12,983 |   | 220 |   | 3.42 |   |
| Total  interest-bearing deposits & liabilities |       | 399,014     |       | 6,254                              |       | 3.16 | % | 376,609 |   | 4,627 |   | 2.48 | % |
| Non  interest-bearing demand deposits              |       | 72,143      |       |                               |       |   |   | 74,020 |   |   |   |   |   |
| Other  non-interest-bearing liabilities            |       | 3,508       |       |                               |       |   |   | 2,857 |   |   |   |   |   |
| Total  liabilities                                 |       | 474,665     |       |                               |       |   |   | 453,486 |   |   |   |   |   |
| Stockholders’  equity                         |       | 68,150      |       |                               |       |   |   | 64,879 |   |   |   |   |   |
| Total  liabilities and stockholders’ equity   |       | $           | 542,815    |                               |       |   |   |   | $ | 518,365 |   |   |   |   |   |
| Net interest  income                               |       |        |       | $                                  | 11,866     |   |   |   |   |   | $ | 11,466 |   |   |   |
| Interest rate  spread                              |       |        |       |                               |       | 4.04 | % |   |   |   |   | 4.28 | % |
| Net interest margin                                |       |        |       |                               |       | 4.71 | % |   |   |   |   | 4.82 | % |

 

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The followingtable sets forth information on changes in net interest income which areattributable to changes in interest rates and changes in volume for the periodsindicated.  Non-accruing loans have beenincluded in the computation of average loans. Changes attributable to thecombined effect of volume and interest rates have been allocatedproportionately.

**Analysis of Changes in Interest Income and ExpenseDue to Changes in Volume and Rate**

(dollars in thousands except per shareamounts)

 
| ** **                                                   | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|--------------------------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                   | ** ** | **2007 vs. 2006**                         | ** ** | **2007 vs. 2006**                       | ** ** |
| ** **                                                   | ** ** | **Increase (Decrease) Due to**       | ** ** | **Increase (Decrease) Due to**     | ** ** |
| ** **                                                   | ** ** | **Rate**                                            | ** ** | **Volume**                                        | ** ** | **Total** | ** ** | **Rate** | ** ** | **Volume** | ** ** | **Total** | ** ** |
| **Interest-Earning Assets**                                  |       |                                                |       |                                              |       |   |   |   |   |   |   |   |   |
| Federal funds sold                                           |       | $                                                   | 309        |                                              | $          | (411 | ) | $ | (102 | ) | $ | 451 |   | $ | (1,107 | ) | $ | (656 | ) |
| Investment securities                                        |       | 120                                                 |       | 163                                               |       | 283 |   | 290 |   | 557 |   | 847 |   |
| Loans                                                        |       | 58                                                  |       | 693                                               |       | 751 |   | 412 |   | 1,424 |   | 1,836 |   |
| Total net change in  income on Interest-earning assets       |       | 487                                                 |       | 445                                               |       | 932 |   | 1,153 |   | 874 |   | 2,027 |   |
| **Interest-Bearing Liabilities**                             |       |                                                |       |                                              |       |   |   |   |   |   |   |   |   |
| Deposits                                                     |       | 566                                                 |       | 281                                               |       | 847 |   | 1,036 |   | 526 |   | 1,562 |   |
| Securities sold under agreements  to repurchase              |       | 15                                                  |       | 21                                                |       | 36 |   | 30 |   | 35 |   | 65 |   |
| Total net change in  expense on Interest-bearing liabilities |       | 581                                                 |       | 302                                               |       | 883 |   | 1,066 |   | 561 |   | 1,627 |   |
| Net change in net interest income                            |       | $                                                   | (94        | )                                                 | $          | 143 |   | $ | 49 |   | $ | 87 |   | $ | 313 |   | $ | 400 |   |

 

**NON-INTERESTINCOME****                                              **Non-interestincome, which consists primarily of fees and service charges on deposits andother income, was $852,000 and $1.6 million for the quarter and six monthsended June 30, 2007 compared to $792,000 and $1.5 million for the same periodsin 2006. The largest component of these increases related to an increase innon-sufficient fund fees, ATM fees and late charges collected on non-performingloans.

**NON-INTERESTEXPENSE****                                         **Non-interestexpense was $4.0 million and $8.0 million for the quarter and six months endedJune 30, 2007 compared to $3.6 million and $7.1 million in the like periods in2006. These increases were primarily attributable to increases in salary andbenefit expenses, advertising costs and consulting expenses. The increase insalary expense from 2006 to 2007 was primarily attributable to higher salaries,overall growth in employment and equity compensation expenses.  In 2007, Bancorp continued its efforts toincrease and enhance its Retail Banking and Consumer and Commercial Lendingstaff in addition to increasing staff within the Residential Lendingdepartment.

The efficiencyratio is computed by dividing total operating expenses by non-interest incomeand net interest income after provision for loan losses.  An increase in the efficiency ratio indicatesthat more resources are being utilized to generate the same or greater volumeof income. The efficiency ratio for the quarter and six months ended June 30,2007 was 62.1 percent and 58.6 percent compared to 55.8 percent and 54.6percent in the same time periods in 2006. These increases from 2006 wereprimarily due to increases in non-interest expenses.

**INCOMETAX EXPENSE          **Incometax expense for the quarter and six months ended June 30, 2007 was $570,000 and$1.3 million compared to $737,000 and $1.6 million for the quarter and sixmonths ended June 30, 2006. Bancorp’s effective tax rates were 23.7 percent and27.4 percent for the six months ended June 30, 2007 and 2006, respectively. Theeffective tax rate is lower than the federal statutory rate due to tax creditsfrom tax-exempt bonds and tax-exempt interest from municipal bonds and loans.

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**REVIEW OFFINANCIAL CONDITION**

Assets totaled $557.6 million atJune 30, 2007, compared to $532.8 million at December 31, 2006.  This increase was primarily due to a increaseof $18.6 million in deposits.

**INVESTMENT SECURITIES AND FEDERALFUNDS SOLD          **Totalinvestment securities and federal funds increased $11.9 million to $186.6 millionat June 30, 2007 compared to $174.7 million at December 31, 2006. This increasewas primarily due to a $9.1 million increase in federal funds sold.

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

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

**Investment Securities Composition**

(dollars in thousands)
| ** **                        | ** ** | **June 30, 2007** | ** ** | **December 31, 2006** | ** ** |
|-----------------------------------|------------|-----------------------------|------------|---------------------------------|------------|
| **Held-to-maturity**              | ** ** | ** **                  | ** ** | ** **                      | ** ** |
| State and  political subdivisions |       | $                           | 37,315     |                            | $          | 35,034 |   |
| Total                             |       | $                           | 37,315     |                            | $          | 35,034 |   |
| **Available-for-sale**            | ** ** | ** **                  | ** ** | ** **                      | ** ** |
| U.S. government  agencies         |       | $                           | 75,827     |                            | $          | 90,520 |   |
| Mortgage-backed-securities        |       | 32,314                      |       | 19,777                          |       |
| State and  political subdivisions |       | 6,307                       |       | 3,644                           |       |
| Total                             |       | $                           | 114,448    |                            | $          | 113,941 |   |

 

**LOANS                **Netloans were $335.0 million at June 30, 2007 compared to $320.6 million atDecember 31, 2006.  This increase wasprimarily due to a $20.4 million increase in real estate commercial andresidential loans and a $5.7 million in consumer loans which was partiallyoffset by decreases of $4.6 million and $7.6 million in commercial loans andreal estate construction loans, respectively.

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.

Mostof Bancorp’s business activity is with customers located within Skagit, Snohomishand Whatcom Counties. Bancorp originates commercial, real estate and consumerloans. Generally, loans are secured by accounts receivable, inventory, depositaccounts, personal property or real estate. Rights to collateral vary and arelegally documented to the extent practicable.

Real estate loanscomprise the largest category of loans with a total of $239.9 million or 70.3percent and $227.0 million or 69.3 percent as of June 30, 2007 and December 31,2006, respectively. Bancorp is committed to providing competitive commercialreal estate lending within our primary market areas.  Our real estate portfolio consists ofcommercial and residential loans.  Theseloans are secured by property such as office buildings, retail buildings, owneroccupied commercial business properties, farm land, timber land, residentialland development properties and residential properties. While Bancorp hassignificant balances secured by real estate, Bancorp believes that its lendingpolicies and concentration policies are sufficient to minimize risks.  Also, economic conditions may affect aborrower’s ability to meet the stated repayment terms. Fixed-rate and variablerate residential mortgage loans are offered through Bancorp’s home loandepartment. Bancorp places a majority of these loans through CountrywideMortgage and Washington Mutual.

Commercial loanswere $67.4 million as of June 30, 2007 and $72.0 million as of December 31,2006.  Commercial loans, secured andunsecured, are made primarily to small and medium-sized businesses includingfarms operating within Skagit, Snohomish and Whatcom Counties.  These loans are available for generaloperating purposes, acquisition of fixed assets, purchases of equipment andmachinery, financing of inventory and accounts receivable, and other businesspurposes.  Bancorp originates SmallBusiness Administration (SBA) loans, including 504 and 7A loans.

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Consumer loanswere $34.1 million at June, 2007 and $28.4 million at December 31, 2006.Bancorp makes secured and unsecured consumer loans including loans toindividuals, primarily customers of Bancorp, for various purposes, includinghome equity loans, purchases of automobiles, mobile homes, boats and otherrecreational vehicles, home improvement loans and loans for education andpersonal investments.

The Board ofDirectors has approved specific lending policies and procedures for Bancorp andmanagement is responsible for implementation of the policies.  The lending policies and procedures includeguidelines for concentrations of credit, loan terms, loan-to-value ratios,collateral appraisals and interest rates. The loan policies also vest varying levels of loan authority inmanagement, Bancorp’s loan officers and the Board of Directors.

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

**Loan Composition**

(dollars in thousands)
| ** **                                       | ** ** | **June 30, 2007** | ** ** | **December 31, 2006** | ** ** |
|--------------------------------------------------|------------|-----------------------------|------------|---------------------------------|------------|
| ** **                                       | ** ** | **Amount**                  | ** ** | **%**                           | ** ** | **Amount** | ** ** | **%** | ** ** |
| Real estate –  residential & commercial |       | $                           | 215,426    |                            | 63.1       | % | $ | 194,989 |   | 59.5 | % |
| Real estate  construction                        |       | 24,450                      |       | 7.2                             | %          | 32,031 |   | 9.8 | % |
| Commercial,  industrial & agricultural       |       | 67,424                      |       | 19.7                            | %          | 72,033 |   | 22.0 | % |
| Consumer                                         |       | 34,096                      |       | 10.0                            | %          | 28,385 |   | 8.7 | % |
| Total loans                                      |       | 341,396                     |       | 100                             | %          | 327,438 |   | 100 | % |
| Less:                                            |       |                        |       |                            |       |   |   |   |   |
| Allowance for  loan losses                       |       | 4,866                       |       |                            |       | 5,176 |   |   |   |
| Deferred loan  fees                              |       | 1,561                       |       |                            |       | 1,694 |   |   |   |
| Net loans                                        |       | $                           | 334,969    |                            |       |   | $ | 320,568 |   |   |   |

 

**PROVISIONAND ALLOWANCE FOR LOAN LOSSES**          Theallowance for loan losses was $4.9 million as of June 30, 2007 compared to $5.2million at December 31, 2006. When available information confirms that specificloans, or portions thereof, are uncollectible, those amounts are charged-offagainst the allowance for loan losses. Net charges-offs for the three months and six months ended June 30, 2007were $152,000 and $160,000 compared to $534,000 and $358,000 for the three andsix months ended June 30, 2006.

For the quarterand six months ended June 30, 2007, Bancorp reported no provision and a$150,000 benefit for loan losses, respectively, compared to no provision orbenefit for loan losses in 2006. This was primarily related to the improvedcredit quality in the loan portfolio and minimal net charge-offs. In thefuture, normal growth of the loan portfolio may require an increase in theallowance for loan losses.

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

Bancorp currentlymonitors its loan portfolio for potential risk of loss according to an internalrisk-grading system. Management monitors Bancorp’s credit quality to identifypotential problem credits and any loss exposure in a timely manner.  Additionally, loans are subject toexaminations by regulators, who, based upon their judgment, may require Bancorpto make additional provisions or adjustments to its allowance for loanlosses.  Bancorp has assessed and willcontinue to assess on an on-going basis, the impact of the economy on thecredit risk in the loan portfolio.  

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Currently,management is not aware of any unusually large loan concentrations inindustries negatively impacted by the current economy.

The followingtable presents the activity in the allowance for loan losses for the datesindicated.

**Allowance for Loan Loss Activity**

(dollars in thousands)
| ** **                                                                | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|---------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                | ** ** | **2007**                                            | ** ** | **2006**                                          | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                                                      |       |                                                |       |                                              |       |   |   |   |   |
| Allowance as of  beginning of period                                      |       | $                                                   | 5,018      |                                              | $          | 5,354 |   | $ | 5,176 |   | $ | 5,178 |   |
| Provision  (benefit) for loan losses                                      |       | —                                              |       | —                                            |       | (150 | ) | — |   |
| Charge-offs                                                               |       | (286                                                | )          | (709                                              | )          | (331 | ) | (923 | ) |
| Recoveries                                                                |       | 134                                                 |       | 175                                               |       | 171 |   | 565 |   |
| Net charge-offs                                                           |       | (152                                                | )          | (534                                              | )          | (160 | ) | (358 | ) |
| Balance at end  of period                                                 |       | $                                                   | 4,866      |                                              | $          | 4,820 |   | $ | 4,866 |   | $ | 4,820 |   |
| Ratio of net  charge-offs (annualized) to average loans during the period |       | 0.18                                                | %          | 0.72                                              | %          | 0.10 | % | 0.24 | % |
| Ratio of allowance to  net loans at end of period                         |       | 1.45                                                | %          | 1.61                                              | %          | 1.45 | % | 1.61 | % |

 

**NON-PERFORMINGASSETS**                          Non-performingassets decreased to $5.4 million as of June 30, 2007, compared to $5.7 millionas of December 31, 2006. At June 30, 2007, one relationship comprised $3.5million of the non-accrual balance. Generally, these loans are well collateralized though loss of principalon certain types of these loans will remain in question until the loans arepaid or collateral is liquidated.  AtJune 30, 2007, Bancorp had a $920,000 specific allocation of its allowance forloan losses relating to three credit relationships. Bancorp will aggressivelycontinue its collection efforts and liquidation of collateral, to recover aslarge a portion of the non-accrual assets as possible.

The followingtable presents non-performing asset information related to loans accounted foron a non-accrual basis, accruing loans 90 days or more past due and other realestate owned for the dates indicated.

**Non-Performing Assets**

(dollarsin thousands)
| ** **                                                | ** ** | **June 30, 2007** | ** ** | **December 31, 2006** | ** ** |
|-----------------------------------------------------------|------------|-----------------------------|------------|---------------------------------|------------|
| Non-accrual  loans                                        |       | $                           | 5,430      |                            | $          | 5,734 |   |
| Loans past due  90 days or more, still accruing           |       | —                      |       | —                          |       |
| Total non-performing  loans                               |       | 5,430                       |       | 5,734                           |       |
| Other real  estate owned                                  |       | —                      |       | —                          |       |
| Total  non-performing assets                              |       | $                           | 5,430      |                            | $          | 5,734 |   |
| Total  non-performing loans to net loans                  |       | 1.62                        | %          | 1.79                            | %          |
| Total  non-performing loans to total assets               |       | 0.97                        | %          | 1.08                            | %          |
| Total  non-performing assets to total assets              |       | 0.97                        | %          | 1.08                            | %          |
| Total non-performing  assets to allowance for loan losses |       | 111.59                      | %          | 110.78                          | %          |

 

**DEPOSITS          **Bancorp offers afull range of deposit services including checking accounts, savings accounts,money market accounts and various types of certificates of deposit.  Transaction accounts and certificates ofdeposit are tailored to Bancorp’s primary market area at rates competitive withthose offered in the area.  At June 30,2007, total deposits were $467.9 million compared to $449.3 million at December31, 2006.  Within the total, timedeposits increased $25.8 million while core deposits decreased $7.2 million.Starting in 2004 and continuing in 2005 and 2006, as interest rates began toincrease, time deposits became more attractive to investors. Time depositsincreased to 36.3 percent of deposits at June 30, 2007 compared to 32.1 percentof deposits at December 31, 2006 as outlined in the following table.

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The followingtable presents the balance and percent of total deposits in the various categoriesof deposits offered by Bancorp as of the dates indicated.

**DepositComposition**

**(dollars in thousands)**
| ** **                   | ** ** | **June 30, 2007** | ** ** | **December 31, 2006** | ** ** |
|------------------------------|------------|-----------------------------|------------|---------------------------------|------------|
| ** **                   | ** ** | **Amount**                  | ** ** | **% of Total**        | ** ** | **Amount** | ** ** | **% of Total** | ** ** |
| Non-interest  bearing demand |       | $                           | 70,829     |                            | 15.1       | % | $ | 81,250 |   | 18.1 | % |
| Interest bearing  demand     |       | 85,600                      |       | 18.3                            | %          | 83,602 |   | 18.6 | % |
| Money market                 |       | 63,549                      |       | 13.6                            | %          | 59,855 |   | 13.3 | % |
| Savings                      |       | 77,915                      |       | 16.7                            | %          | 80,434 |   | 17.9 | % |
| Time                         |       | 170,049                     |       | 36.3                            | %          | 144,202 |   | 32.1 | % |
| Total deposits               |       | $                           | 467,942    |                            | 100.0      | % | $ | 449,343 |   | 100.0 | % |

 

**SECURITIESSOLD UNDER AGREEMENTS TO REPURCHASE           **Asof June 30, 2007 and December 31, 2006, securities sold under agreements torepurchase were $17.9 million and $14.1 million, respectively. These borrowingsdecrease or increase primarily based on the availability of funds and currentcompetitive interest rates offered. These borrowings are collateralized by securities with an estimated fairvalue exceeding the face value of the borrowings.

**CAPITALRESOURCES**    Stockholders’equity increased to $68.4 million at June 30, 2007 from $66.5 million atDecember 31, 2006.  This increase wasprimarily due to net income of $4.3 million which was partially offset by stockrepurchases of $368,000 and payment of cash dividends of $1.5 million. Bookvalue per share at June 30, 2007 was $101.85 compared to a book value of $98.80at December 31, 2006.

Bancorp has only one class of stock, which is common stock.  Bancorp’s stock is not actively traded orquoted and no broker currently makes a market in the stock. However, sales andtransfers of the stock do occur.  SkagitState Bank acts as transfer agent for Bancorp stock.  To facilitate trading, the Bank maintains alist of persons interested (known to the Bank) in either purchasing or sellingBancorp stock.  Purchasers and sellersthen negotiate their own transactions with the Bank acting as transfer agentfor those transactions. From time to time, Bancorp repurchases shares ofits common stock. The number of shares ofstock that will be repurchased and the price that will be paid is the result ofmany factors including market and economic conditions, the number of sharesavailable, Bancorp’s liquidity and capital needs and regulatoryrequirements.  For the six months endedJune 30, 2007, Bancorp repurchased 2,088 shares of stock for a average price of$176 per share.

Bankingregulations require bank holding companies and banks to maintain certainminimum capital levels.  As the followingtable indicates as of June 30, 2007 and December 31, 2006, Skagit StateBancorp, Inc. and Skagit State Bank both exceeded the well-capitalizedrequirements.

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| ** **                           | ** ** | ** ** | ** ** | ** **                 | ** ** | ** **                 | ** ** | ** **                 | ** ** | **To Be Well**   | ** ** |
|--------------------------------------|------------|------------|------------|----------------------------|------------|----------------------------|------------|----------------------------|------------|----------------------------|------------|
| ** **                           | ** ** | ** ** | ** ** | ** **                 | ** ** | ** **                 | ** ** | ** **                 | ** ** | **Capitalized Under** | ** ** |
| ** **                           | ** ** | ** ** | ** ** | ** **                 | ** ** | **For Capital**       | ** ** | **Prompt Corrective** | ** ** |
| ** **                           | ** ** | **Actual** | ** ** | **Adequacy Purposes** | ** ** | **Action Provisions** | ** ** |
| **(dollars in thousands)** | ** ** | **Amount** | ** ** | **Ratio**                  | ** ** | **Amount**                 | ** ** | **Minimu**                 | ** ** | **Amount**                 | ** ** | **Ratio** | ** ** |
| As of June 30,  2007                 |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| Total Capital                        |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| (to Risk-Weighted Assets)            |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| Skagit State Bank                    |       | $          | 73,687     |                       | 17.36      | %                          | $     | 33,954                     | 3     | 8.00                       | %          | $  | 42,443 | 3 | 10.00 | % |
| Skagit State Bancorp, Inc.           |       | $          | 74,165     |                       | 17.47      | %                          | $     | 33,956                     | 3     | 8.00                       | %          | $  | 42,445 | 3 | 10.00 | % |
| Tier I Capital                       |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| (to Risk-Weighted Assets)            |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| Skagit State Bank                    |       | $          | 68,821     |                       | 16.22      | %                          | $     | 16,977                     | 3     | 4.00                       | %          | $  | 25,466 | 3 | 6.00 | % |
| Skagit State Bancorp, Inc.           |       | $          | 69,299     |                       | 16.33      | %                          | $     | 16,978                     | 3     | 4.00                       | %          | $  | 25,467 | 3 | 6.00 | % |
| Tier I Capital                       |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| (to Average Assets)                  |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| Skagit State Bank                    |       | $          | 68,821     |                       | 12.45      | %                          | $     | 22,107                     | 3     | 4.00                       | %          | $  | 27,634 | 3 | 5.00 | % |
| Skagit State Bancorp, Inc.           |       | $          | 69,299     |                       | 12.54      | %                          | $     | 22,107                     | 3     | 4.00                       | %          | $  | 27,634 | 3 | 5.00 | % |
|                                 |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| As of December  31, 2006             |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| Total Capital                        |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| (to Risk-Weighted Assets)            |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| Skagit State Bank                    |       | $          | 71,548     |                       | 17.96      | %                          | $     | 31,878                     | 3     | 8.00                       | %          | $  | 39,847 | 3 | 10.00 | % |
| Skagit State Bancorp, Inc.           |       | $          | 71,796     |                       | 18.02      | %                          | $     | 31,878                     | 3     | 8.00                       | %          | $  | 39,847 | 3 | 10.00 | % |
| Tier I Capital                       |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| (to Risk-Weighted Assets)            |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| Skagit State Bank                    |       | $          | 66,565     |                       | 16.71      | %                          | $     | 15,939                     | 3     | 4.00                       | %          | $  | 23,908 | 3 | 6.00 | % |
| Skagit State Bancorp, Inc.           |       | $          | 66,813     |                       | 16.77      | %                          | $     | 15,939                     | 3     | 4.00                       | %          | $  | 23,908 | 3 | 6.00 | % |
| Tier I Capital                       |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| (to Average Assets)                  |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| Skagit State Bank                    |       | $          | 65,565     |                       | 12.66      | %                          | $     | 21,031                     | 3     | 4.00                       | %          | $  | 26,289 | 3 | 5.00 | % |
| Skagit State  Bancorp, Inc.          |       | $          | 66,813     |                       | 12.71      | %                          | $     | 21,031                     | 3     | 4.00                       | %          | $  | 26,289 | 3 | 5.00 | % |

 

**LIQUIDITY**

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

Bancorp hasgenerally been a net seller of federal funds. At June 30, 2007 and December 31, 2006, Bancorp’s federal funds soldwere $34.8 million and $25.7 million, respectively. Other sources of potentialliquidity include loan repayments, investment securities repayments andborrowing through pre-approved credit lines. Liquidity is also obtained bymaintaining assets that are readily convertible to cash through maturities andsales.  As of June 30, 2007, Bancorp had$35.0 million in approved credit lines from various financial institutions.

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

18

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**Item 3.    QUANTITATIVE AND QUALITATIVE DISCLOSURESABOUT MARKET RISK**

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

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

Bancorp believesthat there have not been any material changes about Bancorp’s market risk fromthe information that was provided in the Form 10-K for the year ended December31, 2006.

# **Item 4.    CONTROLSAND PROCEDURES**

Evaluation of Disclosure Controls and Procedures

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

Changes in Internal Controls

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

**PART II -               OTHERINFORMATION**

**Item 1.                    Legal Proceedings**

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

**Item 1A. Risk Factors**

There have been nomaterial changes in Bancorp’s risk factors from those disclosed in the 2006Annual Report on Form 10-K.  Forinformation regarding risk factors, refer to Bancorp’s 2006 Annual Report onForm 10-K.

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

None

**Item 3.                    Defaults Upon Senior Securities**

None

# **Item 4.                    Submissionof Matters to a Vote of Security Holders**

(a)                                  Skagit State Bank’s Annual Shareholder’s Meetingwas held on April 18, 2007.

(b)                                 Not Applicable

(c)           A brief descriptionof each matter voted upon at the Annual Meeting and number of votes cast for,against or withheld, including a separate tabulation with respect to eachnominee to serve on the Board is presented below:

(1)                                  Election of two (2) Directors for terms expiringin 2010 or until their successor is nominated and has qualified.

Directors:

Michael E. Pegram

19

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Votes For:                                                 557,195

Votes Withheld:                                          2,712

DanielPeth

Votes For:                                                 557,733

Votes Withheld:                                          2,174

**Item 5.                    Other Information**

None

**Item 6.                    Exhibits**

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

 

20

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**SIGNATURES**

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

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

 

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