UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington D.C., 20549

FORM 10-Q

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

For the quarterly period ended March 31, 2011

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

For the transition period from to

Commission File Number 000-52096

SKAGIT STATE BANCORP, INC.

(Exact Name of Registrant as Specified in Its Charter)

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

301 East Fairhaven Avenue

Burlington, Washington 98233

(Address of Principal Executive Offices) (Zip Code)

(360) 755-0411

(Registrant’s Telephone Number, Including Area Code)

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

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

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

Large accelerated filer o		Accelerated filer o

Non-accelerated filer o		Smaller Reporting Company x

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

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

The number of shares of the issuer’s Common Stock outstanding at May 4th, 2011 was 588,346.

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SKAGIT STATE BANCORP, INC. AND SUBSIDIARY

TABLE OF CONTENTS

PART I.	FINANCIAL INFORMATION

	Item 1.	Financial Statements

		Consolidated Balance Sheet as of March 31, 2011 and December 31, 2010	Page 3

		Consolidated Statement of Income for the three months ended March 31, 2011 and 2010	Page 4

		Consolidated Statement of Changes in Stockholders’ Equity and Comprehensive Income for the three months ended March 31, 2011 and 2010	Page 5

		Consolidated Statement of Cash Flows for the three months ended March 31, 2011 and 2010	Page 6

		Notes to Consolidated Financial Statements	Pages 7-25

	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	Pages 25-36

	Item 3.	Quantitative and Qualitative Disclosures About Market Risk	Page 36

	Item 4.	Controls and Procedures	Page 36

PART II.	OTHER INFORMATION

	Item 1.	Legal Proceedings	Page 36

	Item 1 A.	Risk Factors	Page 36-40

	Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	Page 40

	Item 3.	Defaults Upon Senior Securities	Page 40

	Item 4.	Removed and Reserved	Page 40

	Item 5.	Other Information	Page 40

	Item 6.	Exhibits	Page 40

		Signatures	Page 41

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Item 1. Financial Statements

SKAGIT STATE BANCORP, INC. AND SUBSIDIARY

CONSOLIDATED BALANCE SHEET (Unaudited)

(dollars in thousands except share data)	March 31, 2011			December 31, 2010
ASSETS
ASSETS
Cash and due from banks	$	10,759		$	10,461
Federal funds sold	71,167			80,413
Investment securities
Available-for-sale, at fair value	214,516			180,971
Held-to-maturity, at amortized cost	38,308			38,367
Loans held for sale	—			78
Loans	358,968			365,319
Allowance for loan losses	(7,346		)	(7,079		)
Net loans	351,622			358,240
Bank premises and equipment, net	10,671			10,772
Other real estate owned	4,334			5,813
Accrued interest receivable	2,400			2,521
Other assets	5,349			5,235
TOTAL ASSETS	$	709,126		$	692,871

LIABILITIES AND STOCKHOLDERS’ EQUITY
LIABILITIES
Deposits
Interest-bearing	$	527,956		$	511,782
Non-interest-bearing	78,372			79,099
Total deposits	606,328			590,881
Other borrowings	34,464			34,118
Other liabilities	1,472			1,900
Total liabilities	642,264			626,899
COMMITMENTS AND CONTINGENCIES (Note 8)

STOCKHOLDERS’ EQUITY
Common stock no par value, 5,000,000 shares authorized, 587,639 and 587,377 shares issued and outstanding at March 31, 2011 and December 31, 2010 respectively	12,601			12,541
Accumulated other comprehensive income, net of tax	1,494			1,639
Retained earnings	52,767			51,792
Total stockholders’ equity	66,862			65,972
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY	$	709,126		$	692,871

See accompanying notes to these consolidated financial statements

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SKAGIT STATE BANCORP, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENT OF INCOME (Unaudited)

	Three months ended March 31,
(dollars in thousands except per share data)	2011		2010

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

See accompanying notes to these consolidated financial statements

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SKAGIT STATE BANCORP, INC. AND SUBSIDIARY

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

Three months ended March 31, 2011 and 2010

				Accum. Other					Total
	Common Stock			Comprehensive			Retained		Stockholders’			Comprehensive
(dollars in thousands except share and per share amounts)	Shares	Amount		Income			Earnings		Equity			Income
BALANCE, January 1, 2010	586,905	$	12,303	$	1,872		$	48,682	$	62,857
Comprehensive income:
Net income	—	—		—			1,209		1,209			$	1,209
Other comprehensive income:
Unrealized gains on available-for-sale securities, net of taxes of $284	—	—		552			—		552			552
Total other comprehensive income												552
Comprehensive income												$	1,761
Stock compensation expense and restricted stock awards	289	64		—			—		64
BALANCE, March 31, 2010	587,194	$	12,367	$	2,424		$	49,891	$	64,682

BALANCE, January 1, 2011	587,377	$	12,541	$	1,639		$	51,792	$	65,972
Comprehensive income:
Net income	—	—		—			975		975			$	975
Other comprehensive income:
Unrealized losses on available-for-sale securities, net of tax benefit of $75	—	—		(145		)	—		(145		)	(145		)
Total other comprehensive income												(145		)
Comprehensive income												$	830
Stock compensation expense and restricted stock awards	262	60		—			—		60
BALANCE, March 31, 2011	587,639	$	12,601	$	1,494		$	52,767	$	66,862

See accompanying notes to these consolidated financial statements

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SKAGIT STATE BANCORP, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENT OF CASH FLOWS (Unaudited)

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

See accompanying notes to these consolidated financial statements

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SKAGIT STATE BANCORP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

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

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

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

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

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

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

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

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

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

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

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

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

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

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Note 2: NEW ACCOUNTING PRONOUNCEMENTS

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

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

Note 3: EARNINGS PER SHARE

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

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

Note 4: STOCK-BASED COMPENSATION

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

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

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

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

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

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

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

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

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Note 5: INVESTMENT SECURITIES

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

March 31, 2011

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

December 31, 2010

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

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

March 31, 2011

	Less Than 12 Months				12 Months or Greater				Total
(dollars in thousands)	Fair Value		Unrealized Losses		Fair Value		Unrealized Losses		Fair Value		Unrealized Losses
Available-For-Sale Securities
U.S. government agencies	$	43,898	$	296	$	—	$	—	$	43,898	$	296
Residential mortgage-backed securities and collateralized mortgage obligations	28,477		824		—		—		28,477		824
State and political subdivisions	1,139		50		—		—		1,139		50
Total available-for-sale	73,514		1,170		—		—		73,514		1,170
Held-To-Maturity Securities
State and political subdivisions	5,476		63		—		—		5,476		63
Total held-to-maturity	5,476		63		—		—		5,476		63
Total investment securities	$	78,990	$	1,233	$	—	$	—	$	78,990	$	1,233

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December 31, 2010

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

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

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

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

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

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Note 6: LOANS

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

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

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

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

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

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

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

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

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

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

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

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

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

March 31, 2011

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

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December 31, 2010

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

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

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

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

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

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

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

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

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

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

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

The four risk ratings for consumer loans are as follows:

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

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

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

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

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

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

March 31, 2011

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

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

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December 31, 2010

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

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

Note 7: ALLOWANCE FOR LOAN LOSSES

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

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While Bancorp believes that it uses the best information available to determine the allowance for loan losses and that our processes adequately address the various components that could potentially result in credit losses, the processes and the various components include features that may be susceptible to significant change. There are numerous components that enter into the evaluation of the allowance for loan losses. Some are quantitative while others require Bancorp to make qualitative judgments. Unforeseen market conditions and unfavorable differences between the actual outcome of credit-related events and our estimates and projections could require an additional provision for credit losses, which would negatively impact Bancorp’s results of operations in future periods. Also, growth of the loan portfolio and a further decline in the performance of the economy, in general, or a further decline in real estate values in our market areas, in particular, could have an adverse impact on collectability, increase the level of non-performing loans or have other adverse effects which alone or in aggregate could have a material adverse effect on our business, financial condition, results of operation and cash flows which may require additional provisions to our allowance for loan losses. The ultimate recovery of loans is susceptible to future market factors beyond Bancorp’s control. Additionally, loans are subject to examinations 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. Generally, substandard or non-accrual loans are reviewed for impairment and are analyzed individually on a quarterly basis. Smaller balance loans, including commercial loans under the threshold or consumer and credit card loans, may be grouped with other loans in its product type and risk grade category for reserve purposes. In general, the specific allocation for a loan is equal to the impairment measured by ASC 310. If the loan is collateral dependent, a specific reserve is established when the value of the loan collateral is less than Bancorp’s recorded investment in the loan. If the loan is not collateral dependent, a specific allocation is established when the discounted cash flow is less than Bancorp’s recorded investment in the loan.

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

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

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

(dollars in thousands)

Allowance for loan losses:

March 31, 2011	Commercial		Commercial Real Estate			Other Real Estate			Real Estate Construction		Consumer			Unallocated		Total
Balance, beginning of year	$	1,494	$	2,564		$	1,400		$	67	$	855		$	699	$	7,079
Loans charged off	—		—			—			—		(92		)	—		(92		)
Recoveries	3		—			—			—		31			—		34
Provision (benefit)	659		(243		)	(125		)	23		10			1		325
Balance, end of period	$	2,156	$	2,321		$	1,275		$	90	$	804		$	700	$	7,346

Ending balance: individually evaluated for impairment	$	1,260	$	445		$	39		$	—	$	25		$	—	$	1,769
Ending balance: collectively evaluated for impairment	$	896	$	1,876		$	1,236		$	90	$	779		$	700	$	5,577

Loans Receivables:
Ending balance	$	65,202	$	102,966		$	146,870		$	4,346	$	40,276				$	359,660
Ending balance: individually evaluated for impairment	$	3,801	$	6,938		$	7,460		$	1,032	$	149				$	19,380
Ending balance: collectively evaluated for impairment	$	61,401	$	96,028		$	139,410		$	3,314	$	40,127				$	340,280

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

Note 8: COMMITMENTS

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

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

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

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

Note 9: INCOME TAXES

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

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

Note 10: FAIR VALUE MEASUREMENTS

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

Financial Instruments

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

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

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

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

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

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

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

	March 31, 2011				December 31, 2010
	Carrying				Carrying
(dollars in thousands)	Amount		Fair Value		Amount		Fair Value
Financial Assets
Cash and due from banks	$	10,759	$	10,759	$	10,461	$	10,461
Federal funds sold	71,167		71,167		80,413		80,413
Investment securities	252,824		253,653		219,338		219,833
Loans held for sale	—		—		78		78
Net loans	351,622		332,383		358,240		338,704
Accrued interest receivable	2,400		2,400		2,521		2,521

Financial Liabilities
Demand and savings deposits	396,087		396,087		375,541		375,541
Time deposits	210,241		211,535		215,340		216,736
Other borrowings	34,464		34,464		34,118		34,118
Accrued interest payable	215		215		234		234

Fair Value Hierarchy

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

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

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

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

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

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

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

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

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

(dollars in thousands)			Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Unobservable Inputs
Description	Total		(Level 1)		(Level 2)		(Level 3)
March 31, 2011

Available-for-sale securities
U.S. Treasury and government agencies	$	119,775	$	—	$	119,775	$	—
Residential mortgage-backed securities and collateralized mortgage obligations	85,752		—		85,752		—
State and political subdivisions	8,989		—		8,989		—
Total	$	214,516	$	—	$	214,516	$	—

December 31, 2010

Available-for-sale securities
U.S. Treasury and government agencies	$	85,775	$	—	$	85,775	$	—
Residential mortgage-backed securities and collateralized mortgage obligations	86,431		—		86,431		—
State and political subdivisions	8,765		—		8,765		—
Total	$	180,971	$	—	$	180,971	$	—

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

(dollars in thousands)

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

			Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Unobservable Inputs		Total Gains/(Losses) for the Twelve
Description	Total		(Level 1)		(Level 2)		(Level 3)		Months Ended

December 31, 2010
Impaired loans
Commercial	$	3,159	$	—	$	—	$	3,159	$	(1,065	)
Commercial real estate	5,353		—		—		5,353		578
Other real estate	7,331		—		—		7,331		(241		)
Real estate construction	969		—		—		969		(114		)
Consumer	153		—		—		153		(29		)
Other real estate owned	5,813		—		—		5,813		(473		)
Total	$	22,778	$	—	$	—	$	22,778	$	(1,344	)

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

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

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

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

FORWARD LOOKING STATEMENTS

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

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

· increased loan delinquency rates;

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

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

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

· reduced demand for banking products and services;

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

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

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

BUSINESS

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

RESULTS OF OPERATIONS

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

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

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

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

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

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

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

Condensed Average Balance Sheets

(dollars in thousands except share data)

	2011						2010
Three months ended March 31,	Average Balance		Interest		Yield /Cost		Average Balance		Interest		Yield /Cost
Assets
Federal funds sold	$	82,491	$	52	0.26	%	$	78,298	$	49	0.25	%
Taxable investment securities	183,916		1,108		2.44		104,867		1,018		3.94
Tax exempt securities	46,960		257		2.22		49,614		274		2.24
Loans	352,932		4,905		5.64		384,601		5,640		5.95
Total interest-earning assets	666,299		6,322		3.85	%	617,380		6,981		4.59	%
Non-interest earning assets	32,748						35,957
Total assets	$	699,047					$	653,337

Liabilities and Stockholders’ Equity
Interest-bearing demand	$	108,782	$	125	0.47	%	$	101,409	$	84	0.34	%
Savings and money market	197,296		297		0.61		167,364		355		0.86
Certificates of deposit	215,606		758		1.43		210,840		1,081		2.08
Total interest-bearing deposits	521,684		1,180		0.92		479,613		1,520		1.29
Other borrowings	34,655		74		0.87		37,465		82		0.89
Total interest-bearing deposits & liabilities	556,339		1,254		0.91	%	517,078		1,602		1.26	%
Non interest-bearing demand deposits	75,242						71,007
Other non-interest-bearing liabilities	1,331						1,510
Total liabilities	632,912						589,595
Stockholders’ equity	66,135						63,742
Total liabilities and stockholders equity	$	699,047					$	653,337
Net interest income			$	5,068					$	5,379
Interest rate spread					2.93	%					3.33	%
Net interest margin					3.08	%					3.53	%

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

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

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

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

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

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

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

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

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

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REVIEW OF FINANCIAL CONDITION

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

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

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

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

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

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

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

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

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

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

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

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

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

Loan Composition

(dollars in thousands)	March 31, 2011		December 31, 2010
Commercial	$	65,202	$	69,177
Commercial real estate
Raw land and land development	37,884		37,233
Other commercial real estate	65,082		65,516
Other real estate
Residential	33,218		34,681
Farmland and owner occupied nonfarm nonresidential	113,652		115,291
Real estate construction
Commercial	892

Skagit State Bancorp, Inc. 10-Q