Exhibit 13

SKAGIT STATE BANCORP, INC. AND SUBSIDIARY

TABLE OF CONTENTS

December 31, 2010, 2009 and 2008

	PAGE

SELECTED FINANCIAL DATA	1

TO OUR STOCKHOLDERS AND FRIENDS	2

MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING	3

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM	4

FINANCIAL STATEMENTS

Consolidated Balance Sheet	5

Consolidated Statement of Income	6

Consolidated Statement of Changes in Stockholders’ Equity and Comprehensive Income	7

Consolidated Statement of Cash Flows	8

Notes to Consolidated Financial Statements	9-35

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS; QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK	35-54

CORPORATE DIRECTORY	55

LOCATION DIRECTORY	56

STOCK INFORMATION	57

ANNUAL MEETING

The annual meeting of stockholders will be held at 6:30 p.m. on Tuesday, April 19, 2011, at McIntyre Hall, 2501 East College Way, Mount Vernon, Washington.

SELECTED FINANCIAL DATA

(dollars in thousands except per share data)

As of and for the year ended December 31,	2010			2009			2008			2007			2006

STATEMENT OF INCOME
Interest income	$	28,014		$	28,646		$	32,187		$	36,822		$	33,219
Interest expense	5,978			7,180			10,132			13,137			10,000
Net interest income	22,036			21,466			22,055			23,685			23,219
Provision (benefit) for loan losses	1,700			3,595			2,080			(150		)	—
Net interest income after provision (benefit) for loan losses	20,336			17,871			19,975			23,835			23,219
Non-interest income	4,138			3,979			4,365			3,776			3,214
Non-interest expense	17,835			18,498			18,104			16,420			14,568
Income before income taxes	6,639			3,352			6,236			11,191			11,865
Income tax expense	1,175			45			998			2,615			3,177
Net income	$	5,464		$	3,307		$	5,238		$	8,576		$	8,688
Basic earnings per share	$	9.31		$	5.64		$	8.64		$	12.76		$	12.69
Diluted earnings per share	$	9.29		$	5.60		$	8.57		$	12.72		$	12.68
Cash dividends declared per share	$	4.00		$	3.50		$	4.50		$	4.50		$	3.00

BALANCE SHEET
Total assets	$	692,871		$	647,888		$	566,876		$	592,663		$	532,788
Net loans	358,240			386,649			393,775			350,663			320,568
Deposits	590,881			545,436			469,538			500,420			449,343
Other borrowings	34,118			38,128			32,665			15,851			14,102
Stockholders’ equity	65,972			62,857			61,801			72,683			66,544

KEY OPERATING RATIOS
Return on average stockholders’ equity	8.30		%	5.22		%	8.27		%	12.33		%	13.35		%
Return on average assets	0.81		%	0.56		%	0.91		%	1.54		%	1.68		%
Net interest margin	3.43		%	3.85		%	4.10		%	4.52		%	4.83		%
Average stockholders’ equity to average assets	9.70		%	10.75		%	11.05		%	12.45		%	12.55		%
Dividend pay-out ratio	42.96		%	62.06		%	52.08		%	35.27		%	23.64		%
Book value per share	$	112.32		$	107.10		$	105.41		$	108.32		$	98.80

March 10, 2011

To Our Stockholders and Friends,

The past year turned out to be what many had predicted, with the banking environment facing continued challenges during the year. It was a bumpy ride, with modest improvement. Uncertainty is still part of the forecast for 2011 and economists around the region say that things might not get wildly better in the coming year, but likely won’t get worse. The year 2011 will continue to be a year of challenges, however with some improvement in the economy and some stabilization in real estate prices, we are cautiously optimistic.

Net income for 2010 was $5,464,000, yielding basic earnings per share of $9.31, up $3.67 per share from $5.64 for 2009. The provision for loan loss in 2010 was $1,700,000, compared to a provision of $3,595,000 for 2009. Net loans decreased by $28,409,000, ending the year at $358,240,000. Deposits continued to surge, growing 8.33% from $545,436,000 to $590,881,000.

This is a time of great opportunity for Skagit State Bank. Many of our competitors continue to struggle while we are experiencing a success story… our profits are strong, our leadership team is strong, our people are engaged and we look forward to the future.

Sincerely,

Cheryl R. Bishop

President and Chief Executive Officer

MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING

Bancorp’s management, including its Chief Executive Officer and its Chief Financial Officer, is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934. Internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America.

Bancorp’s internal control over financial reporting includes policies and procedures that pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and disposal of assets; provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with accounting principles generally accepted in the United State of America, and that receipts and expenditures are made only in accordance with authorizations of management and directors of Bancorp; and provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposal of assets that could have a material impact on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements and can only provide reasonable assurance with respect to financial statement preparation and fair presentation. Further, because of changes in conditions, the effectiveness of internal control may vary over time.

Management assessed the effectiveness of Bancorp’s internal control over financial reporting as of December 31, 2010, using the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control — Integrated Framework. Based on this assessment, management concluded that as of December 31, 2010, Bancorp’s internal control over financial reporting was effective based on those criteria.

This annual report does not include an attestation report of our registered public accounting firm regarding internal control over financial reporting. Additionally, management’s report was not subject to attestation by our registered public accounting firm pursuant to rules of the Securities and Exchange Commission that permits us, as a non-accelerated filer, to provide only management’s report in this annual report.

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors and Stockholders

Skagit State Bancorp, Inc.

We have audited the accompanying consolidated balance sheets of Skagit State Bancorp, Inc. and Subsidiary (the “Company”) as of December 31, 2010 and 2009, and the related consolidated statements of income, changes in stockholders’ equity and comprehensive income, and cash flows for the years then ended. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with the auditing standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall consolidated financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Skagit State Bancorp, Inc. and Subsidiary as of December 31, 2010 and 2009, and the consolidated results of their operations and their cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America.

Bellingham, Washington

March 10, 2011

SKAGIT STATE BANCORP, INC. AND SUBSIDIARY

CONSOLIDATED BALANCE SHEET

(dollars in thousands, except share data)
December 31,	2010			2009

ASSETS

ASSETS
Cash and due from banks	$	10,461		$	14,441
Federal funds sold	80,413			62,531
Investment securities
Available-for-sale, at fair value	180,971			118,561
Held-to-maturity, at amortized cost	38,367			40,298
Loans held for sale	78			574
Loans	365,319			393,532
Allowance for loan losses	(7,079		)	(6,883		)
Net loans	358,240			386,649
Bank premises and equipment, net	10,772			10,944
Other real estate owned	5,813			6,284
Accrued interest receivable	2,521			2,531
Other assets	5,235			5,075
TOTAL ASSETS	$	692,871		$	647,888

LIABILITIES AND STOCKHOLDERS’ EQUITY

LIABILITIES
Deposits
Interest-bearing	$	511,782		$	471,597
Non-interest-bearing	79,099			73,839
Total deposits	590,881			545,436
Other borrowings	34,118			38,128
Other liabilities	1,900			1,467
Total liabilities	626,899			585,031

COMMITMENTS AND CONTINGENCIES (Notes 10 and 15)

STOCKHOLDERS’ EQUITY
Common stock no par value, 5,000,000 shares authorized; 587,377 and 586,905 shares issued and outstanding at December 31, 2010 and 2009 respectively	12,541			12,303
Accumulated other comprehensive income, net of tax	1,639			1,872
Retained earnings	51,792			48,682
Total stockholders’ equity	65,972			62,857
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY	$	692,871		$	647,888

See accompanying notes to these financial statements.

SKAGIT STATE BANCORP, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENT OF INCOME

(dollars in thousands, except per share amounts) Years Ended December 31,	2010			2009			2008

INTEREST INCOME
Interest and fees on loans	$	22,584		$	23,243		$	25,486
Investment securities
Taxable	4,115			4,192			5,208
Exempt from federal income tax	1,096			1,133			1,208
Federal funds sold	219			78			285
Total interest income	28,014			28,646			32,187

INTEREST EXPENSE
Deposits	5,640			6,877			9,579
Other borrowings	338			303			553
Total interest expense	5,978			7,180			10,132

NET INTEREST INCOME	22,036			21,466			22,055
Provision for loan losses	1,700			3,595			2,080
NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES	20,336			17,871			19,975

NON-INTEREST INCOME
Service charges on deposits	3,127			3,005			3,060
Other	757			736			827
Gain on sale of assets	254			238			478
Total non-interest income	4,138			3,979			4,365

NON-INTEREST EXPENSES
Salaries	7,458			7,330			7,900
Payroll taxes and employee benefits	1,936			1,867			1,828
Provision for other real estate owned losses	473			1,167			1,479
Bank premises and equipment	951			948			1,027
Occupancy	746			779			780
Loan collection and OREO expenses	514			583			360
Advertising	708			643			747
Deposit Insurance	947			1,218			69
Other	4,102			3,963			3,914
Total non-interest expenses	17,835			18,498			18,104
INCOME BEFORE PROVISION FOR INCOME TAX	6,639			3,352			6,236

PROVISION (BENEFIT) FOR INCOME TAX
Current	1,569			1,221			1,398
Deferred	(394		)	(1,176		)	(400		)
Total provision for income tax	1,175			45			998
NET INCOME	$	5,464		$	3,307		$	5,238
BASIC EARNINGS PER SHARE	$	9.31		$	5.64		$	8.64
DILUTED EARNINGS PER SHARE	$	9.29		$	5.60		$	8.57
DIVIDENDS DECLARED PER SHARE	$	4.00		$	3.50		$	4.50

See accompanying notes to these financial statements.

SKAGIT STATE BANCORP, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY AND COMPREHENSIVE INCOME

Years Ended December 31, 2010, 2009 and 2008

						Accum. Other						Total
	Common Stock					Comprehensive			Retained			Stockholders’			Comprehensive
(dollars in thousands, except share and per share amounts)	Shares		Amount			Income (Loss)			Earnings			Equity			Income
BALANCE, December 31, 2007	670,997		$	13,564		$	694		$	58,425		$	72,683
Comprehensive income
Net income	—		—			—			5,238			5,238			$	5,238
Other comprehensive income
Unrealized gains on available-for-sale securities, net of taxes of $840	—		—			1,631			—			1,631			1,631
Total other comprehensive income															1,631
Comprehensive income															$	6,869
Cash dividend declared, $4.50 per share	—		—			—			(2,646		)	(2,646		)
Common stock redemption	(85,022	)	(1,721		)	—			(13,583		)	(15,304		)
Stock compensation expense and restricted stock awards	310		199			—			—			199
BALANCE, December 31, 2008	586,285		$	12,042		$	2,325		$	47,434		$	61,801
Comprehensive income
Net income	—		—			—			3,307			3,307			$	3,307
Other comprehensive loss
Unrealized loss on available-for-sale securities, net of benefit of $233	—		—			(453		)	—			(453		)	(453		)
Total other comprehensive loss															(453		)
Comprehensive income															$	2,854
Cash dividend declared, $3.50 per share	—		—			—			(2,059		)	(2,059		)
Stock options exercised	25		4			—			—			4
Stock compensation expense and restricted stock awards	595		257			—			—			257
BALANCE, December 31, 2009	586,905		$	12,303		$	1,872		$	48,682		$	62,857
Comprehensive income
Net income	—		—			—			5,464			5,464			$	5,464
Other comprehensive loss
Unrealized loss on available-for-sale securities, net of benefit of $120	—		—			(233		)	—			(233		)	(233		)
Total other comprehensive loss															(233		)
Comprehensive income															$	5,231
Cash dividend declared, $4.00 per share	—		—			—			(2,354		)	(2,354		)
Stock compensation expense and restricted stock awards	472		238			—			—			238
BALANCE, December 31, 2010	587,377		$	12,541		$	1,639		$	51,792		$	65,972

See accompanying notes to these financial statements

SKAGIT STATE BANCORP, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENT OF CASH FLOWS

(dollars in thousands) Years Ended December 31,	2010			2009			2008
CASH FLOWS FROM OPERATING ACTIVITIES
Net income	$	5,464		$	3,307		$	5,238
Adjustments to reconcile net income to net cash flows from operating activities
Provision for loan losses	1,700			3,595			2,080
Provision for other real estate owned losses	473			1,167			1,479
Depreciation	824			831			884
Loss (gain) on sale of assets	—			8			(232		)
Gain on sale of other real estate owned	(11		)	—			—
Gain on sale of loans	(243		)	(238		)	(246		)
Amortization of investment security premiums and discounts, net	27			(167		)	(218		)
Provision for deferred income taxes	(394		)	(1,176		)	(400		)
Stock compensation for employee services	238			257			199
Changes in operating assets and liabilities
Originations of loans held for sale	(15,016		)	(16,854		)	(18,212		)
Proceeds from sales of loans held for sale	15,755			16,868			18,108
(Increase) decrease in interest receivable	10			(101		)	1,034
Decrease (increase) in other assets	354			(1,611		)	(770		)
(Decrease) increase in other liabilities	433			(1,405		)	(837		)
Net cash flows from operating activities	9,614			4,481			8,107
CASH FLOWS FROM INVESTING ACTIVITIES
Proceeds from maturities, calls, and principal payments of investment securities — available-for-sale	56,294			41,122			47,441
Purchases of investment securities — available-for-sale	(119,092		)	(57,557		)	(20,445		)
Proceeds from maturities, calls, and principal payments of investment securities — held-to-maturity	4,982			7,302			8,309
Purchases of investment securities — held-to-maturity	(3,043		)	(11,080		)	(4,901		)
Net (increase) decrease in federal funds sold	(17,882		)	(62,531		)	41,195
Net (increase) decrease in loans	25,290			2,222			(52,138		)
Purchase of premises and equipment	(476		)	(642		)	(338		)
Capitalized expenditures for improvements to other real estate owned	—			(136		)	(200		)
Proceeds from sale of assets	—			—			301
Proceeds from sale of other real estate owned	1,252			—			—
Net cash flows from investing activities	(52,675		)	(81,300		)	19,224
CASH FLOWS FROM FINANCING ACTIVITIES
Net increase (decrease) in demand deposits, money market, NOW and savings accounts	36,540			30,600			(707		)
Net increase (decrease) in time deposits	8,905			45,298			(30,175		)
Amount paid for redemption of common stock	—			—			(15,304		)
Net increase (decrease) in other borrowings	(4,010		)	5,463			16,814
Cash dividends	(2,354		)	(2,059		)	(2,646		)
Proceeds from exercise of stock options	—			4			—
Net cash flows from financing activities	39,081			79,306			(32,018		)
NET CHANGE IN CASH AND DUE FROM BANKS	(3,980		)	2,487			(4,687		)
CASH AND DUE FROM BANKS, beginning of year	14,441			11,954			16,641
CASH AND DUE FROM BANKS, end of year	$	10,461		$	14,441		$	11,954
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash paid during the year for income taxes	$	1,980		$	266		$	1,902
Cash paid during the year for interest	$	6,110		$	7,155		$	10,408
SUPPLEMENTAL INFORMATION ABOUT NONCASH FINANCING AND INVESTING ACTIVITIES
Property taken in settlement of loans	$	1,419		$	1,309		$	6,946
Property sold through seller financing	$	1,105		$	—		$	—

See accompanying notes to these financial statements

NOTE 1 — NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Financial Statement Presentation: The accompanying consolidated financial statements include the accounts of Skagit State Bancorp, Inc. and its subsidiary Skagit State Bank, (collectively, “Company” or “Bancorp”). The consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America and reporting practices applicable to the banking industry. All significant inter-company accounts and transactions have been eliminated. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included.

Nature of Operations: Skagit State Bank (the “Bank”) provides a full range of banking services to individual and corporate customers through its 12 branches in Skagit, Snohomish and Whatcom counties. The Bank is subject to significant competition from other financial institutions. The Bank is also subject to the regulations of certain federal and state of Washington agencies and undergoes periodic examinations by those regulatory authorities. The Bank began operations in 1958 and is a state-chartered commercial bank with its headquarters in Burlington (Skagit County), Washington.

Use of Estimates: In preparing the financial statements, management is required to make estimates and assumptions that affect the reported amounts of revenues and expenses for the periods presented, and assets and liabilities as of the date of the balance sheet. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses, deferred income taxes, the valuation of real estate owned, and investment securities. Uncertainties with respect to such estimates and assumptions are inherent in the preparation of Bancorp’s financial statements; accordingly, it is possible that actual results could differ from these estimates or assumptions, which could have a material effect on the reported amounts of the consolidated financial position and results of operation.

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

Cash and Cash Equivalents: For purposes of the statement of cash flows, cash and cash equivalents include cash on hand and due from banks, all of which have original maturities of three months or less. Bancorp maintains cash balances at several banks. Accounts at each institution are insured by the Federal Deposit Insurance Corporation up to $250,000.

Federal Funds Sold: Federal funds sold include funds the bank has sold overnight to various financial institutions. In addition, since the Federal Reserve Bank is currently paying interest on reserves held overnight with them, Bancorp considers reserve funds held at the Federal Reserve Bank as federal funds sold. Bancorp is required to maintain an average balance with the Federal Reserve Bank or maintain such reserve balances in the form of cash. The Bank’s reserve requirement as of December 31, 2010 and 2009 was $1.7 million and $2.3 million, respectively.

Investment Securities: Bancorp’s investment portfolio is classified into two groups. 1) Securities Available for Sale (AFS); and 2) Securities Held to Maturity (HTM). Investment securities classified as available-for-sale are recorded at fair value, with the net unrealized gain or loss included in comprehensive income within the statement of stockholders’ equity, net of tax. Securities available for sale may be sold. Realized gains or losses on dispositions are based on the net proceeds and the adjusted carrying amount of securities sold, using the specific identification method. Investment securities Bancorp has the intent and ability to hold to maturity are classified as held-to-maturity and recorded at amortized cost. Purchase premiums or discounts are recognized as adjustments to interest income using the interest method over the period to call or maturity.

Investments with fair values that are less than amortized cost are considered impaired. Impairment may result from either a decline in the financial condition of the issuing entity or, in the case of fixed rate investments, from rising interest rates. For any security in an unrealized loss position, management assesses whether the security is other-than—temporarily impaired. In estimating other-than-temporary impairment losses, management considers, among other things, the length of time and the extent to which the fair values has been less than cost, the financial condition and near-terms prospects of the issuer, and the intent and ability of Bancorp to retain its investment in the issue for a

period of time sufficient to allow for any anticipated recovery in costs. The assessment of whether an other-than-temporary decline exists involves a high degree of subjectivity and judgment and is based on the information available to management at a point in time. Due to the subjective nature of the valuation process, it is possible that the actual fair values of these investments could differ from the estimated amounts, thereby affecting Bancorp’s financial position, results of operations and cash flows. If the estimated value of investments is less than the cost or amortized cost, Bancorp evaluates whether an event or change in circumstances has occurred that may have a significant adverse effect on the fair value of the investment.

For securities deemed other-than-temporary impaired, if Bancorp intends to sell the security or it is more likely than not that it will be required to sell the security, the other-than-temporary impairment will be recognized in earnings equal to the entire difference between the cost basis and fair value. If Bancorp does not intend to sell the security and it is not more likely than not that Bancorp will sell the security before recovery of its cost basis, the difference between the cost basis and fair value is reflected in earnings as realized losses to the extent the impairment is related to credit losses. The amount of the impairment related to other factors is recognized in other comprehensive income. The previous cost basis less the other-than-temporary impairment recognized in earnings becomes the new cost basis of the security.

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

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

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

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

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

Troubled Debt Restructures: Loan are reported as troubled debt restructures when Bancorp grants a concession to the borrower experiencing financial difficulties that would it would not otherwise consider. Examples of such concessions include forgiveness of principal or accrued interest or providing a lower interest rate than “market” for loans of similar risk. Interest income on restructured loans is recognized pursuant to the terms of a new loan agreement. At December 31, 2010 there was $2.0 million in commitments to lend additional funds to borrowers whose terms have been modified in a troubled debt restructuring.

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

The allowance is based upon Bancorp’s evaluation of the pertinent factors underlying the quality and composition of the loan portfolio, levels and trends in losses and delinquencies, current economic conditions, specific industry conditions and estimated value of any underlying collateral. Additions to the allowance, in the form of provisions, are reflected in current operating results, while charge-offs to the allowance are made when a loss is determined to have occurred. Bancorp’s evaluation of the allowance for loan losses is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available. Further information regarding Bancorp’s policies and methodology used to estimate the allowance for possible loan losses is presented in Note 4 Allowance for Loan Losses in the accompanying notes to consolidated financial statements found elsewhere is this report.

Bank Premises and Equipment: Bank premises and equipment are shown at cost less accumulated depreciation. Depreciation is computed using the straight-line method over the estimated useful lives of the assets. The estimated useful life ranges up to 30 years for buildings and improvements and ranges from 3 to 7 years for all furniture, fixtures and equipment. Upon sale or retirement, the cost and related accumulated depreciation are removed from the respective property or equipment accounts, and the resulting gains or losses are reflected in operations. Expenditures for maintenance and repairs are charged to expense as incurred.

Other Real Estate Owned: Other real estate owned includes properties acquired through foreclosure and other properties owned, but no longer used for banking purposes. These properties are recorded at the lower of the recorded amount of the loan or estimated fair value less estimated costs to sell. Valuation of the property occurs when it is foreclosed upon and annually thereafter. Write-downs arising from the acquisition of property, in full or partial satisfaction of loans, are charged to the allowance for loan losses. Subsequent write-downs after acquisition, identified through management’s periodic valuations, are written down through non-interest expenses. Legal and professional fees associated with foreclosures are expensed as incurred. Costs incurred to improve property are capitalized to the extent they are deemed to be recoverable; however, in no event are recorded costs allowed to exceed fair value. Subsequent gains, losses, or expenses recognized on the sale of these properties are included in non-interest income or expense.

Other Borrowings: Bancorp pledges certain financial instruments it owns to collateralize the sales of securities that are subject to an obligation to repurchase the same or similar securities (“repurchase agreements”). Under these arrangements, Bancorp transfers the assets, but still retains effective control through an agreement that both entitles and obligates Bancorp to repurchase the assets. As a result, repurchase agreements are accounted for as collateralized financing arrangements and not as a sale and subsequent repurchase of securities. The obligation to repurchase the securities is reflected as a liability in the consolidated balance sheets while the securities underlying the agreements remain in the respective asset accounts.

Bancorp has the capacity to borrow funds from the Federal Reserve Bank. This credit line has pledge requirements whereby Bancorp must pledge collateral sufficient to cover any borrowed funds taken. Bancorp also has federal funds credit lines at other financial institutions which are subject to the financial institution’s availability of funds and Bancorp’s financial position.

Income Taxes: Bancorp files a consolidated federal income tax return. Bancorp accounts for income taxes using the liability method and deferred taxes are reflected at currently enacted income tax rates applicable to the period in which the deferred tax assets or liabilities are expected to be realized or settled.

Deferred taxes result from temporary differences in the recognition of certain income and expense amounts between Bancorp’s financial statements and its tax returns. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes. The calculation of the provision for federal income taxes is complex and requires estimates and significant judgments in arriving at the amount of tax benefits to be recognized in the financial statements for a specific period. Differences between the position taken by management and that of taxing authorities could result in a reduction of a tax benefit or increase to tax liability, which could adversely affect future income tax expense.

Bancorp reviews its uncertain tax positions annually and evaluates these deferred tax assets to determine if those tax benefits are expected to be realized in future periods. This evaluation includes reviewing the evidence currently available, both positive and negative, including existence of taxes paid in available carry-back years, forecasts of future income, cumulative losses, applicable tax planning strategies and assessments of the current and future economic and business conditions. To the extent a deferred tax asset is no longer considered “more likely than not” to be realized, a deferred tax valuation allowance is established. This valuation allowance reduces deferred tax assets to the amount expected to be realized.

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

Advertising Costs: Bancorp expenses advertising costs as they are incurred.

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

Stock-Based Compensation: Bancorp has a stock-based equity compensation plan which is described more fully in Note 9. Under this plan, Bancorp is authorized to grant options or restricted stock up to 100,000 shares. Bancorp recognizes stock-based compensation expense on a straight-line basis over the vesting period based on the number of awards or options expected to vest using the grant-date fair value.

Reclassifications: Certain amounts in prior years’ financial statements have been reclassified to conform to the current year’s presentation. These reclassifications had no effect on retained earnings or net income as previously reported.

Accounting Pronouncements: The following accounting pronouncements have been issued, but are not yet effective for Bancorp:

In January 2010, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2010-06, an update to ASU 820-10, “Fair Value Measurements”. This update adds a new requirement to disclose transfers in and out of level 1 and level 2, along with the reasons for the transfers, and requires a gross presentation of purchases and sales of level 3 activities. Additionally, the update clarifies that entities provide fair value measurement disclosures for each class of assets and liabilities and that entities provide enhanced disclosures around level 2 valuation techniques and inputs. Bancorp adopted the disclosure requirements for level 1 and level 2 transfers and the expanded fair value measurement and valuation disclosures effective January 1, 2010. The adoption of these disclosure requirements had no impact on Bancorp’s financial position, results of operations, and earnings per share. The disclosures regarding purchases and sale for level 3 activities are required to be implemented beginning January 1, 2011.

On July 21, 2010, the FASB issued ASU 2010-20 which amends ASU 310 and expands required disclosures for the Financing Receivables and the Allowance for Loan and Lease Losses. The objective of these enhanced disclosures is to improve financial statements users’ understanding of (i) the nature of a company’s credit risk associated with financing receivables and (ii) the company’s assessment of risk in estimating its allowance for loan and lease losses

as well as changes in the allowance and the reasons for those changes. These disclosures with the exception of the troubled debt restructurings disclosure were implemented by the Bank on December 31, 2010. On January 4, 2011, the FASB issued ASU No. 2011-01, Receivables (Topic 310) — Deferral of the Effective Date of Disclosures about Troubled Debt Restructurings. The deferral of disclosures relating to troubled debt restructures and the disclosure requirements will become effective once FASB finalizes any standards update related to their exposure draft “Clarifications for Troubled Debt Restructurings by Creditors” which was proposed during 2010. The revised standards are expected to be finalized during the first quarter of 2011.

NOTE 2 — INVESTMENT SECURITIES AND FEDERAL FUNDS SOLD

The following tables summarize the aggregate amortized cost and estimated fair value of investment securities as of December 31:

	2010
	Amortized		Gross Unrealized				Estimated
(dollars in thousands)	Cost		Gains		Losses		Fair Value
Available-For-Sale Securities
U.S. government agencies	$	85,474	$	612	$	311	$	85,775
Residential mortgage-backed securities and collateralized mortgage obligations	84,510		2,718		797		86,431
State and political subdivisions	8,504		323		62		8,765
Total available-for-sale	178,488		3,653		1,170		180,971
Held-To-Maturity Securities
State and political subdivisions	38,367		730		235		38,862
Total held-to-maturity	38,367		730		235		38,862
Total investment securities	$	216,855	$	4,383	$	1,405	$	219,833

	2009
	Amortized		Gross Unrealized				Estimated
(dollars in thousands)	Cost		Gains		Losses		Fair Value
Available-For-Sale Securities
U.S. government agencies	$	39,698	$	274	$	132	$	39,840
Mortgage-backed securities	66,640		2,556		200		68,996
State and political subdivisions	9,387		366		28		9,725
Total available-for-sale	115,725		3,196		360		118,561
Held-To-Maturity Securities
State and political subdivisions	40,298		889		626		40,561
Total held-to-maturity	40,298		889		626		40,561
Total investment securities	$	156,023	$	4,085	$	986	$	159,122

The following tables show the gross unrealized losses and fair value of investments with unrealized losses that are not deemed to be other-than-temporarily impaired as of December 31;

	2010
	Less Than 12 Months				12 Months or Greater				Total
(dollars in thousands)	Fair Value		Unrealized Losses		Fair Value		Unrealized Losses		Fair Value		Unrealized Losses
Available-For-Sale Securities
U.S. government agencies	$	35,373	$	311	$	—	$	—	$	35,373	$	311
Residential mortgage-backed securities and collateralized mortgage obligations	24,599		797		—		—		24,599		797
State and political subdivisions	1,128		62		—		—		1,128		62
Total available-for-sale	61,100		1,170		—		—		61,100		1,170
Held-To-Maturity Securities
State and political subdivisions	12,076		235		—		—		12,076		235
Total held-to-maturity	12,076		235		—		—		12,076		235
Total investment securities	$	73,176	$	1,405	$	—	$	—	$	73,176	$	1,405

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

At December 31, 2010, Bancorp held no security in the available-for-sale portfolio and no security in the held-to-maturity portfolio that had an unrealized loss for more than one year. Bancorp does not intend to sell securities that are identified as temporarily impaired nor does available evidence suggest it is more likely than not that management will be required to sell any impaired securities. The unrealized losses are largely due to increases in market interest rates over the yields available at the time the underlying securities were purchased. Management believes the nature of the securities in the investment portfolio present a high probability of collecting all contractual amounts due. Based on the evaluation, management has determined that no investment security in Bancorp’s investment portfolio is other-than-temporarily impaired.

Available for sale investment securities with a carrying value of $96.0 million and $101.3 million, as of December 31, 2010 and 2009, respectively, were pledged as collateral for public fund deposits, securities sold under agreements to repurchase, Treasury Tax and Loan payments, and Federal Reserve Bank discount window borrowings. There were no sales of securities during 2010 and 2009.

The amortized cost and estimated fair value of investment securities at December 31, 2010, by contractual maturity, are shown below. Actual maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties.

	2010
	Available-For-Sale				Held-To-Maturity
	Amortized		Estimated		Amortized		Estimated
(dollars in thousands)	Cost		Fair Value		Cost		Fair Value
U.S. government agencies
1 year	$	5,007	$	5,012	$	—	$	—
2-5 years	70,301		70,812		—		—
6-10 years	7,000		6,805		—		—
Over 10 years	3,166		3,146		—		—
Residential mortgage-backed securities and collateralized mortgage obligations
1 year	—		—		—		—
2-5 years	—		—		—		—
6-10 years	37,851		39,721		—		—
Over 10 years	46,659		46,710		—		—
State and political subdivisions
1 year	1,181		1,205		8,601		8,645
2-5 years	4,541		4,800		8,463		8,699
6-10 years	1,592		1,631		13,477		13,526
Over 10 years	1,190		1,129		7,826		7,992
Total investment securities	$	178,488	$	180,971	$	38,367	$	38,862

Federal Funds Sold: Investments in federal funds sold are made with various banks. To reduce risk, Bancorp will generally invest no more than $10,000,000 in federal funds sold with any one bank with the exception of the Federal Reserve Bank which there is no limit. Federal funds sold as of December 31, 2010 were $80.4 million and $62.5 million as of December 31, 2009.

NOTE 3 — LOANS

The major segments and classes of loans at December 31 are as follows:

(dollars in thousands)	2010			2009
Commercial	$	69,177		$	76,858
Commercial real estate
Raw land and land development	37,233			37,607
Other commercial real estate	65,516			64,768
Other real estate
Residential	34,681			36,778
Farmland and owner occupied nonfarm nonresidential	115,291			122,746
Real estate construction
Commercial	826			3,646
Residential	3,210			10,990
Consumer
Home equity	23,522			23,247
Credit cards and other consumer	16,622			17,905
	$	366,078		$	394,545
Less deferred loan fees	(759		)	(1,013		)
Total Loans	$	365,319		$	393,532

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

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

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

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

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

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

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

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

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

During 2006, the FDIC issued guidance entitled “Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices”. The guidance set forth two thresholds to identify institutions with Commercial Real Estate (CRE) loan concentrations. Financial institutions are deemed to have a CRE concentration if loans for construction, land development, and other land represent 100 percent or more of total capital or if loans for construction, land development, and other land and loans secured by multifamily and nonfarm nonresidential property(excluding loans

secured by owner-occupied properties) represent 300 percent or more of total capital. Total reported loans for construction, land development, and raw land were 59% and 78% of total risk based capital for December 31, 2010 and 2009, respectively. Bancorp considers both ratios noted above to be within acceptable levels of concentration risk.

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

Bancorp originates both variable and fixed-rate loans. At December 31, 2010 and 2009, $157.1 million and $160.5 million of loans outstanding were variable rate loans. Loans participations sold to others totaled $3.1 million and $3.9 million as of December 31, 2010 and 2009. Bancorp does originate loans intended for sale which are carried at the lower of aggregate cost or fair value. As of December 31, 2010 and 2009, Bancorp held $78,000 and $574,000 as loans held-for-sale. Gains on sale of loans were $243,000, $238,000 and $246,000 during 2010, 2009 and 2008. The servicing rights on such loans are not retained. There were no sales of loans, other than sales of loans originated as loans held for sale during 2010, 2009 and 2008. In addition, no loans were reclassified to held-for-sale during 2010. Bancorp acquired no loans with deteriorated credit quality for 2010, and 2009. The following table is an aging analysis of past due loans as of December 31, 2010:

(dollars in thousands)	30-59 Days Past Due		60-89 Days Past Due		Greater Than 90 Days		Total Past Due		Current		Total Loan Receivables		Recorded Investment > 90 Days and Accruing
Commercial	$	—	$	50	$	11	$	61	$	69,116	$	69,177	$	—
Commercial real estate
Raw land and land development	—		—		—		—		37,233		37,233		—
Other commercial real estate	68		—		—		68		65,448		65,516		—
Other real estate
Residential	72		263		370		705		33,976		34,681		—
Farmland and owner occupied nonfarm nonresidential	—		187		168		355		114,936		115,291		—
Real estate construction
Commercial	—		—		—		—		826		826		—
Residential	—		—		706		706		2,504		3,210		—
Consumer
Home equity	—		—		36		36		23,486		23,522		—
Credit cards and other consumer	141		82		51		274		16,348		16,622		—
Total	$	281	$	582	$	1,342	$	2,205	$	363,873	$	366,078	$	—

At December 31, 2010, $11.0 million of Bancorp’s non-accruing loans were not past due greater than 30 days.

The following is a summary of non-accrual loans as of December 31:

(dollars in thousands)	2010		2009
Commercial	$	3,699	$	998
Commercial real estate
Raw land and land development	4,568		4,753
Other commercial real estate	1,135		—
Other real estate
Residential	1,047		800
Farmland and owner occupied nonfarm nonresidential	1,209		2,637
Real estate construction
Commercial	—		—
Residential	968		1,395
Consumer
Home equity	105		74
Credit cards and other consumer	63		85
Total	$	12,794	$	10,742

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

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

	December 31, 2009
(dollars in thousands)	Unpaid Principal Balance		Recorded Investment with No Related Allowance		Recorded Investment with Related Allowance		Related Allowance		Total Recorded Investment
Commercial	$	1,053	$	989	$	64	$	22	$	1,053
Raw land and land development	9,416		6,786		2,314		930		9,100
Other commercial real estate	1,147		—		1,147		6		1,147
Residential	3,117		2,542		467		14		3,009
Farmland and owner occupied nonfarm nonresidential	7,217		7,189		—		—		7,189
Construction-commercial	—		—		—		—		—
Construction-residential	2,970		450		2,261		203		2,711
Consumer-home equity	78		74		—		—		74
Credit cards and other consumer	109		14		71		5		85
Total	$	25,107	$	18,044	$	6,324	$	1,180	$	24,368

	December 31, 2010				December 31, 2009
(dollars in thousands)	Average Recorded Investment		Interest Income Recognized		Average Recorded Investment
Commercial	$	1,691	$	4	$	740
Raw land and land development	6,599		169		5,330
Other commercial real estate	1,074		99		946
Residential	1,659		76		1,270
Farmland and owner occupied nonfarm nonresidential	3,745		140		3,266
Construction-commercial	—		—		—
Construction-residential	1,645		44		1,436
Consumer-home equity	84		—		58
Credit cards and other consumer	80		—		79
Total	$	16,577	$	532	$	13,125

Interest income collected on impaired loans was $532,000, $1.1 million, and $300,000 for the years ended December 31, 2010, 2009 and 2008, respectively. Average balances of impaired loans were $16.6 million, $13.1 million and $3.5 million for the years ended December 31, 2010, 2009 and 2008, respectively. Additional interest income of $636,000, $514,000 and $173,000 would have been recorded for the year ended December 31, 2010, 2009 and 2008, respectively, had non-accrual loans been current in accordance with their original terms. At December 31, 2010, there were $2.2 million in unfunded commitments to lend to borrowers representing impaired and non-accruing loans. At December 31, 2010, four relationships represented seventy-three percent of total impaired loans.

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

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

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

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

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

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

The four risk ratings for consumer loans are as follows:

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

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

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

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

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

The following tables present Bancorp’s risk rating loan balances by class as of December 31, 2010:

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

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

NOTE 4 —ALLOWANCE FOR LOAN LOSSES

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

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

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

The assessment for impairment occurs when and while loans are designated as substandard per Bancorp’s internal risk rating system or when and while such loans are on non-accrual. Substandard or non-accrual loans with an outstanding balance of $250,000 are reviewed for impairment and are analyzed individually on a quarterly basis. Smaller balance loans, including commercial loans under the threshold or consumer and credit card loans, are grouped with other loans in its product type and risk grade category for reserve purposes. In general, the specific allocation for a loan is equal to the impairment measured by ASC 310. If the loan is collateral dependent, a specific reserve is established when the value of the loan collateral is less than Bancorp’s recorded investment in the loan. If the loan is not collateral dependent, a specific allocation is established when the discounted cash flow is less than Bancorp’s recorded investment in the loan.

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

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

The following is an analysis of the changes in the allowance for loan losses as of December 31, 2010 and 2009:

(dollars in thousands)

Allowance for loan losses:

December 31, 2010

	Commercial			Commercial Real Estate			Other Real Estate			Real Estate Construction			Consumer			Unallocated			Total
Balance, beginning of year	$	1,457		$	2,287		$	1,156		$	328		$	924		$	731		$	6,883
Loans charged off	(635		)	(55		)	(340		)	(239		)	(385		)	—			(1,654		)
Recoveries	55			—			7			—			88			—			150
Provision (benefit)	617			332			577			(22		)	228			(32		)	1,700
Balance, end of year	$	1,494		$	2,564		$	1,400		$	67		$	855		$	699		$	7,079

Ending balance: individually evaluated for impairment	$	540		$	350		$	2		$	—		$	14		$	—		$	906
Ending balance: collectively evaluated for impairment	$	954		$	2,214		$	1,398		$	67		$	841		$	699		$	6,173

Loans Receivables:
Ending balance	$	69,177		$	102,749		$	149,972		$	4,036		$	40,144					$	366,078
Ending balance: individually evaluated for impairment	$	3,699		$	5,703		$	7,333		$	968		$	168					$	17,871
Ending balance: collectively evaluated for impairment	$	65,478		$	97,046		$	142,639		$	3,068		$	39,976					$	348,207

(dollars in thousands)

Allowance for loan losses:

December 31, 2009

	Commercial			Commercial Real Estate			Other Real Estate			Real Estate Construction			Consumer			Unallocated		Total
Balance, beginning of year	$	1,683		$	1,218		$	951		$	291		$	590		$	717	$	5,450
Loans charged off	(317		)	(1,367		)	(155		)	(284		)	(474		)	—		(2,597		)
Recoveries	90			—			207			—			138			—		435
Provision (benefit)	1			2,436			153			321			670			14		3,595
Balance, end of year	$	1,457		$	2,287		$	1,156		$	328		$	924		$	731	$	6,883

Ending balance: individually evaluated for impairment	$	22		$	936		$	14		$	203		$	5		$	—	$	1,180
Ending balance: collectively evaluated for impairment	$	1,435		$	1,351		$	1,142		$	125		$	919		$	731	$	5,703

Loans Receivables:
Ending balance	$	76,858		$	102,375		$	159,524		$	14,636		$	41,152				$	394,545
Ending balance: individually evaluated for impairment	$	1,053		$	10,247		$	10,198		$	2,711		$	159				$	24,368
Ending balance: collectively evaluated for impairment	$	75,805		$	92,128		$	149,326		$	11,925		$	40,993				$	370,177

The following is an analysis of the changes in the allowance for loan losses as of December 31, 2008:

(dollars in thousands)	2008
Balance, beginning of year	$	4,535
Provision for loan losses	2,080
Loans charged off	(1,612		)
Recoveries on loans previously charged off	447
Balance, end of year	$	5,450

NOTE 5 — BANK PREMISES AND EQUIPMENT

The major classifications of bank premises and equipment are as follows:

(dollars in thousands)	2010			2009
Land	$	3,980		$	3,820
Buildings and leasehold improvements	10,582			10,311
Furniture, fixtures and equipment	5,233			5,039
	19,795			19,170
Less accumulated depreciation	(9,023		)	(8,226		)
Total bank premises and equipment	$	10,772		$	10,944

Depreciation expense on premises and equipment was $824,000 in 2010, $831,000 in 2009 and $884,000 in 2008.

NOTE 6 — DEPOSITS

The major classifications of deposits and the total remaining maturities for time deposits at December 31 are as follows:

(dollars in thousands)	2010		2009
Non-interest-bearing demand	$	79,099	$	73,839
Interest-bearing demand	109,085		101,504
Money market deposit accounts	87,289		77,288
Savings	100,068		86,370
Subtotal	$	375,541	$	339,001

Time Deposits
Due within one year	$	173,438	$	158,885
After one year but within two years	37,845		39,680
After two years but within three years	2,822		7,065
After three years but within four years	397		287
After four years but within five years	238		307
After five years	600		211
Total time deposits	$	215,340	$	206,435
Total deposits	$	590,881	$	545,436

Certificates of deposit, greater than or equal to $100,000 included in the above amounts, totaled $116.7 million and $114.9 million at December 31, 2010 and 2009, respectively. At December 31, 2010 and 2009, $244,000 and $152,000 in deposit overdrafts were reclassified as loans outstanding. At December 31, 2010 and 2009, brokered time deposits totaled $19.5 million and $24.0 million, respectively.

NOTE 7 — OTHER BORROWINGS

The Bancorp’s primary source of other borrowings include securities sold under agreement to repurchase, federal funds purchased from correspondent banks, and discount window borrowings from the Federal Reserve Bank of San Francisco. The following table details Bancorp’s other borrowings as of December 31:

(dollars in thousands)	2010			2009
Balance outstanding at end of year	$	34,118		$	38,128
Weighted average interest rate at year end	0.85		%	0.94		%
Maximum month-end balance during the year	$	45,731		$	38,128
Average monthly balance during the year	$	38,516		$	18,065
Weighted average interest rate during the year	0.88		%	1.68		%
Carrying value of collateral for repurchase agreements	$	45,476		$	41,103

Bancorp offers repurchase agreements to its customers. The agreements are fully collateralized by certain securities of the U.S. Government and its agencies and other approved investments including FHLB, FNMA, FFCB and FHLMC securities under agreements to repurchase. The securities underlying the agreements are held by a safekeeping agent. As of December 31, 2010, securities sold under agreements to repurchase were $34.1 million with variable interest rates between 0.40% to 2.00%. All are scheduled to mature during 2011.

Bancorp has the capacity to borrow funds from the Federal Reserve Bank. As of December 31, 2010, Bancorp held investment securities at the Federal Reserve with a market value of $35.0 million as collateral for discount window borrowings. Bancorp also has federal funds credit lines at other financial institutions which are subject to the financial institution’s availability of funds and Bancorp’s financial position. There were no outstanding borrowings under these lines as of December 31, 2010 and 2009.

NOTE 8 — INCOME TAXES

A reconciliation of the effective income tax rate with the federal statutory tax rate is as follows:

	2010					2009					2008
(dollars in thousands)	Amount			Rate		Amount			Rate		Amount			Rate

Income tax provision at statutory rate	$	2,257		34.0	%	$	1,140		34.0	%	$	2,120		34.0	%
Effect of non-taxable interest income	(373		)	(5.6	)	(385		)	(11.5	)	(411		)	(6.6	)
Non-deductible expenses	425			6.4		440			13.1		452			7.3
Tax credits	(1,190		)	(17.9	)	(1,219		)	(36.4	)	(1,224		)	(19.6	)
Other	56			0.8		69			2.1		61			0.9
Total income taxes	$	1,175		17.7	%	$	45		1.3	%	$	998		16.0	%

The tax credits noted in the preceding table are from Bancorp’s investment in Qualified Zone Academy Bonds. In lieu of receiving periodic interest payments, Bancorp receives an annual income tax credit until maturity of the bond. The tax credits become available one year after the bond is issued and each successive one year period thereafter until maturity. At December 31, 2010 and 2009, Bancorp had $20.7 million in Qualified Zone Academy Bonds. At December 31, 2010 Qualified Zone Academy Bonds had maturity dates ranging from approximately less than a year to 12 years. The tax credits earned were $1.2 million for each of the last three years ended 2010, 2009 and 2008, respectively.

The following table shows the nature and components of Bancorp’s net deferred tax asset as of December 31:

(dollars in thousands)	2010			2009

Deferred Tax Assets
Allowance for loan losses	$	2,407		$	2,340
Unrealized loss on securities available-for-sale	—			—
Other deferred tax assets	387			241
Other accrued expenses	112			109
Other real estate owned	484			386
Total deferred assets	3,390			3,076

Deferred Tax Liabilities
Deferred loan fees for tax purposes in excess of amounts deferred for financial reporting	(38		)	(50		)
Investment securities	(37		)	(33		)
Premises and equipment	(151		)	(225		)
Unrealized gain on securities available-for-sale	(844		)	(965		)
Other	(50		)	(49		)
Total deferred liabilities	(1,120		)	(1,322		)
Net deferred tax asset	$	2,270		$	1,754

As of December 31, 2010, a valuation allowance against deferred tax assets has not been established as it is more likely than not, based on Bancorp’s historical performance, that these deferred tax assets will be realized. Our policy is to recognized interest and penalties on unrecognized tax benefits in provision for income taxes. There were no amounts related to interest and penalties recognized for the years ended December 31 2010, 2009 and 2008. The tax years subject to examination by federal taxing authorities are for the years ending December 31, 2009, 2008 and 2007.

NOTE 9 — EMPLOYEE BENEFIT PLANS

401(k) Plan: Bancorp has a 401(k) plan covering substantially all of its employees. Eligible employees may contribute amounts through payroll deductions. Bancorp matches 100% of each eligible employee’s elected contributions, up to a maximum of 4% of the employee’s annual eligible compensation. At the discretion of the Board of Directors, Bancorp also makes an annual discretionary profit sharing contribution of 2%, which is allocated to eligible employees based upon annual eligible compensation. All employee contributions vest immediately and employer contributions vest over a 6 year period. Employees have the option of investing contributions among selected mutual funds. During years ended December 31, 2010, 2009 and 2008, Bancorp contributed approximately $370,000, $384,000 and $355,000, respectively, to the 401(k) plan.

Incentive Stock Plan: Bancorp has one share-based payment plan, which is shareholder approved, and permits the grant of share-based awards to its employees and directors up to 100,000 shares. The plan addresses stock options, restricted stock awards and other stock based compensation awards. This plan is primarily designed to recognize, motivate, reward and retain eligible employees and to better align the interest of Bancorp’s employees with those of its shareholders.

No options or awards were granted in 2010. During 2009, Bancorp granted options and in 2008 granted both options and restricted stocks awards. It is the Bancorp’s policy to issue new shares of common stock for options and restricted stock awards. Total equity compensation expense was $238,000 in 2010, $256,000 in 2009 and $199,000 in 2008. In 2009, cash received from the exercise of options and restricted stock awards totaled $4,000 and in 2010 and 2008, no options were exercised. There was no tax benefit realized on stock options and restricted stock awards in 2010, 2009 and 2008.

Stock Options: No stock options were awarded in 2010. All options granted during 2009 were Incentive Stock Options and were granted at a price equal to the market value of the stock on the grant date, have a term of 10 years and vest over a five year period. Bancorp measures the fair value of each stock option at the date of the grant, using the Black Scholes option valuation model. The application of this valuation model involves assumptions that are judgmental and sensitive in the determination of compensation expense. The fair value of all options is amortized on a straight-line basis over the vesting periods. Estimated forfeitures will be evaluated in subsequent periods and may change based on new facts and circumstances. Assumptions used in arriving at the fair value of options granted are presented in the following table.

	2009		2008
Expected price volatility	18.41	%	16.14	%
Risk-free interest rate	2.05	%	3.37	%
Dividend yield on underlying stock	2.30	%	2.38	%
Weighted-average expected life in years	7.00		7.00
Weighted-average grant date fair value	30.78		31.84

The volatility factor is based on historical stock prices over the most recent period commensurate with the estimated expected life of the award. The risk-free interest rate is based on the U.S. Treasury curve in effect at the time of the award. As Bancorp does not have a long history of stock options, an average or mid-point based on the vesting term and the expiration term was used in determining the weighted average expected life on options granted to employees. The expected dividend yield is based on dividend trends and the market value of the Bancorp’s stock price at the time of the award.

The following table summarizes the activity related to options outstanding at December 31, 2010. The aggregate intrinsic value represents the total pretax intrinsic value (amount by which the fair value of the underlying stock exceeds the exercise price of an option or award, times the number of shares).

(dollars in thousands except share and per share amounts)

	Shares	Weighted Average Exercise Price		Weighted Average Remaining Contractual Terms (in years)	Aggregate Intrinsic Value
Outstanding at January 1, 2010	28,761	$	179.40	7.58	$	—
Granted	—
Exercised	—
Forfeited	775	161.00
Outstanding at December 31, 2010	27,986	$	179.91	6.60	$	—
Exercisable at December 31, 2010	14,083	$	171.90	5.84	$	—

The unrecognized share-based compensation cost relating to stock option expense at December 31, 2010 was $333,000 which will be recognized over the remaining vesting schedule of the options. The total intrinsic value of options exercised during the twelve months ended December 31, 2010, 2009 and 2008 was $0, $1,000 and $0. The total fair value of shares vested during the year ended December 31, 2010, 2009, and 2008 was $857,000, $676,000 and $532,000.

A summary of the status of Bancorp’s non-vested stock options as of December 31, 2010, and activity during the year ended December 31, 2010, is presented below:

	Shares	Weighted Average Grant-Date Fair Value

Nonvested at January 1, 2010	19,820	$	31.67
Awarded	—
Vested	5,608	32.05
Forfeited	310	35.07
Nonvested at December 31, 2010	13,902	$	31.45

Stock Awards: Recipients of restricted stock awards do not pay any cash consideration to Bancorp for the shares and receive all dividends with respect to all such shares, whether or not shares have vested. The awards vest over a five year period. Bancorp measures the fair value of each stock award at the date of the grant and recognizes compensation based on the market price of Bancorp’s common stock. The unrecognized share-based compensation cost relating to restricted stock awards expense at December 31, 2010 was $127,000, which will be recognized over the remaining years of the original five year vesting period of the awards. The weighted average grant date fair value of restricted stock awards granted during 2008 was $189.00. No awards were granted during 2010 or 2009. The total intrinsic value of stock awards exercised and the total fair value of shares vested during the year ended December 31, 2010, 2009 and 2008 was $72,000, $112,000 and $62,000.

The following table summarizes the activity relating to restricted stock awards outstanding at December 31, 2010. The aggregate intrinsic value represents the total pretax intrinsic value (amount by which the fair value of the underlying stock exceeds the exercise price of an option or award, times the number of shares).

(dollars in thousands except share and per share amounts)

	Shares	Weighted Average Remaining Contractual Terms (in years)	Aggregate Intrinsic Value
Outstanding at January 1, 2010	1,564	2.80	$	235
Granted	—	—	—
Vested	472	—	72
Forfeited	123
Outstanding at December 31, 2010	969	1.90	$	145

NOTE 10 — COMMITMENTS

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

Commitments to originate loans or provide funds under existing lines of credit or to fund municipal warrants are agreements to lend to a customer as long as there is no violation of conditions established in the loan documents. Commitments generally have fixed expiration dates or other termination clauses. Total commitment amounts may not necessarily represent future cash-flow requirements. Standby letters of credit are conditional commitments issued by Bancorp to guarantee the performance of a customer to a third party. Commercial and standby letters of credit are granted primarily to commercial borrowers and are primarily issued to support public and private borrowing arrangements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Bancorp has not incurred any losses on its letter of credit commitments in 2010, 2009 or 2008.

The following table represents the off-balance sheet commitments with their remaining terms as of December 31, 2010: (dollars in thousands)

	Total		Less Than One Year		One Year Through Three Years		Three Years Through Five Years		Thereafter
Unfunded commitments to extend credit	$	66,920	$	32,064	$	6,967	$	11,350	$	16,539
Credit card arrangements	11,418		11,418		—		—		—
Commitments to fund municipal warrants	3,138		2,229		500		211		198
Standby letters of credit	1,785		643		923		184		35

NOTE 11 —FAIR VALUE OF FINANCIAL INSTRUMENTS

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

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

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

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

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

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

The carrying amounts and estimated fair values of Bancorp’s financial instruments at December 31, 2010 and 2009 are as follows:

	2010				2009
	Carrying				Carrying
(dollars in thousands)	Amount		Fair Value		Amount		Fair Value
Financial Assets
Cash and due from banks	$	10,461	$	10,461	$	14,441	$	14,441
Federal funds sold	80,413		80,413		62,531		62,531
Investment securities	219,338		219,833		158,859		159,122
Net loans	358,240		338,704		386,649		361,780
Accrued interest receivable	2,521		2,521		2,531		2,531

Financial Liabilities
Demand and savings deposits	375,541		375,541		339,001		339,001
Time deposits	215,340		216,736		206,435		208,142
Other borrowings	34,118		34,118		38,128		38,128
Accrued interest payable	234		234		366		366

NOTE 12 —FAIR VALUE MEASUREMENTS

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

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

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

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

In general, Bancorp determines fair value based upon quoted prices when available or through the use of alternative approaches, such as matrix or model pricing, when market quotes are not readily accessible or available. The valuation techniques used are based on observable and unobservable inputs. Valuation adjustments may be made to ensure that financial instruments are recorded at fair value. While management believes Bancorp’s valuation methodologies are appropriate and consistent with other market participants, the use of different methodologies or assumptions used to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date. There were no transfers between levels during 2010.

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

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

Other Real Estate Owned — Other real estate owned includes properties acquired through foreclosure and other properties owned but no longer used for banking purposes. These properties are recorded at the lower of the recorded amount of the loan, or estimated fair value less estimated costs to sell based on periodic evaluations using Level 3 inputs. Valuation of the property occurs when it is foreclosed upon and annually thereafter. Write-downs

arising from the acquisition of property, in full or partial satisfaction of loans, are charged to the allowance for loan losses. Subsequent write-downs after acquisition, identified through management’s periodic valuations, are written down through non-interest expenses.

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

(dollars in thousands)

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

Skagit State Bancorp, Inc. 10-K