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, 2012

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 x 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 2nd, 2012 was 580,301.

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SKAGIT STATE BANCORP, INC. AND SUBSIDIARY

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PART I.	FINANCIAL INFORMATION

	Item 1.	Financial Statements

		Consolidated Balance Sheet as of March 31, 2012 and December 31, 2011	Page 3

		Consolidated Statement of Income for the three months ended March 31, 2012 and 2011	Page 4

		Consolidated Statement of Comprehensive Income for the three months ended March 31, 2012 and 2011	Page 5

		Consolidated Statement of Changes in Stockholders’ Equity for the three months ended March 31, 2012 and 2011	Page 6

		Consolidated Statement of Cash Flows for the three months ended March 31, 2012 and 2011	Page 7

		Notes to Consolidated Financial Statements	Pages 8-28

	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	Pages 28-39

	Item 3.	Quantitative and Qualitative Disclosures About Market Risk	Page 39

	Item 4.	Controls and Procedures	Page 39

PART II.	OTHER INFORMATION

	Item 1.	Legal Proceedings	Page 39

	Item 1 A.	Risk Factors	Page 39-43

	Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	Page 43

	Item 3.	Defaults Upon Senior Securities	Page 43

	Item 4.	Mine Safety Disclosures	Page 43

	Item 5.	Other Information	Page 43

	Item 6.	Exhibits	Page 43

		Signatures	Pages 44-47

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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, 2012			December 31, 2011
ASSETS
ASSETS
Cash and due from banks	$	16,040		$	11,119
Federal funds sold	55,783			41,895
Investment securities
Available-for-sale, at fair value	273,284			265,388
Held-to-maturity, at amortized cost	33,766			34,662
Loans held for sale	317			521
Loans	349,357			353,769
Allowance for loan losses	(5,356		)	(5,183		)
Net loans	344,001			348,586
Bank premises and equipment, net	11,033			11,036
Other real estate owned	3,576			4,397
Accrued interest receivable	2,585			2,638
Other assets	3,728			3,147
TOTAL ASSETS	$	744,113		$	723,389
LIABILITIES AND STOCKHOLDERS’ EQUITY
LIABILITIES
Deposits
Interest-bearing	$	546,683		$	528,989
Non-interest-bearing	94,843			91,303
Total deposits	641,526			620,292
Other borrowings	30,178			31,334
Other liabilities	1,015			1,339
Total liabilities	672,719			652,965
COMMITMENTS AND CONTINGENCIES (Note 8)

STOCKHOLDERS’ EQUITY
Common stock no par value, 5,000,000 shares authorized, 580,054 and 581,529 shares issued and outstanding at March 31, 2012 and December 31, 2011, respectively	12,642			12,644
Accumulated other comprehensive income, net of tax	3,408			3,769
Retained earnings	55,344			54,011
Total stockholders’ equity	71,394			70,424
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY	$	744,113		$	723,389

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)	2012		2011

INTEREST INCOME
Interest and fees on loans	$	4,727	$	4,905
Investment securities
Taxable	1,313		1,108
Exempt from federal income tax	241		257
Federal funds sold	32		52
Total interest income	6,313		6,322
INTEREST EXPENSE
Deposits	774		1,180
Other borrowings	50		74
Total interest expense	824		1,254
NET INTEREST INCOME	5,489		5,068
Provision for loan losses	300		325
NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES	5,189		4,743
NON-INTEREST INCOME
Service charges on deposits	828		787
Other	217		175
Gains on sale of assets and loans	119		78
Total non-interest income	1,164		1,040
NON-INTEREST EXPENSES
Compensation and employee benefits	2,435		2,335
Provision for other real estate owned losses	2		213
Occupancy and equipment	377		369
Data processing	439		431
B&O tax expense	97		107
Consulting and professional fees	99		74
Loan collection and OREO expenses	96		135
Advertising	208		220
Deposit Insurance	160		246
Other	449		462
Total non-interest expenses	4,362		4,592
INCOME BEFORE PROVISION FOR INCOME TAX	1,991		1,191
PROVISION FOR INCOME TAX
Current	445		216
Total provision for income tax	445		216
NET INCOME	$	1,546	$	975
BASIC EARNINGS PER SHARE	$	2.66	$	1.66
DILUTED EARNINGS PER SHARE	$	2.66	$	1.66

See accompanying notes to these consolidated financial statements

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SKAGIT STATE BANCORP, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME (Unaudited)

	Three months ended March 31,
(dollars in thousands except per share data)	2012			2011

Net Income	$	1,546		$	975
Other comprehensive loss, net of tax:
Unrealized loss on available-for-sale securities:
Unrealized holding loss arising during period	(546		)	(220		)
Income tax benefit related to unrealized loss	185			75
Net unrealized loss during period	(361		)	(145		)
Other comprehensive loss, net of tax	(361		)	(145		)
COMPREHENSIVE INCOME	$	1,185		$	830

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 (Unaudited)

Three months ended March 31, 2012 and 2011

						Accum. Other						Total
	Common Stock					Comprehensive			Retained			Stockholders’
(dollars in thousands except share and per share amounts)	Shares		Amount			Income			Earnings			Equity
BALANCE, January 1, 2011	587,377		$	12,541		$	1,639		$	51,792		$	65,972
Net income	—		—			—			975			975
Other comprehensive income (loss)	—		—			(145		)	—			(145		)
Stock compensation expense and restricted stock awards	262		60			—			—			60
BALANCE, March 31, 2011	587,639		$	12,601		$	1,494		$	52,767		$	66,862

BALANCE, January 1, 2012	581,529		$	12,644		$	3,769		$	54,011		$	70,424
Net income	—		—			—			1,546			1,546
Other comprehensive income (loss)	—		—			(361		)	—			(361		)
Common stock redemption	(1,722	)	(37		)	—			(213		)	(250		)
Stock compensation expense and restricted stock awards	247		35			—			—			35
BALANCE, March 31, 2012	580,054		$	12,642		$	3,408		$	55,344		$	71,394

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,	2012			2011
CASH FLOWS FROM OPERATING ACTIVITIES
Net income	$	1,546		$	975
Adjustments to reconcile net income to net cash flows from operating activities
Provision for loan losses	300			325
Provision for other real estate owned losses	2			213
Depreciation	145			156
Gains on sale of other real estate owned	(53		)	(18		)
Gains on loans held for sale	(66		)	(60		)
Amortization of investment security premiums and discounts, net	236			91
Stock compensation for employee services	35			60
Changes in operating assets and liabilities
Origination of loans held for sale	(2,714		)	(2,256		)
Proceeds from sale of loans held for sale	2,984			2,394
(Increase) decrease in interest receivable	53			121
Decrease (increase) in other assets	(396		)	(39		)
(Decrease) increase in other liabilities	(324		)	(428		)
Net cash flows from operating activities	1,748			1,534
CASH FLOWS FROM INVESTING ACTIVITIES
Proceeds from maturities, calls, and principal payments of investment securities — available-for-sale	27,059			13,417
Purchases of investment securities — available-for-sale	(35,737		)	(47,274		)
Proceeds from maturities, calls, and principal payments of investment securities — held-to-maturity	1,504			61
Purchases of investment securities — held-to-maturity	(608		)	—
Net (increase) decrease in federal funds sold	(13,888		)	9,246
Net decrease in loans	3,985			7,576
Purchase of premises and equipment	(142		)	(55		)
Proceeds from sale of other real estate owned	1,172			—
Net cash flows from investing activities	(16,655		)	(17,029		)
CASH FLOWS FROM FINANCING ACTIVITIES
Net increase in demand deposits, money market, NOW and savings accounts	24,781			20,546
Net increase (decrease) in time deposits	(3,547		)	(5,099		)
Amount paid for redemption of common stock	(250		)	—
Net increase (decrease) in other borrowings	(1,156		)	346
Net cash flows from financing activities	19,828			15,793
NET CHANGE IN CASH AND DUE FROM BANKS	4,921			298
CASH AND DUE FROM BANKS, beginning of period	11,119			10,461
CASH AND DUE FROM BANKS, end of period	$	16,040		$	10,759
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash paid during the period for income taxes	$	—		$	—
Cash paid during the period for interest	$	819		$	1,273
NONCASH FINANCING AND INVESTING TRANSACTIONS
Property taken in settlement of loans	$	300		$	126
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, 2012 are not necessarily indicative of the results anticipated for the year ending December 31, 2012. For additional information, refer to the audited financial statements and footnotes for the most recent annual period ended December 31, 2011 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, assumptions and economic assumptions, that may prove inaccurate or are subject to variation, which 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, 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, 2011.

Reclassifications: Certain reclassifications have been made to the 2011 financial statements to conform to the 2012 presentation. Such classifications have no effect on reported amounts of financial condition, earnings, cash flow, or 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 the sale of mortgage loans are recognized as 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, 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 are generally 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, when management determines that circumstances have improved and there has been a sustained period of repayment performance by the borrower.

Troubled Debt Restructures: Troubled debt restructures are loans on which, due to the borrower’s financial difficulties, Bancorp has granted a concession 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.

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, Bancorp utilizes a comprehensive loan grading system to determine the risk potential in the portfolio and also considers 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 an 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 the 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 June 2011, the FASB issued ASU 2011-05 which amends Comprehensive Income (Topic 220). The amendments require that all non-owner changes in stockholders’ equity be presented in either a single continuous statement of comprehensive income or in two separate but consecutive statements. The objective is to improve the comparability, consistency and transparency of financial reporting, and to increase the prominence of items reported in other comprehensive income. These amendments are to be applied retrospectively and are effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. Disclosures required by ASU 2011-02 are included in Consolidated Statement of Comprehensive Income. The adoption of the disclosure requirements had no material impact on Bancorp’s consolidated financial position, results of operations, and earnings per share.

ASU 2011-04, “Fair Value Measurement (Topic 820) - Amendments to Achieve Common Fair Value Measurements and Disclosure Requirements in U.S. GAAP and IFRSs.” ASU 2011-04 amends Topic 820, “Fair Value Measurements and Disclosures,” to converge the fair value measurement guidance in U.S. generally accepted accounting principles and International Financial Reporting Standards. ASU 2011-04 clarifies the application of existing fair value measurement requirements, changes certain principles in Topic 820 and requires additional fair value disclosures. ASU 2011-04 was effective for annual periods beginning after December 15, 2011. The adoption of this amendment had no material impact on Bancorp’s consolidated financial position, results of operations, and earnings per share.

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)	2012		2011
Numerator:
Net income	$	1,546	$	975
Denominator:
Denominator for basic earnings per share - Weighted average shares outstanding	581,026		587,496
Effect of dilutive securities:
Stock options and unvested restricted stock grants	380		850
Denominator for diluted earning per share - Weighted average shares outstanding	581,406		588,346
Basic earnings per share	$	2.66	$	1.66
Diluted earnings per share	$	2.66	$	1.66

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. As of March 31, 2012 there were 72,707 common shares available for grant. Total equity compensation expense was $35,000 for the three months ended March 31, 2012 and $60,000 for the like period in 2011.

Stock Options: No options were awarded for the three months ended March 31, 2012 or the twelve months ended December 31, 2011. The unrecognized share-based compensation cost relating to stock option expense at March 31, 2012 was $144,000, 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, 2012. 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, 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, 2012	24,917	$	179.58	6.01	$	—
Granted	—
Exercised	—
Forfeited	—
Outstanding at March 31, 2012	24,917	$	179.58	5.76	$	—
Exercisable at March 31, 2012	20,073	$	176.14	5.53	$	—

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, 2012 was $41,000, 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, 2012 or for the twelve months ended December 31, 2011. The total intrinsic value of stock awards exercised and vested during the three months ended March 31, 2012 was $36,000.

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 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, 2012.

(dollars in thousands except share and per share amounts)	Shares	Weighted Average Remaining Contractual Terms (in years)	Aggregate Intrinsic Value
Outstanding at January 1, 2012	494	1.14	$	73
Granted	—
Vested	247		36
Forfeited	—
Outstanding at March 31, 2012	247	0.89	$	36

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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, 2012

	Amortized		Gross Unrealized				Estimated
(dollars in thousands)	Cost		Gains		Losses		Fair Value
Available-For-Sale Securities
U.S. government agencies	$	120,756	$	1,192	$	28	$	121,920
Residential mortgage-backed securities and collateralized mortgage obligations	132,533		3,756		143		136,146
State and political subdivisions	14,830		432		44		15,218
Total available-for-sale	268,119		5,380		215		273,284
Held-To-Maturity Securities
State and political subdivisions	33,766		2,018		—		35,784
Total held-to-maturity	33,766		2,018		—		35,784
Total investment securities	$	301,885	$	7,398	$	215	$	309,068

December 31, 2011

	Amortized		Gross Unrealized				Estimated
(dollars in thousands)	Cost		Gains		Losses		Fair Value
Available-For-Sale Securities
U.S. government agencies	$	128,231	$	1,428	$	20	$	129,639
Residential mortgage-backed securities and collateralized mortgage obligations	120,578		3,875		34		124,419
State and political subdivisions	10,869		466		5		11,330
Total available-for-sale	259,678		5,769		59		265,388
Held-To-Maturity Securities
State and political subdivisions	34,662		1,576		0		36,238
Total held-to-maturity	34,662		1,576		0		36,238
Total investment securities	$	294,340	$	7,345	$	59	$	301,626

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, 2012

	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	$	6,970	$	27	$	3,002	$	1	$	9,972	$	28
Residential mortgage-backed securities and collateralized mortgage obligations	29,717		143		—		—		29,717		143
State and political subdivisions	2,441		44		—		—		2,441		44
Total available-for-sale	39,128		214		3,002		1		42,130		215
Held-To-Maturity Securities
State and political subdivisions	—		—		—		—		—		—
Total held-to-maturity	—		—		—		—		—		—
Total investment securities	$	39,128	$	214	$	3,002	$	1	$	42,130	$	215

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December 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	$	8,005	$	20	$	—	$	—	$	8,005	$	20
Residential mortgage-backed securities and collateralized mortgage obligations	7,815		34		—		—		7,815		34
State and political subdivisions	374		5		—		—		374		5
Total available-for-sale	16,194		59		—		—		16,194		59
Held-To-Maturity Securities
State and political subdivisions	—		—		—		—		—		—
Total held-to-maturity	—		—		—		—		—		—
Total investment securities	$	16,194	$	59	$	—	$	—	$	16,194	$	59

At March 31, 2012, Bancorp held one security 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 twenty securities in an unrealized loss position for less than twelve months as of March 31, 2012.

Available-for-sale investment securities with a carrying value of $106.6 million and $116.9 million as of March 31, 2012 and December 31, 2011, were pledged as collateral for public fund deposits, securities sold under agreement to repurchase and Federal Reserve Bank discount window borrowings. There were no sales of securities for the three months ended March 31, 2012 and March 31, 2011.

The amortized cost and estimated fair value of investment securities at March 31, 2012, 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.

	2012
	Available-For-Sale				Held-To-Maturity
	Amortized		Estimated		Amortized		Estimated
(dollars in thousands)	Cost		Fair Value		Cost		Fair Value
0-1 year	$	36,780	$	36,987	$	6,422	$	6,448
1-5 years	78,364		79,554		9,656		10,057
5-10 years	7,368		7,451		12,742		13,501
Over 10 years	13,074		13,146		4,946		5,778
Residential mortgage-backed securities and collateralized mortgage obligations	132,533		136,146		—		—
Total investment securities	$	268,119	$	273,284	$	33,766	$	35,784

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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, 2012			December 31, 2011
Commercial	$	61,875		$	65,408
Commercial real estate
Raw land and land development	37,559			36,332
Other commercial real estate	64,692			62,363
Other real estate
Residential	34,286			34,066
Farmland and owner occupied nonfarm nonresidential	107,385			111,484
Real estate construction
Commercial	—			1,456
Residential	6,565			5,242
Consumer
Home equity	21,489			22,070
Credit cards and other consumer	15,942			15,803
	349,793			354,224
Less deferred loan fees	(436		)	(455		)
Total Loans	$	349,357		$	353,769

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 of the length of time the term loan is outstanding, this 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 to 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, 2012 and December 31, 2011, $150.0 million and $154.3 million of loans outstanding were variable rate loans, respectively. Loans participations sold to others totaled $2.1 million and $2.3 million as of March 31, 2012 and December 31, 2011, respectively. Bancorp does originate loans intended for sale which are carried at the lower of aggregate cost or fair value. As of March 31, 2012 and December 31, 2011, Bancorp held $317,000 and $521,000 as loans held-for-sale. There were no sales of loans, other than 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.

Troubled Debt Restructures (TDR): Troubled debt restructures are loans on which, due to the borrower’s financial difficulties, Bancorp has granted a concession 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 if the restructured loan qualifies for accrual status. At March 31, 2012 there was $10.8 million in troubled debt restructures with $478,000 in commitments to lend additional funds to borrowers whose terms have been modified in a troubled debt restructuring.

The following table presents troubled debt restructurings that occurred during the three months ended March 31, 2012.

(dollars in thousands)

Troubled Debt Restructurings

	Number			Increases (decreases)		Charge-offs
	of	Recorded		in the Allowance		to the Allowance
	Contracts	Investment		for Loan Losses		for Loan Losses
Commercial real estate
Raw land and land development	4	$	1,240	$	—	$	—
Other real estate
Residential	3	821		—		—
Total	7	$	2,061	$	—	$	—

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The recorded investment in the table above are period end balances that are inclusive of all partial pay-downs and charge-offs since the modification date. Loans modified in a TDR that were fully paid down, charged-off, or foreclosed upon by period end are not reported.

All TDR’s in the table above were the result of interest deferral, restructure of payments and extension of maturity. Bancorp has not forgiven any principal on the above loans. Loans modified in a TDR are typically already on a non-accrual status and partial charge-offs have in some cases already been taken against the outstanding loan balance. As a result, loans modified in a TDR for Bancorp may have the financial effect of increasing the specific allowance associated with the loan.

Bancorp had two loans modified in a TDR within the previous 12 months that subsequently defaulted and were taken into other real estate owned. A subsequent default of a TDR is defined as a TDR that is 60 days or more past due at any time subsequent to the modification.

The following table is an aging analysis of past due loans as of March 31, 2012 and December 31, 2011:

March 31, 2012

(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	$	18	$	—	$	—	$	18	$	254	$	61,603	$	61,875
Commercial real estate
Raw land and land development	—		—		—		—		6,968		30,591		37,559
Other commercial real estate	362		—		—		362		6		64,324		64,692
Other real estate
Residential	—		—		—		—		1,908		32,378		34,286
Farmland and owner occupied nonfarm nonresidential	122		—		—		122		6,380		100,883		107,385
Real estate construction
Commercial	—		—		—		—		—		—		—
Residential	—		—		—		—		798		5,767		6,565
Consumer
Home equity	—		—		—		—		34		21,455		21,489
Credit cards and other consumer	151		44		—		195		26		15,721		15,942
Total	$	653	$	44	$	—	$	697	$	16,374	$	332,722	$	349,793

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December 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	$	38	$	—	$	—	$	38	$	267	$	65,103	$	65,408
Commercial real estate
Raw land and land development	—		—		—		—		7,179		29,153		36,332
Other commercial real estate	—		—		—		—		10		62,353		62,363
Other real estate
Residential	79		34		—		113		1,600		32,353		34,066
Farmland and owner occupied nonfarm nonresidential	—		—		—		—		6,649		104,835		111,484
Real estate construction
Commercial	—		—		—		—		—		1,456		1,456
Residential	—		—		—		—		658		4,584		5,242
Consumer
Home equity	—		—		—		—		88		21,982		22,070
Credit cards and other consumer	147		33		—		180		30		15,593		15,803
Total	$	264	$	67	$	—	$	331	$	16,481	$	337,412	$	354,224

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

	March 31, 2012
(dollars in thousands)	Unpaid Principal Balance		Recorded Investment with No Related Allowance		Recorded Investment with Related Allowance		Related Allowance		Total Recorded Investment
Commercial	$	934	$	886	$	—	$	—	$	886
Raw land and land development	8,877		5,477		1,953		234		7,430
Other commercial real estate	368		368		—		—		368
Residential	2,471		2,291		—		—		2,291
Farmland and owner occupied nonfarm nonresidential	6,629		6,592		37		37		6,629
Construction-commercial	—		—		—		—		—
Construction-residential	798		798		—		—		798
Consumer-home equity	99		34		52		20		86
Credit cards and other consumer	42		26		—		—		26
Total	$	20,218	$	16,472	$	2,042	$	291	$	18,514

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	December 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	$	943	$	725	$	170	$	40	$	895
Raw land and land development	9,086		6,850		788		75		7,638
Other commercial real estate	374		11		363		20		374
Residential	2,092		1,984		—		—		1,984
Farmland and owner occupied nonfarm nonresidential	6,935		6,935		—		—		6,935
Construction-commercial	—		—		—		—		—
Construction-residential	658		658		—		—		658
Consumer-home equity	101		34		54		20		88
Credit cards and other consumer	45		30		—		—		30
Total	$	20,234	$	17,227	$	1,375	$	155	$	18,602

	March 31, 2012				December 31, 2011
(dollars in thousands)	Average Recorded Investment		Interest Income Recognized		Average Recorded Investment		Interest Income Recognized
Commercial	$	891	$	11	$	1,796	$	8
Raw land and land development	7,535		9		6,468		35
Other commercial real estate	371		8		893		17
Residential	2,138		6		1,404		4
Farmland and owner occupied nonfarm nonresidential	6,782		5		6,553		7
Construction-commercial	—		—		—		—
Construction-residential	728		—		738		0
Consumer-home equity	87		—		128		—
Credit cards and other consumer	28		—		43		—
Total	$	18,560	$	39	$	18,023	$	71

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 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 in which 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 to be 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, 2012

			Commercial Credit Indicator
(dollars in thousands)	Pass		Watch		Special Mention		Substandard		Non-Rated		Total
Commercial	$	54,592	$	2,802	$	2,481	$	2,000	$	—	$	61,875
Commercial real estate
Raw land and land development	26,874		0		559		9,232		42		36,707
Other commercial real estate	59,507		0		847		4,323		15		64,692
Other real estate
Residential	16,700		402		853		2,291		446		20,692
Farmland and owner occupied nonfarm nonresidential	91,385		2,436		2,578		10,738		28		107,165
Real estate construction
Commercial	—		—		—		—		—		—
Residential	916		—		—		798		—		1,714
Consumer
Home equity	1,095		—		499		138		—		1,732
Credit cards and other consumer	—		—		—		26		—		26
Total	$	251,069	$	5,640	$	7,817	$	29,546	$	531	$	294,603

			Consumer Credit Indicator
	A		B		C		D		Non-Rated		Total
Commercial	$	—	$	—	$	—	$	—	$	—	$	—
Commercial real estate
Raw land and land development	474		315		63		—		—		852
Other commercial real estate	—		—		—		—		—		—
Other real estate
Residential	9,229		2,837		989		539		—		13,594
Farmland and owner occupied nonfarm nonresidential	220		—		—		—		—		220
Real estate construction
Commercial	—		—		—		—		—		—
Residential	3,567		520		4		760		—		4,851
Consumer
Home equity	14,021		3,305		1,528		826		77		19,757
Credit cards and other consumer	7,612		1,557		535		509		5,703		15,916
Total	$	35,123	$	8,534	$	3,119	$	2,634	$	5,780	$	55,190

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December 31, 2011

			Commercial Credit Indicator
(dollars in thousands)	Pass		Watch		Special Mention		Substandard		Non-Rated		Total
Commercial	$	57,590	$	3,536	$	2,155	$	2,127	$	—	$	65,408
Commercial real estate
Raw land and land development	25,351		0		562		9,508		42		35,463
Other commercial real estate	57,470		50		492		4,336		15		62,363
Other real estate
Residential	17,215		607		864		1,600		463		20,749
Farmland and owner occupied nonfarm nonresidential	94,520		2,935		2,753		10,909		127		111,244
Real estate construction
Commercial	1,456		—		—		—		—		1,456
Residential	562		—		—		658		—		1,220
Consumer
Home equity	1,106		—		499		88		—		1,693
Credit cards and other consumer	—		—		—		30		—		30
Total	$	255,270	$	7,128	$	7,325	$	29,256	$	647	$	299,626

			Consumer Credit Indicator
	A		B		C		D		Non-Rated		Total
Commercial	$	—	$	—	$	—	$	—	$	—	$	—
Commercial real estate
Raw land and land development	487		317		65		—		—		869
Other commercial real estate	—		—		—		—		—		—
Other real estate
Residential	8,600		3,004		818		895		—		13,317
Farmland and owner occupied nonfarm nonresidential	240		—		—		—		—		240
Real estate construction
Commercial	—		—		—		—		—		—
Residential	2,795		467		—		760		—		4,022
Consumer
Home equity	14,380		3,415		1,650		861		71		20,377
Credit cards and other consumer	7,241		1,582		616		540		5,794		15,773
Total	$	33,743	$	8,785	$	3,149	$	3,056	$	5,865	$	54,598

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. In analyzing the adequacy of the allowance for loan losses, we utilize a comprehensive loan grading system to determine the risk potential in the portfolio and also consider the results of independent third party credit reviews. Bancorp’s process is designed to account for credit deterioration as it occurs. The allowance is based upon Bancorp’s evaluation of the pertinent factors underlying the quality and composition of the loan portfolio, levels and trends in losses and delinquencies, current economic conditions, specific industry conditions and estimated value of any underlying collateral. These evaluations are inherently subjective and it requires management to make numerous assumptions, estimates and judgments that are susceptible to significant revision as more information becomes available.

While Bancorp believes that it uses the best information available to determine the allowance for loan losses and that our processes adequately address the various components that could potentially result in credit losses, the processes and 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

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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 identified. 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 allowance 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 the dates indicated:

(dollars in thousands)

Allowance for loan losses:

	Three months ended March 31, 2012
	Commercial			Commercial Real Estate		Other Real Estate			Real Estate Construction		Consumer			Unallocated		Total
Balance, beginning of year	$	1,204		$	1,586	$	1,115		$	97	$	670		$	511	$	5,183
Loans charged off	(1		)	—		(133		)	—		(62		)	—		(196		)
Recoveries	11			—		33			—		25			—		69
Provision (benefit)	(108		)	151		110			3		(33		)	177		300
Balance, end of period	$	1,106		$	1,737	$	1,125		$	100	$	600		$	688	$	5,356

Ending balance: individually evaluated for impairment	$	—		$	234	$	37		$	—	$	20		$	—	$	291
Ending balance: collectively evaluated for impairment	$	1,106		$	1,503	$	1,088		$	100	$	580		$	688	$	5,065

Loans Receivables:
Ending balance	$	61,875		$	102,251	$	141,671		$	6,565	$	37,431				$	349,793
Ending balance: individually evaluated for impairment	$	886		$	7,798	$	8,920		$	798	$	112				$	18,514
Ending balance: collectively evaluated for impairment	$	60,989		$	94,453	$	132,751		$	5,767	$	37,319				$	331,279

(dollars in thousands)

Allowance for loan losses:

	Three months ended 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 with deteriorated credit quality	$	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

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Note 8: COMMITMENTS AND CONTINGENCIES

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, 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 2012 or 2011.

The following is a summary of the off-balance-sheet financial instruments or contracts outstanding as of March 31, 2012: (dollars in thousands)

Unfunded commitments to extend credit	$	67,067
Credit card arrangements	$	11,523
Commitments to fund municipal warrants	$	3,850
Standby letters of credit	$	2,022

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 nontaxable income generated from tax-exempt municipal bonds and warrants. For the three months ended March 31, 2012, Bancorp had $241,000 in tax-exempt income. In addition, Bancorp had $18.6 million in Qualified Zone Academy Bonds as of March 31, 2012. 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.

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Fair Value Hierarchy

ASC 820 defines fair value and establishes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). The three levels of the fair value hierarchy are described below:

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 judgment or estimates 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.

Financial Instruments

Cash and 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 due to their short maturity period.

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 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 2012 and 2011 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.

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.

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

	March 31, 2012				December 31, 2011
	Carrying				Carrying
(dollars in thousands)	Amount		Fair Value		Amount		Fair Value
Financial Assets
Cash and due from banks (Level 1)	$	16,040	$	16,040	$	11,119	$	11,119
Federal funds sold (Level 1)	55,783		55,783		41,895		41,895
Investment securities (Level 2)	307,050		309,068		300,050		301,626
Loans held for sale (Level 2)	317		317		521		521
Net loans (Level 3)	344,001		326,529		348,586		331,484
Accrued interest receivable (Level 2)	2,585		2,585		2,638		2,638
Financial Liabilities
Demand and savings deposits (Level 2)	446,073		446,073		421,292		421,292
Time deposits (Level 3)	195,453		196,226		199,000		199,956
Other borrowings (Level 2)	30,178		30,178		31,334		31,334
Accrued interest payable (Level 2)	161		161		156		156

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.

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 include considerable observable data that may include dealer quotes, market spreads, cash flows, the treasury yield curve, yield/spread relationships, consensus prepayment rates, and the bonds terms and conditions, among other things.

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

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

There were no transfers between levels during 2012. The following table shows assets measured at fair value on a recurring basis as of the dates indicated.

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(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, 2012
Available-for-sale securities
U.S. Treasury and government agencies	$	121,920	$	—	$	121,920	$	—
Residential mortgage-backed securities and collateralized mortgage obligations	136,146		—		136,146		—
State and political subdivisions	15,218		—		15,218		—
Total	$	273,284	$	—	$	273,284	$	—

December 31, 2011
Available-for-sale securities
U.S. Treasury and government agencies	$	129,639	$	—	$	129,639	$	—
Residential mortgage-backed securities and collateralized mortgage obligations	124,419		—		124,419		—
State and political subdivisions	11,330		—		11,330		—
Total	$	265,388	$	—	$	265,388	$	—

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, 2012
Impaired loans
Commercial	$	886	$	—	$	—	$	886	$	40
Commercial real estate	7,564		—		—		7,564		(139		)
Other real estate	8,883		—		—		8,883		(121		)
Real estate construction	798		—		—		798		—
Consumer	92		—		—		92		—
Other real estate owned	3,576		—		—		3,576		(2		)
Total	$	21,799	$	—	$	—	$	21,799	$	(222	)

			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, 2011
Impaired loans
Commercial	$	855	$	—	$	—	$	855	$	40
Commercial real estate	7,917		—		—		7,917		(1,387		)
Other real estate	8,919		—		—		8,919		(96		)
Real estate construction	658		—		—		658		—
Consumer	98		—		—		98		(6		)
Other real estate owned	4,397		—		—		4,397		(816		)
Total	$	22,844	$	—	$	—	$	22,844	$	(2,265	)

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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.

Note 11: SUBSEQUENT EVENT

The JOBS Act was enacted on April 5, 2012, which, among other things, increased the threshold requiring SEC registration with the SEC for issuers with less than 2,000 shareholders and provided that bank holding companies could deregister its shares and therefore, be exempt from the reporting requirements if it had less than 1,200 shareholders, and met certain other criteria. Bancorp currently has 776 shareholders, satisfies the other criteria to qualify for deregistration, and as a result, Bancorp is reviewing its options and may file a Form 15 to deregister its shares from registration with the SEC. Such deregistration would become effective 90 days from filing the Form 15.

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, 2011 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:

· the risks associated with lending and potential adverse changes in the credit quality of loans in our portfolio, including results 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.

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RESULTS OF OPERATIONS

Net income was $1.5 million and $975,000 for the quarters ended March 31, 2012 and 2011, respectively, with diluted earnings per share at $2.66 and $1.66, respectively. Annualized return on average assets was 0.85 percent for the quarter ended March 31, 2012, compared to 0.57 percent during the same time period in 2011. Annualized return on average equity was 8.73 percent for the quarter ended March 31, 2012 compared to 5.98 percent for the same time period in 2011.

The increase in net income for the quarter ended March 31, 2012 compared to the like quarter in 2011 was primarily due to a $421,000 increase in net interest income from $5.1 million to $5.5 million, an $124,000 increase in non-interest income from $1.0 million to $1.2 million, a $211,000 decrease in the provision for other real estate owned losses from $213,000 to $2,000, and an $86,000 decrease in deposit insurance from $246,000 to $160,000, respectively.

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. Bancorp’s non-interest expenses consist primarily of salaries and employee benefits expenses, 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 was $5.5 million for the quarter ended March 31, 2012 compared to $5.1 million for the like period in 2011. The net interest margin is net interest income expressed as a percent of average interest-earning assets. For the quarter ended March 31, 2012, the net interest margin increased to 3.17 percent compared to 3.08 percent for the like period in 2011. The increase for the quarter ended March 31, 2012 compared to the like period in 2011 was primarily a result of 32 basis point decrease in the cost of funds.

Interest-earning assets: The largest component of interest income is interest earned on loans. Total loan interest income decreased by $178,000 to $4.7 million for three months ended March 31, 2012 compared to $4.9 million for the three months ended March 31, 2011. This decrease was the result of a $7.7 million decrease in average loan balances and a decrease in loan yield from 5.64 to 5.51 for 2011 and 2012, respectively.

Interest earned on investments and federal funds sold were $1.6 million for the quarter ended March 31, 2012 compared to $1.4 million for the quarter ended March 31, 2011. This increase was primarily the result of a $69.7 million increase in average investment balances from 2011 to 2012, which was partially offset by a decrease in yield from 2.40 for 2011 to 2.08 for 2012.

Interest-bearing liabilities: Interest expense decreased $430,000 to $824,000 for the three months ended March 31, 2012 compared to $1.3 million for the three months ended March 31, 2011. This decrease was primarily the result of a 47 basis point decrease in the cost of funds for time deposits for the quarter ended March 31, 2012 compared to the like period in 2011. This decrease was partially offset by a $9.8 million increase in average interest-bearing deposit balances for the quarter.

The following table presents information regarding average balances of assets and liabilities as well as the total amount 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 $108,000 for the quarter ended March 31, 2012, and $143,000 for the quarter ended March 31, 2011 are included in interest earned on loans. Non-accruing loans have been included in the computation of average loans.

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Condensed Average Balance Sheets

(dollars in thousands except share data)

	2012						2011
	Average				Yield		Average				Yield
Three months ended March 31,	Balance		Interest		/Cost		Balance		Interest		/Cost
Assets
Federal funds sold	$	51,097	$	32	0.25	%	$	82,491	$	52	0.26	%
Taxable investment securities	253,811		1,313		2.08		183,916		1,108		2.44
Tax exempt securities	46,811		241		2.07		46,960		257		2.22
Loans	345,216		4,727		5.51		352,932		4,905		5.64
Total interest-earning assets	696,935		6,313		3.64	%	666,299		6,322		3.85	%
Non-interest earning assets	30,830						32,748
Total assets	$	727,765					$	699,047

Liabilities and Stockholders’ Equity

Skagit State Bancorp, Inc. 10-Q