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

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

For the quarterly period ended June 30, 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~~August 4th, 2011 was 588,346.

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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, 2011 and December 31, 2010	Page 3
		Consolidated Balance Sheet as of June 30, 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 Income for the three and six months ended June 30, 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 Changes in Stockholders’ Equity and Comprehensive Income for the six months ended June 30, 2011 and 2010	Page 5
		Consolidated Statement of Cash Flows for the three months ended March 31, 2011 and 2010	Page 6
		Consolidated Statement of Cash Flows for the six months ended June 30, 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 25-3638
	Item 3.	Quantitative and Qualitative Disclosures About Market Risk	Page 3638
	Item 4.	Controls and Procedures	Page 3638
PART II.	OTHER INFORMATION
	Item 1.	Legal Proceedings	Page 3638
	Item 1 A.	Risk Factors	~~Page 36~~Page38-4042
	Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	Page 4042
	Item 3.	Defaults Upon Senior Securities	Page 4042
	Item 4.	Removed and Reserved	~~Page 40~~Page42
	Item 5.	Other Information	Page 4042
	Item 6.	Exhibits	Page 4042
		Signatures	~~Page~~Pages 4143-46

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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~~June 3130, 2011			December 31, 2010
ASSETS
ASSETS
Cash and due from banks	$	10,~~759~~816		$	10,461
Federal funds sold	7149,~~167~~212			80,413
Investment securities
Available-for-sale, at fair value	~~214~~240,~~516~~701			180,971
Held-to-maturity, at amortized cost	3836,~~308~~249			38,367
Loans held for sale	—439			78
Loans	~~358~~353,~~968~~197			365,319
Allowance for loan losses	(76,~~346~~324		)	(7,079		)
Net loans	~~351~~346,~~622~~873			358,240
Bank premises and equipment, net	10,~~671~~983			10,772
Other real estate owned	45,~~334~~034			5,813
Accrued interest receivable	2,~~400~~309			2,521
Other assets	54,~~349~~484			5,235
TOTAL ASSETS	$	~~709~~707,~~126~~100		$	692,871
LIABILITIES AND STOCKHOLDERS’ EQUITY
LIABILITIES
Deposits
Interest-bearing	$	527,~~956~~967		$	511,782
Non-interest-bearing	7879,~~372~~672			79,099
Total deposits	~~606~~607,~~328~~639			590,881
Other borrowings	3429,~~464~~470			34,118
Other liabilities	1,~~472~~028			1,900
Total liabilities	~~642~~638,~~264~~137			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
Common stock no par value, 5,000,000 shares authorized, 587,639 and 587,377 shares issued and outstanding at June 30, 2011 and December 31, 2010 respectively	12,662			12,541
Accumulated other comprehensive income, net of tax	13,~~494~~177			1,639
Retained earnings	5253,~~767~~124			51,792
Total stockholders’ equity	6668,~~862~~963			65,972
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY	$	~~709~~707,~~126~~100		$	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,
	Three months ended June 30,					Six months ended June 30,
(dollars in thousands except per share data)	2011			2010		2011			2010
INTEREST INCOME
Interest and fees on loans	$	45,~~905~~050		$	5,~~640~~766	$	9,955		$	11,406
Investment securities
Taxable	1,~~108~~203			1,~~018~~064		2,311			2,082
Exempt from federal income tax	~~257~~254			~~274~~276		511			550
Federal funds sold	5241			4956		93			105
Total interest income	6,~~322~~548			67,~~981~~162		12,870			14,143
INTEREST EXPENSE
Deposits	1,~~180~~082			1,~~520~~456		2,262			2,976
Other borrowings	7467			8287		141			169
Total interest expense	1,~~254~~149			1,~~602~~543		2,403			3,145
NET INTEREST INCOME	5,~~068~~399			5,~~379~~619		10,467			10,998
Provision for loan losses	~~325~~225			~~550~~370		550			920
NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES	4,743			4,829
NET INTEREST INCOME AFTER
NON-INTEREST INCOME
PROVISION FOR LOAN LOSSES	5,174			5,249		9,917			10,078
Service charges on deposits	787			713
NON-INTEREST INCOME
Other	175			181
Service charges on deposits	892			832		1,679			1,545
Gains on sale of assets and loans	78			51
Other	211			196		386			377
Total non-interest income	1,040			945
Gains on sale of assets and loans	25			45		103			96
NON-INTEREST EXPENSES
Total non-interest income	1,128			1,073		2,168			2,018
Salaries	1,860			1,905
NON-INTEREST EXPENSES
Payroll taxes and employee benefits	475			496
Salaries	1,846			1,930		3,706			3,835
Provision for other real estate owned losses	213			20
Payroll taxes and employee benefits	480			483		955			979
Bank premises and equipment	187			228
Provision for other real estate owned losses	—			245		213			265
Occupancy	182			197
Bank premises and equipment	193			230		380			458
Loan collection and OREO expenses	135			91
Occupancy	176			186		358			383
Advertising	220			157
Loan collection and OREO expenses	242			166		377			280
Deposit Insurance	246			230
Advertising	176			201		396			358
Other	1,074			1,023
Deposit Insurance	260			263		506			493
Total non-interest expenses	4,592			4,347
Other	1,084			1,005		2,158			2,005
INCOME BEFORE PROVISION FOR INCOME TAX	1,191			1,427
Total non-interest expenses	4,457			4,709		9,049			9,056
PROVISION FOR INCOME TAX
INCOME BEFORE PROVISION FOR INCOME TAX	1,845			1,613		3,036			3,040
Provision for income tax	216			218
PROVISION FOR INCOME TAX
NET INCOME	$	975		$	1,209
Current	333			227		549			445
BASIC EARNINGS PER SHARE	$	1.66		$	2.06
Deferred	(22		)	53		(22		)	53
DILUTED EARNINGS PER SHARE	$	1.66		$	2.05
Total provision for income tax	311			280		527			498
NET INCOME	$	1,534		$	1,333	$	2,509		$	2,542
BASIC EARNINGS PER SHARE	$	2.61		$	2.27	$	4.27		$	4.33
DILUTED EARNINGS PER SHARE	$	2.61		$	2.27	$	4.26		$	4.32
DIVIDENDS DECLARED PER SHARE	$	2.00		$	1.75	$	2.00		$	1.75

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~~Six months ended ~~March 31~~June 30, 2011 and 2010

				Accum. Other						Total
	Common Stock			Accum. Other Comprehensive			Retained			Total Stockholders’			Comprehensive
	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	—	—		—			12,~~209~~542			12,~~209~~542			$	12,~~209~~542
Other comprehensive income:
Unrealized gains on available-for-sale securities, net of taxes of $284	—	—		552			—			552			552
Unrealized gains on available-for-sale securities, net of tax expense of $709	—	—		1,377			—			1,377			1,377
Total other comprehensive income													~~552~~1,377
Comprehensive income													$	13,~~761~~919
Stock compensation expense and restricted stock awards	289	64		—			—			64
Cash dividend declared, $1.75 per share	—	—		—			(1,030		)	(1,030		)
BALANCE, March 31, 2010	587,194	$	12,367	$	2,424		$	49,891		$	64,682
Stock compensation expense and restricted stock awards	289	142		—			—			142
BALANCE, June 30, 2010	587,194	$	12,445	$	3,249		$	50,194		$	65,888
BALANCE, January 1, 2011	587,377	$	12,541	$	1,639		$	51,792		$	65,972
Comprehensive income:
Net income	—	—		—			~~975~~2,509			~~975~~2,509			$	~~975~~2,509
Other comprehensive income:
Unrealized losses on available-for-sale securities, net of tax benefit of $75	—	—		(145		)	—			(145		)	(145		)
Unrealized gains on available-for-sale securities, net of tax benefit of $792	—	—		1,538			—			1,538			1,538
Total other comprehensive income													~~(145~~1,538		)
Comprehensive income													$	~~830~~4,047
Stock compensation expense and restricted stock awards	262	60		—			—			60
Cash dividend declared, $2.00 per share	—	—		—			(1,177		)	(1,177		)
BALANCE, March 31, 2011	587,639	$	12,601	$	1,494		$	52,767		$	66,862
Stock compensation expense and restricted stock awards	262	121		—			—			121
BALANCE, June 30, 2011	587,639	$	12,662	$	3,177		$	53,124		$	68,963

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
Six months ended June 30,	2011			2010
CASH FLOWS FROM OPERATING ACTIVITIES
Net income	$	~~975~~2,509		$	12,~~209~~542
Adjustments to reconcile net income to net cash flows from operating activities
Provision for loan losses	~~325~~550			~~550~~920
Provision for other real estate owned losses	213			20265
Depreciation	~~156~~305			~~212~~416
Gain on sale of premises and equipment	(1		)	—
Gains on sale of other real estate owned	(18		)	—
Gains on loans held for sale	(6084		)	(5196		)
Amortization of investment security premiums and discounts, net	91208			(2945		)
Stock compensation for employee services	60			64
Provision for deferred income taxes	(22		)	53
Stock compensation for employee services	121			142
Changes in operating assets and liabilities
Originations of loans held for sale	(23,~~256~~745		)	(35,~~976~~965		)
Proceeds from sales of loans held for sale	23,~~394~~468			36,~~940~~555
Decrease in interest receivable	~~121~~212			~~145~~179
Increase in other assets	(3919		)	(~~167~~284		)
(Decrease) increase in other liabilities	(~~428~~872		)	~~148~~434
Net cash flows from operating activities	12,~~534~~825			25,~~065~~116
CASH FLOWS FROM INVESTING ACTIVITIES
Proceeds from maturities, calls, and principal payments of investment securities — available-for-sale	1339,~~417~~504			820,~~697~~549
Purchases of investment securities — available-for-sale	(4797,~~274~~117		)	(547,~~000~~591		)
Proceeds from maturities, calls, and principal payments of investment securities — held-to-maturity	613,251			13,~~032~~155
Purchases of investment securities — held-to-maturity	—(1,128		)	(12,~~457~~715		)
Net (increase) decrease in federal funds sold	931,~~246~~201			(3114,~~558~~684		)
Net decrease in loans	711,~~576~~248			28,~~503~~266
Purchase of premises and equipment	(55364		)	(97399		)
Net cash flows from investing activities	(17,029		)	(25,880		)
Proceeds from sale of premises and equipment	2			—
Net cash flows from investing activities	(13,403		)	(33,419		)
CASH FLOWS FROM FINANCING ACTIVITIES
Net increase in demand deposits, money market, NOW and savings accounts	2026,~~546~~523			1322,~~884~~185
Net increase (decrease) in time deposits	(59,~~099~~765		)	8,~~542~~960
Net increase (decrease) in other borrowings	~~346~~(4,648		)	(23,~~950~~031		)
Net cash flows from financing activities	15,793			19,476
Cash dividends	(1,177		)	(1,030		)
NET CHANGE IN CASH AND DUE FROM BANKS	298			(4,339		)
Net cash flows from financing activities	10,933			27,084
NET CHANGE IN CASH AND DUE FROM BANKS	355			(1,219		)
CASH AND DUE FROM BANKS, beginning of period	10,461			14,441
CASH AND DUE FROM BANKS, end of period	$	10,~~759~~816		$	1013,~~102~~222
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash paid during the period for income taxes	$	—750		$	~~375~~1,080
Cash paid during the period for interest	$	12,~~273~~445		$	13,~~663~~221
NONCASH FINANCING AND INVESTING TRANSACTIONS
Property taken in settlement of loans	$	~~126~~978		$	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 and six months ended ~~March~~June 3130, 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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purposes, commercial, commercial real estate, other real estate and real estate construction segments are typically graded using the commercial risk ratings.

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

Delinquency and Non-accrual: Loans are defined as delinquent when any payment of principal and/or interest is past due. Loans are placed on nonaccrual status when, in the opinion of management, the collection of full principal and interest is doubtful or when the loan becomes 90 or more days past due. When a loan is placed on nonaccrual status, all interest previously accrued, but not collected, is reversed and charged against interest income. Payments received on nonaccrual loans are generally applied to principal. However, based on management’s assessment of the ultimate collectability of a nonaccrual loan, interest income may be recognized on a cash basis. Nonaccrual loans are returned to accrual 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~~June 3130, 2011 there was $5.78 million in troubled debt restructures with $1.04 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.

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

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~~Note~~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~~: NEW~~ ~~ACCOUNTING~~valuation ~~PRONOUNCEMENTS~~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 material impact on Bancorp’s consolidated financial position, results of operations, and earnings per share.

InOn ~~January~~July 21, 2010, the FASB issued ASU 2010-~~06,~~20 anwhich ~~update~~amends to ASU ~~820-10,~~310 ~~“Fair~~and ~~Value~~expands ~~Measurements”.~~required ~~This~~disclosures ~~update~~for ~~adds~~the aFinancing ~~new~~Receivables ~~requirement~~and tothe ~~disclose~~Allowance ~~transfers~~for inLoan and ~~out~~Lease Losses. The objective of ~~level~~these 1enhanced ~~and~~disclosures ~~level~~is 2,to ~~along~~improve ~~with~~financial ~~the~~statements ~~reasons~~users’ ~~for~~understanding of (i) the ~~transfers,~~nature ~~and~~of ~~requires~~ a ~~gross~~company’s ~~presentation~~credit ofrisk ~~purchases~~associated with financing receivables and ~~sales~~(ii) the ofcompany’s ~~level~~assessment 3of ~~activities.~~risk ~~Additionally,~~in ~~the~~estimating ~~update~~its ~~clarifies~~allowance ~~that~~for ~~entities~~loan ~~provide~~and ~~fair~~lease ~~value~~losses ~~measurement~~as ~~disclosures~~well ~~for~~as ~~each~~changes ~~class~~in ofthe ~~assets~~allowance and ~~liabilities~~the ~~and~~reasons ~~that~~for ~~entities~~those ~~provide~~changes. ~~enhanced~~These disclosures ~~around~~with ~~level~~the 2exception ~~valuation~~of ~~techniques~~the ~~and~~troubled ~~inputs.~~debt ~~Bancorp~~restructurings ~~adopted~~disclosure were implemented by the ~~disclosure~~Bank ~~requirements~~on ~~for~~December 31, ~~level~~2010. In 1April 2011, ~~and~~the ~~level~~FASB 2issued ~~transfers~~ASU ~~and~~No. 2011-02, ~~the~~Receivables ~~expanded~~(Topic ~~fair~~310) ~~value~~— ~~measurement~~Creditor’s ~~and~~Determination ~~valuation~~of ~~disclosures~~Whether ~~effective~~a ~~January 1,~~Restructuring ~~2010~~Is a Troubled Debt Restructuring Deferral. ~~The~~These ~~disclosure~~amended disclosures requirements ~~for~~relating ~~level~~to 3troubled ~~activities~~debt ~~were~~restructures are effective for ~~Bancorp~~the ~~for~~ interim ~~and~~or annual periods beginning on or after ~~December~~June 15, ~~2010.~~2011, ~~The~~and ~~adoption~~for purposes of measuring impairment, are to be applied retrospectively to the ~~disclosure~~beginning ~~requirements~~of ~~had~~the noannual ~~impact~~period onof adoption. Bancorp’s ~~financial~~does ~~position,~~not ~~results~~anticipate the adoption of ~~operations,~~this ~~and~~guidance ~~earnings~~will ~~per~~have ~~share~~a material impact on its consolidated financial statements.

OnIn ~~July~~June 212011, ~~2010,~~ the FASB issued ASU ~~2010~~2011-2005 which amends ~~ASU~~Comprehensive ~~310~~Income ~~and~~(Topic ~~expands required disclosures for the Financing Receivables and the Allowance for Loan and Lease Losses~~220). The ~~objective~~amendments ofrequire ~~these~~that ~~enhanced~~all ~~disclosures~~non-owner ischanges toin ~~improve~~the ~~financial statements users~~stockholders’ ~~understanding~~equity ofbe ~~(i) the~~presented ~~nature~~in ofeither a ~~company’s~~single ~~credit~~continuous ~~risk~~statement ~~associated with financing receivables and (ii) the company’s assessment~~ of ~~risk~~comprehensive inincome ~~estimating~~or ~~its allowance for loan and lease losses as well as changes~~ in ~~the~~two ~~allowance~~separate ~~and~~but ~~the~~consecutive ~~reasons for those changes~~statements. The ~~These~~objective ~~disclosures~~is ~~with~~to ~~the~~improve ~~exception of~~ the ~~troubled~~comparability, ~~debt~~consistency ~~restructurings~~and ~~disclosure~~transparency ~~were~~of ~~implemented~~financial byreporting ~~the~~and ~~Bank~~to onincrease ~~December 31, 2010. In April 2011,~~ the ~~FASB~~prominence ~~issued ASU No. 2011-02, Receivables (Topic 310) — Creditor’s Determination~~ of ~~Whether~~items areported ~~Restructuring~~in Isother acomprehensive ~~Troubled Debt Restructuring Deferral~~income. These ~~amended~~amendments ~~disclosures~~are ~~requirements relating~~ to ~~troubled~~be ~~debt~~applied ~~restructures~~retrospectively and are effective for ~~the~~fiscal ~~interim~~years, orand ~~annual~~interim periods ~~beginning~~within onthose oryears, beginning after ~~June~~December 3015, 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,
	Three months ended June 30,				Six months ended June 30,
(dollars in thousands except share and per share amounts)	2011		2010		2011		2010
Numerator:
Net income	$	~~975~~1,534	$	1,~~209~~333	$	2,509	$	2,542
Denominator:
Denominator for basic earnings per share - Weighted average shares outstanding	587,~~496~~639		587,~~043~~194		587,568		587,119
Effect of dilutive securities:
Stock options and unvested restricted stock grants	~~850~~707		1,~~472~~312		778		1,391
Denominator for diluted earning per share - Weighted average shares outstanding	588,346		588,~~515~~506		588,346		588,510
Basic earnings per share	$	12.6661	$	2.0627	$	4.27	$	4.33
Diluted earnings per share	$	12.6661	$	2.0527	$	4.26	$	4.32

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~~June 3130, 2011 there were 69,608 common shares available for grant. Total equity compensation expense was $60121,000 for the ~~three~~sixmonths ~~months~~ ended ~~March~~June 3130, 2011 and $64142,000 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~~Stock ~~following~~Options: ~~table~~No ~~summarizes~~grants ~~the~~of ~~activity related to~~ options ~~outstanding~~were ~~during~~awarded for the ~~three~~six months ended ~~March~~June 3130, 2011. ~~The~~or ~~aggregate intrinsic value represents~~ the ~~total~~twelve ~~pretax~~months ~~intrinsic~~ended ~~value~~December 31, ~~(amount~~2010. The byunrecognized ~~which~~share-based ~~the~~compensation ~~fair~~cost ~~value~~relating ofto ~~the~~stock ~~underlying~~option ~~stock~~expense ~~exceeds~~at ~~the~~June 30, ~~exercise~~2011 ~~price~~was of$250,000, anwhich ~~option~~will orbe ~~award,~~recognized ~~times~~over the ~~number~~remaining ofvesting ~~shares):~~schedule through 2014.

(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	$	—

The following table summarizes the activity related to options outstanding during the six months ended June 30, 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 (in years)	Aggregate Intrinsic Value
Outstanding at January 1, 2011	27,986	$	179.91	6.60	$	—
Granted	—
Exercised	—
Forfeited	—
Outstanding at June 30, 2011	27,986	$	179.91	6.10	$	—
Exercisable at June 30, 2011	17,186	$	175.72	5.70	$	—

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~~June 3130, 2011 was $~~108~~90,000, 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~~six months ended ~~March~~June 3130, 2011 or for the twelve months ended December 31, 2010. The total intrinsic value of stock awards exercised and vested during the ~~three~~six months ended ~~March~~June 3130, 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~~six months ended ~~March~~June 3130, 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
Outstanding at June 30, 2011	707	1.32	$	117

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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~~June 3130, 2011

Amortized

Gross Unrealized

Estimated

(dollars in thousands)

Cost

Gains

Losses

Fair Value

Available-For-Sale Securities

U.S. government agencies

~~119~~122,~~539~~045

~~532~~1,240

~~296~~6

~~119~~123,~~775~~279

Residential mortgage-backed securities and collateralized mortgage obligations

83104,~~994~~407

23,~~582~~438

~~824~~230

85107,~~752~~615

State and political subdivisions

89,~~719~~436

~~320~~371

50—

89,~~989~~807

Total available-for-sale

~~212~~235,~~252~~888

35,~~434~~049

~~1,170~~236

~~214~~240,~~516~~701

Held-To-Maturity Securities

State and political subdivisions

3836,~~308~~249

~~892~~948

6324

3937,~~137~~173

Total held-to-maturity

3836,~~308~~249

~~892~~948

6324

3937,~~137~~173

Total investment securities

~~250~~272,~~560~~137

45,~~326~~997

~~1,233~~260

~~253~~277,~~653~~874

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~~June 3130, 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	$	4314,~~898~~022	$	~~296~~6	$	—	$	—	$	4314,~~898~~022	$	~~296~~6
Residential mortgage-backed securities and collateralized mortgage obligations	2821,~~477~~065		~~824~~230		—		—		2821,~~477~~065		~~824~~230
State and political subdivisions	~~1,139~~—		50—		—		—		~~1,139~~—		50—
Total available-for-sale	7335,~~514~~087		~~1,170~~236		—		—		7335,~~514~~087		~~1,170~~236
Held-To-Maturity Securities
State and political subdivisions	52,~~476~~051		6324		—		—		52,~~476~~051		6324
Total held-to-maturity	52,~~476~~051		6324		—		—		52,~~476~~051		6324
Total investment securities	$	7837,~~990~~138	$	~~1,233~~260	$	—	$	—	$	7837,~~990~~138	$	~~1,233~~260

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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~~June 3130, 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 3010 securities in an unrealized loss position for less than twelve months as of ~~March~~June 3130, 2011.

Available-for-sale investment securities with a carrying value of $9183.7 6 million and $96.0 million as of ~~March~~June 3130, 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~~six months ended ~~March~~June 3130, 2011 and ~~March~~June 3130, 2010.

The amortized cost and estimated fair value of investment securities at ~~March~~June 3130, 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

149,~~179~~076

149,~~255~~139

82,~~515~~984

83,~~560~~008

1-5 years

93105,~~171~~758

93107,~~783~~187

812,~~637~~502

812,~~924~~788

5-10 years

1612,~~585~~358

1612,~~460~~452

1314,~~360~~222

1314,~~568~~574

Over 10 years

4,~~323~~289

4,~~266~~308

76,~~796~~541

86,~~085~~803

Residential mortgage-backed securities and collateralized mortgage obligations

83104,~~994~~407

85107,~~752~~615

—

Total investment securities

~~212~~235,~~252~~888

~~214~~240,~~516~~701

3836,~~308~~249

3937,~~137~~173

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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~~June 3130, 2011			December 31, 2010
Commercial	$	6558,~~202~~592		$	69,177
Commercial real estate
Raw land and land development	37,~~884~~585			37,233
Other commercial real estate	6561,~~082~~734			65,516
Other real estate
Residential	33,~~218~~131			34,681
Farmland and owner occupied nonfarm nonresidential	~~113~~118,~~652~~757			115,291
Real estate construction
Commercial	~~892~~826			826
Residential	3,~~454~~627			3,210
Consumer
Home equity	2423,~~320~~611			23,522
Credit cards and other consumer	15,~~956~~844			16,622
	$	~~359~~353,~~660~~707		$	366,078
Less deferred loan fees	(~~692~~510		)	(759		)
Total Loans	$	~~358~~353,~~968~~197		$	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.

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

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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~~June 3130, 2011 and December 31, 2010, $~~153~~147.92 million and $157.1 million of loans outstanding were variable rate loans. Loans participations sold to others totaled $2.97 million and $3.1 million as of ~~March~~June 3130, 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~~June 3130, 2011 and December 31, 2010, Bancorp held $0439,000 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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The following table is an aging analysis of past due loans as of June 30, 2011 and December 31, 2010:

June 30, 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	$	—	$	—	$	—	$	—	$	308	$	58,284	$	58,592
Commercial real estate
Raw land and land development	1,835		—		—		1,835		5,553		30,197		37,585
Other commercial real estate	—		—		—		—		1,107		60,627		61,734
Other real estate
Residential	164		—		—		164		1,092		31,875		33,131
Farmland and owner occupied nonfarm nonresidential	991		—		—		991		6,317		111,449		118,757
Real estate construction
Commercial	—		—		—		—		—		826		826
Residential	—		—		—		—		507		3,120		3,627
Consumer
Home equity	—		—		—		—		243		23,368		23,611
Credit cards and other consumer	177		20		—		197		42		15,605		15,844
Total	$	3,167	$	20	$	—	$	3,187	$	15,169	$	335,351	$	353,707

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

	June 30, 2011
(dollars in thousands)	Unpaid Principal Balance		Recorded Investment with No Related Allowance		Recorded Investment with Related Allowance		Related Allowance		Total Recorded Investment
Commercial	$	1,202	$	308	$	—	$	—	$	308
Raw land and land development	6,861		4,436		2,109		494		6,545
Other commercial real estate	1,477		1,107		367		20		1,474
Residential	1,256		1,092		—		—		1,092
Farmland and owner occupied nonfarm nonresidential	6,481		5,594		764		27		6,358
Construction-commercial	—		—		—		—		—
Construction-residential	507		507		—		—		507
Consumer-home equity	246		176		66		22		242
Credit cards and other consumer	62		42		—		—		42
Total	$	18,092	$	13,262	$	3,306	$	563	$	16,568

	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
	June 30, 2011				December 31, 2010
(dollars in thousands)	Average Recorded Investment		Interest Income Recognized		Average Recorded Investment		Interest Income Recognized
Commercial	$	32,~~750~~603	$	—	$	1,691	$	4
Raw land and land development	5,~~195~~645		322		6,599		169
Other commercial real estate	1,~~126~~242		1		1,074		99
Residential	1,~~128~~116		—		1,659		76
Farmland and owner occupied nonfarm nonresidential	6,~~270~~298		—		3,745		140
Construction-commercial	—		—		—		—
Construction-residential	~~1,000~~836		—		1,645		44
Consumer-home equity	~~105~~150		—		84		—
Credit cards and other consumer	5450		—		80		—
Total	$	1817,~~628~~940	$	423	$	16,577	$	532

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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.

16Special 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.

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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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but loss cannot be determined because of specific reasonable factors which may strengthen the credit in the near term.

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

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

~~March~~June 3130, 2011

Commercial Credit Indicator

(dollars in thousands)

Pass

Watch

Special Mention

Substandard

Non-Rated

Total

Commercial

5149,~~412~~649

53,~~305~~039

23,~~551~~211

52,~~934~~693

—

6558,~~202~~592

Commercial real estate

Raw land and land development

24,~~821~~934

69—

~~1,330~~810

10,~~672~~885

36,~~937~~674

Other commercial real estate

5955,~~408~~594

—

2,~~491~~977

3,~~168~~148

6561,~~082~~734

Other real estate

Residential

1617,~~394~~158

~~450~~395

~~692~~577

2,~~124~~006

~~494~~483

20,~~154~~619

Farmland and owner occupied nonfarm nonresidential

8898,~~098~~841

84,~~179~~505

54,~~610~~119

1110,~~264~~922

~~261~~130

~~113~~118,~~412~~517

Real estate construction

Commercial

~~564~~826

—

~~328~~—

—

~~892~~826

Residential

1,~~687~~544

—

~~1,113~~507

—

2,~~800~~051

Consumer

Home equity

1,~~802~~283

—

~~490~~491

~~243~~320

—

2,~~535~~094

Credit cards and other consumer

—11

—

4542

—

4553

Total

~~244~~249,~~186~~840

147,~~003~~939

1312,~~164~~185

3430,~~891~~523

~~815~~673

~~307~~301,~~059~~160

			Consumer Credit Indicator
	A		B		C		D		Non-Rated		Total
Commercial	$	—	$	—	$	—	$	—	$	—	$	—
Commercial real estate
Raw land and land development	~~531~~500		~~324~~321		9290		—		—		~~947~~911
Other commercial real estate	—		—		—		—		—		—
Other real estate
Residential	8,~~903~~396		2,~~492~~488		~~855~~850		~~814~~778		—		1312,~~064~~512
Farmland and owner occupied nonfarm nonresidential	240		—		—		—		—		240
Real estate construction
Commercial	—		—		—		—		—		—
Residential	31671		~~285~~353		—		~~338~~552		—		~~654~~1,576
Consumer
Home equity	1615,~~240~~960		3,~~062~~105		1,~~498~~493		~~932~~898		5361		21,~~785~~517
Credit cards and other consumer	7,~~387~~230		1,~~591~~505		~~719~~729		~~584~~592		5,~~630~~735		15,~~911~~791
Total	$	3332,~~332~~997	$	7,~~754~~772	$	3,~~164~~162	$	2,~~668~~820	$	5,~~683~~796	$	52,~~601~~547

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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~~June 3130, 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
June 30, 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	—(1,100		)	—			—(81		)	—(15		)	(92188		)	—		(921,384		)
Recoveries	318			—6			—4			—			3151			—		3479
Provision (benefit)	~~659~~494			(~~243~~340		)	(~~125~~136		)	2329			1039			1464		~~325~~550
Balance, end of period	$	~~2,156~~906		$	2,~~321~~230		$	1,~~275~~187		$	9081		$	~~804~~757		$	~~700~~1,163	$	76,~~346~~324
Ending balance: individually evaluated for impairment	$	~~1,260~~—		$	~~445~~514		$	3927		$	—		$	2522		$	—	$	~~1,769~~563
Ending balance: collectively evaluated for impairment	$	~~896~~906		$	1,~~876~~716		$	1,~~236~~160		$	9081		$	~~779~~735		$	~~700~~1,163	$	5,~~577~~761
Loans Receivables:
Ending balance	$	6558,~~202~~592		$	~~102~~99,~~966~~319		$	~~146~~151,~~870~~888		$	4,~~346~~453		$	4039,~~276~~455				$	~~359~~353,~~660~~707
Ending balance: individually evaluated for impairment	$	~~3,801~~308		$	68,~~938~~019		$	7,~~460~~450		$	~~1,032~~507		$	~~149~~284				$	1916,~~380~~568
Ending balance: collectively evaluated for impairment	$	6158,~~401~~284		$	9691,~~028~~300		$	~~139~~144,~~410~~438		$	3,~~314~~946		$	4039,~~127~~171				$	~~340~~337,~~280~~139

(dollars in thousands)
Three months ended March 31, 2010
Six months ended June 30, 2010
Allowance as of beginning of period	$	6,883
Provision for loan losses	~~550~~920
Charge-offs	(~~188~~511		)
Recoveries	35100
Net charge-offs	(~~153~~411		)
Balance at end of period	$	7,~~280~~392

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~~June 3130, 2011: (dollars in thousands)

Unfunded commitments to extend credit	$	6672,~~907~~766
Credit card arrangements	~~11,538~~$	11,559
Commitments to fund municipal warrants	~~4,924~~$	5,093
Standby letters of credit	~~1,864~~$	1,683

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. AsFor ofthe ~~March~~six months ended June 3130, 2011, Bancorp had $~~257~~511,000 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~~June 3130, 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, 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.

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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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.

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

June 30, 2011

December 31, 2010

Carrying

(dollars in thousands)

Amount

Fair Value

Amount

Fair Value

Financial Assets

Cash and due from banks

10,~~759~~816

10,461

Federal funds sold

7149,~~167~~212

80,413

Investment securities

~~252~~276,~~824~~950

~~253~~277,~~653~~874

219,338

219,833

Loans held for sale

—439

Net loans

~~351~~346,~~622~~873

~~332~~328,~~383~~407

358,240

338,704

Accrued interest receivable

2,~~400~~309

2,521

Financial Liabilities

Demand and savings deposits

~~396~~402,~~087~~064

375,541

Time deposits

~~210~~205,~~241~~575

~~211~~206,~~535~~621

215,340

216,736

Other borrowings

3429,~~464~~470

34,118

Accrued interest payable

~~215~~192

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~~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. 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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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.

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
June 30, 2011
Available-for-sale securities
U.S. Treasury and government agencies	$	~~119~~123,~~775~~279	$	—	$	~~119~~123,~~775~~279	$	—
Residential mortgage-backed securities and collateralized mortgage obligations	85107,~~752~~615		—		85107,~~752~~615		—
State and political subdivisions	89,~~989~~807		—		89,~~989~~807		—
Total	$	~~214~~240,~~516~~701	$	—	$	~~214~~240,~~516~~701	$	—
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~~Six Months
Description	Total		(Level 1)		(Level 2)		(Level 3)		Ended
March 31, 2011
June 30, 2011
Impaired loans
Commercial	$	~~2,541~~308	$	—	$	—	$	~~2,541~~308	$	(~~721~~305	)
Commercial real estate	67,~~493~~505		—		—		67,~~493~~505		(94164		)
Other real estate	7,~~421~~423		—		—		7,~~421~~423		(37106		)
Real estate construction	~~1,032~~507		—		—		~~1,032~~507		—
Consumer	~~124~~262		—		—		~~124~~262		(2118		)
Other real estate owned	45,~~334~~034		—		—		45,~~334~~034		(213		)
Total	$	21,~~945~~039	$	—	$	—	$	21,~~945~~039	$	(~~1,086~~806	)

			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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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 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~~was to $~~975,000~~1.5 ormillion and $1.663 ~~per~~million for the quarters ended June 30, 2011, and 2010 with diluted earnings per share at $2.61 and $2.27, respectively. Net income was $2.5 million for the ~~quarter~~six months ended ~~March~~June 3130, 2011, ~~compared~~and to2010 with diluted earnings per share at $14.226 ~~million~~and or $24.0532, ~~per~~respectively. ~~diluted~~Annualized ~~earnings~~return ~~per~~on ~~share~~average assets was 0.86 percent and 0.72 percent for the quarter and six months ended ~~March~~June 3130, ~~2010.~~2011, ~~Return~~compared onto ~~average~~0.78 ~~assets~~percent and 0.77 percent during the same time periods in 2010. Annualized return on average equity was 09.5711 percent and 57.9856 percent, ~~respectively,~~ for the ~~three~~quarter and six months ~~ended~~ending ~~March~~June 3130, 2011 compared to 08.7522 percent and 7.6996 percent, respectively, for the ~~three~~same ~~months~~time ~~ended~~periods ~~March 31,~~in 2010. The ~~decrease~~increase in net income for the quarter ended June 30, 2011 compared to the like quarter in 2010 was primarily due to athe ~~decrease~~decreases in provision for loan losses, provision for other real estate owned and interest ~~income~~expenses which ~~was~~were partially offset by decreases in interest ~~expense~~income. For the six months ended June 30, 2011 compared to the like period in 2010, the minimal decrease in net income was the result of a decrease in interest income and provision for loan losses which were offset by decreases in interest expense and an increase in non-interest income.

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~~was to $5.14 million and $10.5 million for the ~~three~~quarter and six months ended ~~March~~June 3130, 2011 ~~from~~compared to $5.46 million and $11.0 million for the like ~~period~~periods 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-~~income ~~bearing~~expressed ~~liabilities:~~as ~~Interest~~a ~~expense~~percent ~~decreased~~of ~~$348,000~~average tointerest-earning $1assets.3 ~~million~~The decreases were for both the ~~three~~quarter and six months ended ~~March~~June 330, 2011 compared to ~~$1.6 million for~~ the ~~three~~like ~~months~~periods ~~ended~~in ~~March 31,~~ 2010. ~~This~~were ~~reduction~~primarily ~~was~~a ~~the~~result ~~primarily~~of the ~~result~~decrease ofin aaverage 65loan ~~basis~~balances ~~point~~and ~~decrease~~yields inon ~~the~~loans ~~cost~~from of2010 ~~funds~~to ~~for~~2011. For ~~time~~the ~~deposits~~quarter and asix 41months ~~basis~~ended ~~point~~June 30, ~~decrease~~2011, in the ~~cost~~net ofinterest ~~funds~~margin ~~for~~decreased ~~savings~~to ~~accounts~~3. ~~This~~19 ~~reduction~~percent ~~was~~and ~~partially~~3.14 ~~offset~~percent bycompared ~~the~~to ~~$ 42~~3.149 ~~million~~percent ~~increase~~and in3.51 ~~average~~percent ~~deposit~~for ~~balances~~the like periods in 2010.

Interest-earning assets: The ~~following~~largest ~~tables~~component ~~present~~of ~~information~~interest ~~regarding~~income ~~average~~is ~~balances~~interest ofearned ~~assets~~on ~~and~~loans. Total ~~liabilities~~loan asinterest ~~well~~income asdecreased ~~the~~by ~~total~~$716,000 ~~amounts~~for ofthree ~~interest~~months ~~income~~ended ~~from~~June 30, ~~average~~2011 ~~interest-earning~~to ~~assets~~$5.1 ~~and~~million ~~interest~~compared ~~expense~~to on$5.8 ~~average~~million ~~interest-bearing~~for ~~liabilities~~the three months ended June 30, ~~resulting~~2010. For ~~yield~~the ~~and~~six ~~cost~~months ~~ratios~~ended June 30, ~~interest~~2011, ~~rate~~loan ~~spread~~interest ~~and~~income ~~net~~decreased ~~interest~~by ~~margin~~$1.4 ~~Tax~~million ~~exempt~~to ~~securities,~~$10.0 ~~included~~million incompared ~~investment~~to ~~securities~~$11.4 ~~below~~million ~~are~~for ~~stated~~the atsame ~~their~~time ~~contractual~~period ~~interest~~in ~~rate~~2010. ~~Loan~~These ~~fees~~decreases were primarily the result of ~~$143,000~~decreases ~~for~~in average loan balances from 2010 to 2011 and decreases in loan yield. For the quarter and six months ended ~~March~~June 3130, 2011, the yield decreased to 5.78 percent and ~~$174,000~~5.71 percent compared to 6.05 percent and 6.00 percent for the ~~quarter~~like ~~ended~~periods ~~March 31,~~in 2010. Additionally, ~~are~~average ~~included~~loan inbalances ~~interest~~decreased ~~earned~~$31.8 onmillion ~~loans~~and $31.7 ~~Non-accruing~~million ~~loans~~for ~~have~~the ~~been~~quarter ~~included~~and insix ~~the~~months ~~computation~~ended ofJune 30, ~~average~~2011 ~~loans~~compared to June 30, 2010.

Interest earned on investments and federal funds sold were $1.5 million and $2.9 million, respectively, for the quarter and six months ended June 30, 2011 compared to $1.4 million and $2.7 million for the quarter and six months ended June 30, 2010. This increase was largely the result of increases in average balances of investments and federal funds sold which were partially offset by decreases in yield.

Interest- bearing liabilities: Interest expense decreased $394,000 to $1.1 million for the quarter months ended June 30, 2011 compared to $1.5 million for the three months ended June 30, 2010. Interest expense decreased $742,000 to $2.4 million for the six months ended June 30, 2011 compared to $3.1 million for the six months ended June 30, 2010. These decreases were primarily the result of 58 and 62 basis point decreases in the cost of funds for time deposits for the quarter and six months ended June 30, 2011 compared to the like periods in 2010. These decreases were partially offset by a $26.4 million and $34.2 million increase in average interest-bearing deposit balances for the quarter and six months, respectively.

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 $161,000 and $304,000 for the quarter and six months ended June 30, 2011, and $252,000 and $426,000 for the quarter and six months ended June 30, 2010, respectively, 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)

2011

2010

Three months ended March 31,

Average Balance

Interest

Yield /Cost

Average Balance

Interest

Yield /Cost

Average

Yield

Average

Yield

Three months ended June 30,

Balance

Interest

/Cost

Balance

Interest

/Cost

Assets

Federal funds sold

8265,~~491~~429

5241

0.2625

7889,~~298~~369

4956

0.25

Taxable investment securities

~~183~~216,~~916~~659

1,~~108~~203

2.4423

~~104~~125,~~867~~262

1,~~018~~064

3.9441

Tax exempt securities

46,~~960~~711

~~257~~254

2.2218

49,~~614~~510

~~274~~276

2.24

Loans

~~352~~350,~~932~~273

45,~~905~~050

5.6478

~~384~~382,~~601~~100

5,~~640~~766

56.9505

Total interest-earning assets

~~666~~679,~~299~~072

6,~~322~~548

3.8587

~~617~~646,~~380~~241

67,~~981~~162

4.5945

Non-interest earning assets

32,~~748~~621

3537,~~957~~453

Total assets

~~699~~711,~~047~~693

~~653~~683,~~337~~694

Liabilities and Stockholders’ Equity

Interest-bearing demand

~~108~~112,~~782~~968

~~125~~128

0.4745

~~101~~110,~~409~~863

84112

0.3441

Savings and money market

~~197~~210,~~296~~193

~~297~~285

0.6154

~~167~~177,~~364~~527

~~355~~333

0.8675

Certificates of deposit

~~215~~207,~~606~~134

~~758~~669

1.4330

~~210~~215,~~840~~474

1,~~081~~011

21.0888

Total interest-bearing deposits

~~521~~530,~~684~~295

1,~~180~~082

0.9282

~~479~~503,~~613~~864

1,~~520~~456

1.2916

Other borrowings

3433,~~655~~228

7467

0.8781

3740,~~465~~569

8287

0.8986

Total interest-bearing deposits & liabilities

~~556~~563,~~339~~523

1,~~254~~149

0.9182

~~517~~544,~~078~~433

1,~~602~~543

1.2614

Non interest-bearing demand deposits

7579,~~242~~526

7172,~~007~~381

Other non-interest-bearing liabilities

1,~~331~~126

1,~~510~~810

Total liabilities

~~632~~644,~~912~~175

~~589~~618,~~595~~624

Stockholders’ equity

6667,~~135~~518

6365,~~742~~070

Total liabilities and stockholders equity

~~699~~711,~~047~~693

~~653~~683,~~337~~694

Net interest income

5,~~068~~399

5,~~379~~619

Interest rate spread

23.9305

3.3331

Net interest margin

3.0819

3.5349

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Condensed Average Balance Sheets

(dollars in thousands except share data)

	2011						2010
	Average				Yield		Average				Yield
Six months ended June 30,	Balance		Interest		/Cost		Balance		Interest		/Cost
Assets
Federal funds sold	$	73,913	$	93	0.25	%	$	83,844	$	105	0.25	%
Taxable investment securities	200,519		2,311		2.32		115,121		2,082		3.65
Tax exempt securities	46,694		511		2.21		49,564		550		2.24
Loans	351,675		9,955		5.71		383,355		11,406		6.00
Total interest-earning assets	672,801		12,870		3.86	%	631,884		14,143		4.51	%
Non-interest earning assets	32,771						36,715
Total assets	$	705,572					$	668,599

Liabilities and Stockholders’ Equity
Interest-bearing demand	$	110,887	$	253	0.46	%	$	106,168	$	196	0.37	%
Savings and money market	203,780		582		0.58		172,460		688		0.80
Certificates of deposit	211,346		1,427		1.36		213,172		2,092		1.98
Total interest-bearing deposits	526,013		2,262		0.87		491,800		2,976		1.22
Other borrowings	33,911		141		0.84		39,013		169		0.87
Total interest-bearing deposits & liabilities	559,924		2,403		0.87	%	530,813		3,145		1.19	%
Non interest-bearing demand deposits	77,631						71,688
Other non-interest-bearing liabilities	1,101						1,688
Total liabilities	638,656						604,189
Stockholders’ equity	66,916						64,410
Total liabilities and stockholders equity	$	705,572					$	668,599
Net interest income			$	10,467					$	10,998
Interest rate spread					2.99	%					3.32	%
Net interest margin					3.14	%					3.51	%

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,
	Three months ended June 30,									Six months ended June 30,
	2011 vs. 2010									2011 vs. 2010
	Increase (Decrease) Due to									Increase (Decrease) Due to
(dollars in thousands)	Volume			Rate			Total			Volume			Rate			Total
Interest-Earning Assets
Federal funds sold	$	3(15	)	$	—		$	3(15	)	$	(13	)	$	1		$	(12	)
Investment securities	2,~~129~~084			(21,~~056~~967		)	73117			2,168			(1,978		)	190
Loans	(~~450~~466		)	(~~285~~250		)	(~~735~~716		)	(914		)	(537		)	(1,451		)
Total net change in income on interest-earning assets	1,~~682~~603			(2,~~341~~217		)	(~~659~~614		)	1,241			(2,514		)	(1,273		)
Interest-Bearing Liabilities
Deposits	~~564~~275			(~~904~~649		)	(~~340~~374		)	370			(1,084		)	(714		)
Other borrowings	(615		)	(25		)	(820		)	(21		)	(7		)	(28		)
Total net change in expense on interest-bearing liabilities	~~558~~260			(~~906~~654		)	(~~348~~394		)	349			(1,091		)	(742		)
Net change in net interest income	$	1,~~124~~343		$	(1,~~435~~563	)	$	(~~311~~220	)	$	892		$	(1,423	)	$	(531	)

PROVISION FOR LOAN LOSSES The provision for loan losses was $~~325~~225,000 and $550,000 for the ~~three~~quarter and six months ended ~~March~~June 3130, 2011 compared to $~~550~~370,000 and $920,000 provision for loan losses for the like ~~period~~periods in 2010. The ~~decrease~~decreases in the provision resulted from decreased ~~net~~levels ~~charge-offs~~of adversely classified assets and the decline in loan balances. For the ~~three~~quarter and six months ended ~~March~~June 3130, 2011 ~~and 2010~~, net charge-offs were $581.2 million and $1.3 million compared to $258,000 and $~~153~~411,000 for the like periods in 2010. For the six months ended June 30, ~~respectively~~2011, charge-offs on one credit relationships was 84 percent of total net charge-offs.

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 $1.01 million for the ~~quarters~~quarter ended ~~March~~June 3130, 2011 ~~and~~compared to the quarter ended June 30, 2010. Non-interest increased to $2.2 million from $2.0 million for the like period in 2010. The increase primarily related to increases in service charges on deposits products.

NON-INTEREST EXPENSE Non-interest ~~expenses~~expense ~~increased~~was to $4.65 million and $9.0 million for the quarter and six months ended ~~March~~June 3130, 2011 compared to $4.37 ~~for~~million and $9.1 million in the like periods in 2010. For the quarter ended ~~March~~June 3130, 2011 compared to the quarter ended June 30, 2010., ~~The~~the ~~increase~~decrease was primarily athe result of a $~~193~~245,000 ~~increase~~decrease in ~~the~~ provisions for other real estate losses and $84,000 decrease in salaries relating to bonus and incentive compensation. ~~These~~For ~~provisions~~the ~~were~~six amonths, the decrease was primarily the result of ~~updated~~a ~~appraisals~~$52,000 ~~received~~decrease in other real estate owned and ~~the~~a $129,000 decrease in ~~fair~~salaries ~~market~~expense ~~values~~related ofprimarily ~~these~~to ~~real~~decreased ~~estate~~bonus ~~properties.~~and ~~Valuation~~incentive ofcompensation ~~the~~which were partially offset by increases in loan collection and other real estate owned ~~property~~expenses, ~~occurs~~computer ~~when~~and itprocessing isexpenses ~~foreclosed~~and ~~upon~~legal and ~~annually~~consulting ~~thereafter~~expenses.

The efficiency ratio is computed by dividing total ~~non-interest~~operating expenses by non-interest income and net interest income before ~~any~~ provision for loan losses. ~~Bancorp’s~~An increase in the efficiency ratio ~~was~~indicates ~~75.2~~that ~~percent~~more ~~and~~resources 68are being utilized to generate the same or greater volume of income.7 ~~percent~~The efficiency ratio for the ~~quarters~~quarter and six months ended ~~March~~June 3130, 2011 was 68.3 percent and ~~2010,~~71.6 ~~respectively~~percent compared to 70.4 percent and 69.6 percent for the same time periods in 2010.

INCOME TAX EXPENSE Income tax expense ~~remained~~for ~~relatively~~the ~~unchanged~~quarter atand six months ended June 30, 2011 was $~~216~~311,000 and $~~218~~527,000 compared to $280,000 ~~respectively~~and $498,000 expense for the ~~quarters~~quarter and six months ended ~~March~~June 3130, ~~2011 and~~ 2010, ~~with~~respectively. Bancorp’s effective tax rates ofwere 1817.14 percent and 1516.34 percent for the six months ended June 30, 2011 and 2010, respectively.

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.30

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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 June 30, 2011, Bancorp had $511,000 in tax-exempt income from tax-exempt bonds and warrants. In addition, Bancorp had $20.7 million in Qualified Zone Academy Bonds as of June 30, 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.

REVIEW OF FINANCIAL CONDITION

Total assets increased to $~~709~~707.1 million at ~~March~~June 3130, 2011 compared to $692.9 million at December 31, 2010. This increase was primarily due to a $1516.48 million increase in deposits. Net loans decreased $11.4 million to $346.9 million during the same time period.

INVESTMENT SECURITIES AND FEDERAL FUNDS SOLD Investment securities and federal funds sold increased $2426.24 million to $~~324~~326.02 million at ~~March~~June 3130, 2011 and within the total, federal funds sold decreased to $7149.2 million at ~~March~~June 3130, 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~~June 3130, 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~~June 3130, 2011, the available-for-sale investment portfolio was comprised of 4044.07 percent Government Sponsored Agency and Government Agency residential mortgage-backed pass-through securities and collateralized mortgage obligations, 4.21 percent of state and municipals and 5551.82 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 $4798.32 million for the ~~three~~six months ended ~~March~~June 3130, 2011, while maturities, security calls and principal pay downs totaled $1342.58 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
	June 30, 2011		December 31, 2010
Held-To-Maturity
State and political subdivisions	$	3836,~~308~~249	$	38,367
Total	$	3836,~~308~~249	$	38,367
Available-For-Sale
U.S. government agencies	$	~~119~~123,~~775~~279	$	85,775
Residential mortgage-backed securities and collateralized mortgage obligations	85107,~~752~~615		86,431
State and political subdivisions	89,~~989~~807		8,765
Total	$	~~214~~240,~~516~~701	$	180,971

LOANS Net loans decreased $611.64 million to $~~351~~346.69 million at ~~March~~June 3130, 2011 from $358.2 million at December 31, 2010. Net loans represented 49.61 percent of total assets at ~~March~~June 3130, 2011. Bancorp continues to originate and fund loans to credit-worthy customers within our markets. However, decreased loan balances reflect the current ~~market~~economic conditions ~~and~~which ~~the~~results in lower loan demand and lower availability of quality loans. Additionally, economic conditions have resulted in lower usage of available lines of credit and operating lines by Bancorp’s borrowers. 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 1817% of our portfolio as of ~~March~~June 3130, 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 2928% of our portfolio as of ~~March~~June 3130, 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~~multifamily ~~Estate Construction: These loans compromised 1% of our portfolio as of March 31, 2011~~ and ~~December 31, 2010~~warehouses. ~~Real~~These ~~Estate construction~~ loans are ~~short~~typically term loans ~~made~~and ~~for~~are ~~the~~made ~~construction~~to ~~period~~purchase ~~required~~or ~~for~~refinance ~~both~~non-owner occupied commercial ~~construction~~real ~~projects and residential construction projects~~estate. Commercial ~~These~~real estate loans ~~are~~also ~~generally~~include ~~secured by the~~ real estate ~~project~~secured ~~being~~raw ~~constructed.~~land ~~Commercial construction~~ loans ~~are~~and ~~available~~land ~~for~~development ~~owner-occupied~~loans ~~real~~which ~~estate~~are ~~utilized~~made ~~by small~~ to ~~medium~~ ~~sized~~acquire ~~businesses~~land ~~and~~or ~~individuals~~finance ~~for~~development ~~their~~preparatory ~~business~~to ~~operations~~erecting ~~and~~residential ~~for~~or ~~non-owner~~commercial ~~occupied real estate~~structures.

~~Consumer~~Other Real Estate Loans: ~~Consumer~~Other real estate loans ~~compromises~~compromised 1143% of our portfolio as of ~~March~~June 3130, 2011 compared to 1240% at December 31, 2010.~~Bancorp~~ ~~makes~~Other ~~secured~~real ~~and~~estate ~~unsecured consumer~~ loans ~~including~~are ~~loans~~typically tomade ~~individuals~~for, ~~primarily~~the ~~customers~~purchase of ~~Bancorp~~or refinance of, residential real estate, real estate used for ~~various~~agricultural purposes, including ~~home~~timberland, ~~equity~~and ~~loans,~~owner-occupied ~~purchases~~real ofestate ~~automobiles,~~utilized ~~mobile~~by ~~homes,~~small ~~boats~~to medium sized businesses and ~~other~~individuals ~~recreational~~for ~~vehicles,~~their ~~home~~business ~~improvement~~operations. ~~loans~~They ~~and~~are typically term loans ~~for~~secured ~~education~~by ~~and~~the ~~personal~~property ~~investments~~being purchased or refinanced.

~~Concentrations:~~Real ~~While~~Estate ~~Bancorp~~Construction: ~~has~~These ~~a diversification of loan types and type of security, Bancorp does have a concentration of~~ loans incompromised 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 771% of ~~the~~our ~~total loan~~ portfolio ~~and~~as ~~39%~~ of ~~total~~June 30, ~~assets~~2011 asand ~~of March~~December 31, ~~2011~~2010. ~~Further~~ ~~declines~~Real inEstate ~~the~~construction ~~performance~~loans ofare ~~the~~short ~~economy,~~term inloans ~~general,~~made orfor ~~further~~the ~~declines~~construction inperiod ~~real~~required ~~estate~~for ~~values~~both incommercial ~~our~~construction ~~market~~projects ~~areas,~~and inresidential ~~particular,~~construction ~~could~~projects. ~~have~~These anloans ~~adverse~~are ~~impact~~generally onsecured ~~collectability,~~by ~~increase~~ the ~~level of~~ real estate ~~non-performing~~project ~~loans~~being ~~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~~constructed. In ~~addition,~~Commercial ~~Bancorp~~construction ~~has~~loans aare ~~high~~available ~~concentration~~for ofowner-occupied ~~loans~~real toestate autilized ~~relatively~~by 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 medium asized ~~group~~businesses ofand ~~approximately~~individuals 43for ~~customers. Also,~~their ~~most of Bancorp’s~~ business ~~activity~~operations ~~is with customers located within Skagit, Snohomish~~ and ~~Whatcom~~for ~~Counties.~~non-owner ~~While~~occupied ~~Bancorp~~real ~~has these concentrations, Bancorp believes that its lending policies and concentration policies are sufficient to minimize risks~~estate. Management employs risk management practices, including board and management oversight and strategic planning, development of underwriting standards, risk assessment and monitoring through stress testing.

Consumer Loans: Consumer loans compromises 11% of our portfolio as of June 30, 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 79% of the total loan portfolio and 39% of total assets as of June 30, 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 50% of our loan portfolio as of June 30, 2011 was comprised of loans to a group of approximately 44 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.

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

Loan Composition

(dollars in thousands)	~~March~~June 3130, 2011			December 31, 2010
Commercial	$	6558,~~202~~592		$	69,177
Commercial real estate
Raw land and land development	37,~~884~~585			37,233
Other commercial real estate	6561,~~082~~734			65,516
Other real estate
Residential	33,~~218~~131			34,681
Farmland and owner occupied nonfarm nonresidential	~~113~~118,~~652~~757			115,291
Real estate construction
Commercial	~~892~~826			826
Residential	3,~~454~~627			3,210
Consumer
Home equity	2423,~~320~~611			23,522
Credit cards and other consumer	15,~~956~~844			16,622
	$	~~359~~353,~~660~~707		$	366,078
Less deferred loan fees	(~~692~~510		)	(759		)
Total Loans	$	~~358~~353,~~968~~197		$	365,319

Management employs risk management practices, including board and management oversight and strategic planning, development of underwriting standards, risk assessment and monitoring through stress testing. In addition, 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. Included in these commercial real estate concentrations are loans for construction, land development, raw land, multifamily, and nonfarm nonresidential non-owner occupied properties. Excluded from these commercial real estate concentrations are nonfarm nonresidential owner occupied properties where the primary source of repayment is the cash flow from the ongoing operations and activities conducted by the party, or affiliate of the party, who owns the property.

ALLOWANCE FOR LOAN LOSSES The allowance for loan losses was $6.3 million or 1.82 percent of net loans as of June 30, 2011 compared to $7.1 million or 1.98 percent of net loans as of December 31, 2010. Additions to the allowance, in the form of provision, are reflected in current operating results, while charge-offs to the allowance are made when a loss is determined to have occurred. The provision for loan losses was $225,000 and $550,000 for the quarter and six months ended June 30, 2011, respectively, compared to $370,000 and $920,000 for the like period in 2010. For the quarter and six month ended June 30, 2011, net charge-offs were $1.2 million and $1.3 million compared to $258,000 and $411,000 for the like periods in 2010.

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ALLOWANCE FOR LOAN LOSSES The allowance for loan losses was $7.3 million or 2.09 percent of net loans as of March 31, 2011 compared to $7.1 million or 1.98 percent of net loans as of December 31, 2010. Additions to the allowance, in the form of provision, are reflected in current operating results, while charge-offs to the allowance are made when a loss is determined to have occurred. 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. For the three months ended March 31, 2011 and 2011, net charge-offs were $58,000 and $153,000, respectively. Net charge-offs have an impact on the historical loss factors used in Bancorp’s allowance for loan losses computation.

The allowance for loan losses (“ALLL”) represents management’s best estimate of losses inherent in the portfolio, consists of specific, general and unallocated components. The allowance consists of specific, general and unallocated components; (i) a specific valuation allowance 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. Bancorp’s process is designed to account for credit deterioration as it occurs. The adjustments are a result of management’s judgment about risks inherent in the portfolio and include such factors as loan quality trends, levels of and trends of non-accrual loans, past due loans, potential problem loans, criticized loan balances, net charge-offs and current economic and business conditions, among other factors and (iii) unallocated general allowances determined based on general economic conditions and other qualitative risk factors. 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 unallocated amount is reviewed periodically based on trends in credit losses, the results of credit reviews and overall economic trends. 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 in this report.

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The following table presents Bancorp’s allocation of the allowance for loan losses by loan category as of the dates indicated. (dollars in thousands)

	March 31, 2011		December 31, 2010
	June 30, 2011		December 31, 2010
Commercial	$	~~2,156~~906	$	1,494
Commercial real estate	2,~~321~~230		2,564
Other real estate	1,~~275~~187		1,400
Real estate construction	9081		67
Consumer	~~804~~757		855
Unallocated	~~700~~1,163		699
Total	$	76,~~346~~324	$	7,079

The following table presents the activity in the allowance for loan losses for the dates indicated.

Allowance for Loan Losses Activity

	Three months ended,
	Three months ended June 30, Six months ended June 30,
(dollars in thousands)	2011			2010			2011			2010
Allowance as of beginning of period	$	7,~~079~~346		$	67,~~883~~280		$	7,079		$	6,883
Provision for loan losses	~~325~~225			~~550~~370			550			920
Charge-offs	(921,292		)	(~~188~~323		)	(1,384		)	(511		)
Recoveries	3445			3565			79			100
Net charge-offs	(581,247		)	(~~153~~258		)	(1,305		)	(411		)
Balance at end of period	$	76,~~346~~324		$	7,~~280~~392		$	6,324		$	7,392
Ratio of net charge-offs to average loans during the period	0(1.0742		)%	(0.1627		)%	(0.74		)%	(0.21		)%
Ratio of allowance to net loans at end of period	21.0982		%	1.9097		%	1.82		%	1.97		%
Ratio of non-performing loans to allowance	~~249~~239.7786		%	~~139~~124.2234		%	239.86		%	124.34		%

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Credit Risk Management

The extension of credit to individuals and businesses is a significant portion of Bancorp’s principal business activity and requires ongoing portfolio and credit management. Bancorp has established lending policies and procedures to manage and monitor risk. These lending policies and procedures include guidelines for concentrations of credit, loan terms, loan-to-value ratios, collateral appraisals, borrower lending limits and loan approval limits. In addition, Bancorp monitors its loan portfolio for potential risk of loss according to an internal risk-grading system and monitors its credit quality to identify potential problem credits and any loss exposure in a timely manner. Bancorp has assessed and will continue to assess on an on-going basis, the impact of the economy on the credit risk in the loan portfolio.

ASSET QUALITY Non-performing assets consist of nonaccrual loans, accruing loans past due 90 days or more, and other real estate owned. At ~~March~~June 3130, 2011, non-performing assets increased to $2220.72 million or 32.2086 percent of total assets compared to $18.6 million or 2.69 percent as of December 31, 2010. The increase was mainly the result of one loan relationship, with an aggregate balance of $5.0 million, moving into non-accrual status during the ~~three~~six months ended ~~March~~June 3130, 2011.

Non-accrual loans -— It is Bancorp’s policy to discontinue the accrual of interest on all loans that are 90 days or more past due or when there are otherwise serious doubts about the collectability of principal or interest within the existing terms of the loan and place them on non-accrual. When a loan is placed on non-accrual status, any accrued but unpaid interest on that date is removed from interest income. Non-accruing loans were $1815.32 million as of ~~March~~June 3130, 2011 compared to $12.8 million as of December 31, 2010.

Troubled Debt Restructurings — Loans are considered troubled debt restructures on loans for which concessions, including the reduction of interest rates below a rate otherwise available to that borrower or the deferral or forgiveness, of interest or principal, have been granted due to the borrower’s weakened financial condition. Restructured loans included in impaired loans were $5.78 million as of ~~March~~June 3130, 2011 of which, $5.78 million was included in non-accrual loans. Restructured loans included in impaired loans were $5.4 million as of December 31, 2010, of which, $5.4 million was included in non-accrual loans.

Other real estate owned — At March 31, 2011 and December 31, 2010, Bancorp held six properties which represent three separate land development projects consisting of finished lots with a carrying balance of $ 3.2 million and $3.4, respectively. Valuation of the property occurs when it is foreclosed upon and annually thereafter. Based on current appraisals received for the three months ended March 31, 2011 and 2010 and the decrease in fair market values of these real estate properties, Bancorp recorded a write-down on other real estate owned of $213,000 and $20,000, respectively. It is Bancorp’s plan to continue its collection efforts and liquidation of collateral, as necessary, to recover as large a portion of other real estate owned as possible.34

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Other real estate owned — Other real estate owned decreased $779,000 to $ 5.0 million compared to $5.8 million at December 31, 2010. During 2011, one commercial real estate property of $1.4 million was sold. In addition, four properties for a total of $978,000 were transferred to other real estate owned. As of June 30, 2011, Bancorp held eight properties which represent three separate land development projects consisting of finished lots with a carrying balance of $3.2 million, two commercial real estate properties with a carrying balance of $996,000, and three residential properties with a carrying balance of $853,000.

Valuation of the property occurs when it is foreclosed upon and annually thereafter. Based on current appraisals received for the six months ended June 30, 2011 and 2010 and the decrease in fair market values of these real estate properties, Bancorp recorded a write-down on other real estate owned of $213,000 and $265,000, respectively. It is Bancorp’s plan to continue its collection efforts and liquidation of collateral, as necessary, to recover as large a portion of other real estate owned as possible.

The following table presents non-performing asset information related to loans accounted for on a non-accrual basis, accruing loans 90 days or more past due and other real estate owned for the dates indicated.

Non-Performing Assets

(dollars in thousands)	~~March~~June 3130, 2011			December 31, 2010
Non-accrual loans	$	1815,~~348~~169		$	12,794
Loans past due 90 days or more	—			—
Total non-performing loans	1815,~~348~~169			12,794
Other real estate owned	45,~~334~~034			5,813
Total non-performing assets	$	2220,~~682~~203		$	18,607
Total non-performing loans to net loans	54.2237		%	3.57		%
Total non-performing loans to total assets	2.5915		%	1.85		%
Total non-performing assets to total assets	32.2086		%	2.69		%

Impaired loans - At ~~March~~June 3130, 2011, impaired loans ~~increased~~decreased to $1916.46 million compared to $17.9 million at December 31, 2010. ~~Four~~Five credit relationships totaling $1312.45 million, accounted for 6975.0 percent of impaired loans as of ~~March~~June 3130, 2011.

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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 according to contractual terms. Factors considered by management in determining impairment include payment status, and the probability of collecting scheduled principal and interest payments when due. Impaired loans include loans in nonaccrual status, troubled debt restructures and other loans that management considers to be impaired. Other loans include loans that management has reviewed for impairment and has determined to be impaired even though the loan may be current and performing in accordance with the contractual loan terms. As a result, these other impaired loans continue to remain on accrual status and are not considered non-performing assets. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired.

Other potential problem loans — Potential problem loans consist of risk rated substandard loans that are currently performing, are not on nonaccrual status, restructured or impaired, but for which management have identified as having a well defined weakness or weaknesses and which there are sufficient doubts as to the borrower’s future ability to comply with repayment terms. These loans are identified through our internal risk grading processes and management monitors these loans closely and reviews their performance on a regular basis. As of ~~March~~June 3130, 2011 and December 31, 2010, Bancorp had classified $1514.50 million and $18.6 million, respectively, as potential problem loans.

Risk Rating System: An effective risk rating system provides information for use in determining the overall level of the Allowance for Loan Loss. Accurate and timely risk rating recognition is a primary component of an effective risk rating system. Risk ratings are reviewed through various channels including the loan approval process, the loan reporting process for approved loans, an external loan review process and through the regulatory review process. The Bank risk rates the commercial loan portfolio on a nine scale system, while 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, 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.~~

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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.

DEPOSITS Bancorp offers a full range of deposit services including checking accounts, savings accounts, money market accounts and various types of certificates of deposit. The transaction accounts and certificates of deposit are tailored to Bancorp’s primary market area at rates competitive with those offered in the area. Bancorp offers both interest and non-interest bearing checking accounts.

Total deposits increased $1516.48 million to $~~606~~607.36 million at ~~March~~June 3130, 2011 compared to $590.9 million at December 31, 2010. Within the total, the increase came from core deposits which increased $2026.5 million. This increase was partially offset by a $59.18 million decrease in time deposits. As a result, core deposits as a percentage of total deposits increased to 6566.32% at ~~March~~June 3130, 2011 compared to 63.6% at December 31, 2010. Core deposits consist of non- interest and interest bearing demand accounts, money market accounts, and saving accounts.

In December 2008, Bancorp initiated service through the Certificate of Deposit Account Registry Service (CDARS). Bancorp uses CDARS to offer existing customers the ability to obtain additional FDIC insurance coverage. Although all CDARS deposits represent direct customer relationships with Bancorp, for regulatory purposes they are required to be classified as brokered deposits. CDARS deposits were $14.52 million and $19.5 million at ~~March~~June 3130, 2011 and December 31, 2010.

The following table presents the balance and percent of total deposits in the various categories of deposits offered by Bancorp as of the dates indicated.

Deposit Composition

	March 31, 2011				December 31, 2010
	June 30, 2011				December 31, 2010
(dollars in thousands)	Amount		% of Total		Amount		% of Total
Non-interest bearing demand	$	7879,~~372~~672	1213.91	%	$	79,099	13.4	%
Interest bearing demand	~~110~~112,~~081~~790		18.26	%	109,085		18.5	%
Money market	~~100~~97,~~439~~758		16.61	%	87,289		14.8	%
Savings	~~107~~111,~~195~~844		1718.74	%	100,068		16.9	%
Time	~~195~~191,~~710~~330		3231.35	%	195,800		33.1	%
Brokered time deposits (CDARS)	14,~~531~~245		2.3	%	19,540		3.3	%
Total deposits	$	~~606~~607,~~328~~639	100.0	%	$	590,881	100.0	%

33OTHER BORROWINGS Borrowings consist of federal funds purchased, discount window borrowings from the Federal Reserve Bank of San Francisco and securities sold under agreements to repurchase. At June 30, 2011 and December 31, 2010, securities sold under agreements to repurchase were $29.5 million and $34.1 million, respectively. These borrowings decrease or increase primarily based on the availability of funds and the current competitive interest rate offered. These borrowings are collateralized by securities with an estimated fair value exceeding the face value of the borrowings. Periodically, Bancorp uses federal funds purchased and Federal Reserve borrowings as a funding source. Bancorp had no Federal Reserve borrowings at June 30, 2011 and December 31, 2010.

CAPITAL RESOURCES Stockholders’ equity increased to $69.0 million at June 30, 2011 from $66.0 million at December 31, 2010. Book value per share at June 30, 2011 was $117.36 compared to $112.32 at December 31, 2010.

Bancorp has only one class of stock, which is common stock and at June 30, 2011, there were 789 shareholders of record. Bancorp’s stock is not actively traded or quoted and no broker currently makes a market in the stock. However, sales and transfers of the stock do occur. Skagit State Bank acts as transfer agent for Bancorp stock. To facilitate trading, the Bank maintains a list of persons interested (known to the Bank) in either purchasing or selling Bancorp stock. Purchasers and sellers then negotiate their own transactions with the Bank acting as transfer agent for those transactions. From time to time, Bancorp repurchases shares of its common stock. The number of shares of stock that will be repurchased and the price that will be paid is the result of many factors including market and economic conditions, the number of shares available, Bancorp’s liquidity and capital needs and regulatory requirements. Bancorp did not repurchase any shares in for the three months ended June 30, 2011 and 2010.

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~~OTHER~~Skagit ~~BORROWINGS Borrowings~~State ~~consist~~Bancorp ofand ~~federal~~Skagit ~~funds~~State ~~purchased,~~Bank ~~discount~~are ~~window~~both ~~borrowings~~subject ~~from~~to ~~the~~various ~~Federal~~regulatory ~~Reserve~~capital ~~Bank~~requirements ofadministered ~~San~~by ~~Francisco~~the Federal Reserve and ~~securities~~the ~~sold~~FDIC under ~~agreements~~which torisk ~~repurchase. At~~percentages ~~March 31,~~are ~~2011~~assigned ~~and~~to ~~December 31,~~various ~~2010,~~categories ~~securities~~of ~~sold~~asset ~~under~~and ~~agreements~~off-balance tosheet ~~repurchase~~items ~~were~~to ~~$34.5~~calculate ~~million~~a ~~and~~risk-adjusted ~~$34.1~~capital ~~million, respectively~~ratio. The ~~These~~federal ~~borrowings~~regulations ~~decrease~~set orforth ~~increase~~the ~~primarily~~qualifications ~~based~~necessary onfor ~~the~~bank ~~availability~~holding ofcompanies ~~funds~~ and ~~the~~banks ~~current~~to ~~competitive~~be ~~interest~~classified ~~rate~~as ~~offered~~“well capitalized”. ~~These~~ ~~borrowings~~Failure ~~are~~to ~~collateralized~~be bywell-capitalized ~~securities~~can ~~with~~impact ana ~~estimated~~bank’s ~~fair~~insurance ~~value~~premium ~~exceeding~~rates, ~~the~~can ~~face~~negatively ~~value~~impact ofa ~~the~~bank’s ~~borrowings.~~ability ~~Periodically,~~to ~~Bancorp~~expand ~~uses~~and ~~federal~~engage ~~funds~~in ~~purchased~~certain ~~and~~activities. ~~Federal~~At ~~Reserve~~June 30, ~~borrowings~~2011, asSkagit aState ~~funding source.~~ Bancorp ~~had~~and nothe ~~Federal~~Bank ~~Reserve~~both ~~borrowings~~exceeded atregulatory ~~March 31,~~capital ~~2011~~requirements and ~~December 31,~~were ~~2010~~“well-capitalized” pursuant to such regulations.

CAPITAL RESOURCES Stockholders’ equity increased to $66.9 million at March 31, 2011 from $66.0 million at December 31, 2010. Book value per share at March 31, 2011 was $113.78 compared to $112.32 at December 31, 2010.

									To Be Well
									Capitalized Under
					For Capital				Prompt Corrective
	Actual				Adequacy Purposes				Action Provisions
(dollars in thousands)	Amount		Ratio		Amount		Ratio		Amount		Ratio
As of June 30, 2011
Total Capital (to Risk-Weighted Assets)
Skagit State Bank	$	71,055	16.15	%	$	35,201	>8.00	%	$	44,002	>10.00	%
Skagit State Bancorp, Inc.	$	71,298	16.20	%	$	35,211	>8.00	%	$	44,014	>10.00	%
Tier I Capital (to Risk-Weighted Assets)
Skagit State Bank	$	65,545	14.90	%	$	17,601	>4.00	%	$	26,401	>6.00	%
Skagit State Bancorp, Inc.	$	65,786	14.95	%	$	17,605	>4.00	%	$	26,408	>6.00	%
Tier I Capital (to Average Assets)
Skagit State Bank	$	65,545	9.21	%	$	28,462	>4.00	%	$	35,578	>5.00	%
Skagit State Bancorp, Inc.	$	65,786	9.25	%	$	28,462	>4.00	%	$	35,578	>5.00	%

As of December 31, 2010
Total Capital (to Risk-Weighted Assets)
Skagit State Bank	$	69,658	15.75	%	$	35,378	>8.00	%	$	44,222	>10.00	%
Skagit State Bancorp, Inc.	$	69,882	15.80	%	$	35,389	>8.00	%	$	44,237	>10.00	%
Tier I Capital (to Risk-Weighted Assets)
Skagit State Bank	$	64,111	14.50	%	$	17,689	>4.00	%	$	26,533	>6.00	%
Skagit State Bancorp, Inc.	$	64,333	14.54	%	$	17,695	>4.00	%	$	26,542	>6.00	%
Tier I Capital (to Average Assets)
Skagit State Bank	$	64,111	9.27	%	$	27,673	>4.00	%	$	34,592	>5.00	%
Skagit State Bancorp, Inc.	$	64,333	9.30	%	$	27,673	>4.00	%	$	34,592	>5.00	%

Bancorp has only one class of stock, which is common stock and at March 31, 2011, there were 781 shareholders of record. Bancorp’s stock is not actively traded or quoted and no broker currently makes a market in the stock. However, sales and transfers of the stock do occur. Skagit State Bank acts as transfer agent for Bancorp stock. To facilitate trading, the Bank maintains a list of persons interested (known to the Bank) in either purchasing or selling Bancorp stock. Purchasers and sellers then negotiate their own transactions with the Bank acting as transfer agent for those transactions. From time to time, Bancorp repurchases shares of its common stock. The number of shares of stock that will be repurchased and the price that will be paid is the result of many factors including market and economic conditions, the number of shares available, Bancorp’s liquidity and capital needs and regulatory requirements. Bancorp did not repurchase any shares in for the three months ended March 31, 2011 and 2010.

Skagit State Bancorp and Skagit State Bank are both subject to various regulatory capital requirements administered by the Federal Reserve and the FDIC under which risk percentages are assigned to various categories of asset and off-balance sheet items to calculate a risk-adjusted capital ratio. The federal regulations set forth the qualifications necessary for bank holding companies and banks to be classified as “well capitalized”. Failure to be well —capitalized can impact a bank’s insurance premium rates, can negatively impact a bank’s ability to expand and engage in certain activities. At March 31, 2011, Skagit State Bancorp and the Bank both exceeded regulatory capital requirements and were “well-capitalized” pursuant to such regulations.

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									To Be Well
									Capitalized Under
					For Capital				Prompt Corrective
	Actual				Adequacy Purposes				Action Provisions
(dollars in thousands)	Amount		Ratio		Amount		Ratio		Amount		Ratio
As of March 31, 2011
Total Capital
(to Risk-Weighted Assets)
Skagit State Bank	$	70,742	16.07	%	$	35,217	>8.00	%	$	44,021	>10.00	%
Skagit State Bancorp, Inc.	$	70,895	16.10	%	$	35,229	>8.00	%	$	44,036	>10.00	%
Tier I Capital
(to Risk-Weighted Assets)
Skagit State Bank	$	65,217	14.81	%	$	17,608	>4.00	%	$	26,413	>6.00	%
Skagit State Bancorp, Inc.	$	65,368	14.84	%	$	17,614	>4.00	%	$	26,421	>6.00	%
Tier I Capital
(to Average Assets)
Skagit State Bank	$	65,217	9.36	%	$	27,869	>4.00	%	$	34,836	>5.00	%
Skagit State Bancorp, Inc.	$	65,368	9.38	%	$	27,869	>4.00	%	$	34,836	>5.00	%
As of December 31, 2010
Total Capital
(to Risk-Weighted Assets)
Skagit State Bank	$	69,658	15.75	%	$	35,378	>8.00	%	$	44,222	>10.00	%
Skagit State Bancorp, Inc.	$	69,882	15.80	%	$	35,389	>8.00	%	$	44,237	>10.00	%
Tier I Capital
(to Risk-Weighted Assets)
Skagit State Bank	$	64,111	14.50	%	$	17,689	>4.00	%	$	26,533	>6.00	%
Skagit State Bancorp, Inc.	$	64,333	14.54	%	$	17,695	>4.00	%	$	26,542	>6.00	%
Tier I Capital
(to Average Assets)
Skagit State Bank	$	64,111	9.27	%	$	27,673	>4.00	%	$	34,592	>5.00	%
Skagit State Bancorp, Inc.	$	64,333	9.30	%	$	27,673	>4.00	%	$	34,592	>5.00	%

LIQUIDITY

Bancorp has a formal liquidity policy that establishes liquidity guidelines and the maintenance of contingency liquidity plans that provide for actions and timely responses to liquidity stress situations and that are in accordance with regulatory guidance. The objective of liquidity risk management is to ensure that Bancorp has the continuing ability to maintain cash flows that are adequate to fund operations including day to day cash flow requirements of either its depositors wanting to withdraw funds or to provide for customers credit needs. The majority of our funding comes from customer deposits within the Bank’s market area. In addition, funding needs are met through loan repayments, investment securities repayments and earnings. Liquidity may also be obtained by borrowing through pre-approved credit lines and by marketable securities that can be readily converted to cash or pledged as collateral for additional borrowings. For the future there can be no guarantee that these unsecured lines of credit will remain available or that securities can be converted to cash with or without loss. Bancorp uses deposits to fund loans and investments that are typically longer in term.

As of ~~March~~June 3130, 2011 Bancorp had approximately $27.0 million in approved unsecured credit lines from various financial institutions and had securities with a market value of $3129.75 million pledged as collateral for borrowing at the Federal Reserve Discount Window, and unpledged marketable securities with a market value of $~~122~~157.81 million available for funding needs. Because the Bank’s primary sources and uses of funds are deposits and loans, the relationship between net loans and total deposits provides one measure of the Bank’s liquidity. The Bank’s loan to deposit ratio decreased to 58.0 percent at March 31, 2011 compared to 60.6 percent at December 31, 2010, as a result of the increase in deposits and the decrease in loans.

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~~The~~available ~~analysis~~for offunding ~~liquidity~~needs. ~~also~~Because ~~includes a review of~~ the ~~statement of cash flows. The cash flows detail Bancorp~~Bank’s ~~operating,~~primary ~~investing~~sources and ~~financing~~uses ~~activities~~of ~~during~~funds ~~the~~are ~~year.~~deposits ~~Cash~~and ~~flows~~loans, ~~from operations contribute to liquidity as well as proceeds from~~ the ~~maturities~~relationship ofbetween ~~securities,~~net ~~loan~~loans ~~repayments~~ and ~~increasing~~total ~~customer~~ deposits. Asprovides ~~indicated~~one inmeasure ~~the statement~~ of ~~cash flows, in~~ the ~~Consolidated~~Bank’s ~~Statement~~liquidity. The ofBank’s ~~Cash~~loan ~~Flows,~~to ~~net~~deposit ~~cash~~ratio ~~flows~~decreased ~~from~~to ~~operating and financing activities contributed $1~~57.51 ~~million~~percent ~~and~~at ~~$15.8 million to liquidity~~June 30, ~~respectively,~~2011 ~~for~~compared ~~the~~to ~~three~~60.6 ~~months~~percent ~~ended~~at ~~March~~December 31, ~~2011.~~2010, ~~The~~as ~~net~~a ~~use~~result of ~~cash~~the ~~from~~increase ~~investing~~in ~~activities~~deposits ofand ~~$17.0 million was primarily for~~ the ~~net~~decrease ~~purchase of $47.3 million~~ in ~~investment securities~~loans.

The analysis of liquidity also includes a review of the statement of cash flows. The cash flows detail Bancorp’s operating, investing and financing activities during the year. Cash flows from operations contribute to liquidity as well as proceeds from the maturities of securities, loan repayments and increasing customer deposits. As indicated in the statement of cash flows, in the Consolidated Statement of Cash Flows, net cash flows from operating and financing activities contributed $2.8 million and $10.9 million to liquidity, respectively, for the six months ended June 30, 2011. The net use of cash from investing activities of $13.4 million was primarily for the net purchase of $98.2 million in investment securities.

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

Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

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

Asset Liability Management: Bancorp maintains an asset/liability management program which is the responsibility of the Asset Liability Committee. The objective of asset liability management is to manage, protect and stabilize Bancorp’s net interest income from undue interest rate risk through various interest rate cycles within the constraints of credit quality, interest rate risk policies, levels of capital and adequate levels of liquidity. The committee meets to monitor the composition of the balance sheet, to review projected earnings trends, and to formulate strategies consistent with these objectives for liquidity, interest rate risk, and capital adequacy. Bancorp believes that there have not been any material changes about Bancorp’s market risk from the information that was provided in the Form 10-K for the year ended December 31, 2010.

Item 4. CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

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

Changes in Internal Controls

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

PART II - OTHER INFORMATION

Item 1. Legal Proceedings

From time to time, Bancorp may be a plaintiff and/or defendant in certain claims and legal actions arising in the ordinary course of commercial banking involving real estate lending transactions and other ordinary routine litigation incidental to the business of Bancorp. Bancorp is not a party to any pending legal proceedings that Bancorp believes would have a material adverse effect on the financial condition of Bancorp.

Item 1A. Risk Factors

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

~~The continued challenging economic environment could have a material adverse effect on our future results of operations or trading price of our stock.~~38

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The continued challenging economic environment could have a material adverse effect on our future results of operations or trading price of our stock.

The national economy, and the financial services sector in particular, are still facing significant challenges. Substantially all of our loans are to businesses and individuals in Skagit, Snohomish or Whatcom Counties, Washington, markets facing many of the same challenges as the national economy, including continued unemployment and declines in commercial and residential real estate. Although some economic indicators are improving both nationally and in the markets we serve, unemployment remains high and there remains substantial uncertainty regarding when and how strongly a sustained economic recovery will occur. A further deterioration in economic conditions in the nation as a whole or in the markets we serve or a protracted recovery period could result in the following consequences, any of which could have an adverse impact, which may be material, on our business, financial condition, results of operations and prospects, and could also cause the market price of our stock to decline:

· economic conditions may worsen, increasing the likelihood of credit defaults by borrowers;

· loan collateral values, especially as they relate to commercial and residential real estate, may decline further, thereby increasing the severity of loss in the event of loan defaults;

· demand for banking products and services may decline, including services for low cost and non-interest-bearing deposits; and

· changes and volatility in interest rates may negatively impact the yields on earning assets and the cost of interest-bearing liabilities.

Bancorp’s concentration in real estate loans could adversely affect Bancorp’s earnings in an economic downturn.

Real estate related loans, including those loans that are collateralized by real estate, comprise the largest category of loans, representing 7779 percent of Bancorp’s total loans. Our real estate portfolio consists of commercial and residential lending. These loans are secured by property such as office buildings, commercial business properties, healthcare buildings, agricultural land, timber land and residential properties. Commercial and commercial real estate loans generally are viewed as having more risk of default than residential real estate loans or certain other types of loans or investments. Typically, these types of loans are larger than residential real estate loans and other loans. Because the loan portfolio contains a number of commercial real estate loans with relatively large balances, the deterioration of one or a few of these loans may cause a significant increase in nonperforming loans. An increase in nonperforming loans could result in a loss of earnings from these loans, an increase in the provision for loan losses or an increase in loan charge-offs, which could have an adverse impact on our results of operations and financial condition.

The Bank 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 4750% of our loan portfolio as of ~~March~~June 3130, 2011 was comprised of loans to a group of approximately 4344 customers. If any material portion of those customers ceased doing business with the Bank, it could have a materially adverse effect on Bancorp’s earnings and financial condition.

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

Bancorp maintains an allowance for loan losses in an amount that we believe is adequate to provide for losses inherent in the loan portfolio. While we strive to carefully manage and monitor credit quality and to identify loans that may become nonperforming, at any time there are loans included in the portfolio that will result in losses, but that have not been identified as nonperforming or potential problem loans. By closely monitoring our credit quality, we attempt to identify deteriorating loans before they become nonperforming assets and adjust the loan loss reserve accordingly. However, because future events are uncertain, and if ~~the~~adverse ~~economy~~economic ~~continues~~conditions continue to ~~deteriorate~~persist, there may be loans that deteriorate to a nonperforming status in an accelerated time frame. As a result, future additions to the allowance may be necessary. Because the loan portfolio contains a number of loans with relatively large balances, the deterioration of one or a few of these loans may cause a significant increase in nonperforming loans, requiring an increase to the loan loss allowance. As a result, future additions to the allowance at elevated levels may be required based on changes in the mix of loans comprising the portfolio, changes in the financial condition of borrowers, such as may result from changes in economic conditions, or as a result of actual events being different from assumptions used by management in determining the allowance. Additionally, banking regulators, as an integral part of their supervisory function, periodically review our loan portfolio and the adequacy of our allowance for loan losses. These regulatory agencies may require us to recognize further loan loss provisions or charge-offs based upon their judgments, which may be different from ours. Any increase in the allowance for loan losses could have a negative effect on our financial condition and results of operation.

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regulators, as an integral part of their supervisory function, periodically review our loan portfolio and the adequacy of our allowance for loan losses. These regulatory agencies may require us to recognize further loan loss provisions or charge-offs based upon their judgments, which may be different from ours. Any increase in the allowance for loan losses could have a negative effect on our financial condition and results of operation.

A continued tightening of the credit markets may make it difficult to obtain adequate funding for loan growth, which could adversely affect our earnings.

A continued tightening of the credit markets and the inability to obtain or retain adequate funds for continued loan growth at an acceptable cost may negatively affect our asset growth and liquidity position and, therefore, our earnings capability. In addition to core deposit growth, maturity of investment securities and loan payments, Bancorp also relies on alternative funding sources through correspondent banking, and borrowing lines with the Federal Reserve Bank to fund loans. In the event the current economic downturn continues, particularly in the housing market, these resources could be negatively affected, both as to price and availability, which would limit and or raise the cost of the funds available to Bancorp.

Fluctuating interest rates can adversely affect Bancorp’s profitability.

Bancorp’s profitability and cash flows are dependent to a large extent upon net interest income. Net interest income is the difference (or “spread”) between the interest earned on loans, securities and other interest-earning assets and Bancorp’s cost of funds, primarily interest expense on deposits and borrowings. Interest rates are highly sensitive to many factors that are beyond our control including, but not limited to, general economic conditions, and policies of various governmental and regulatory agencies. Changes in monetary policy, including changes in interest rates, impact the level of loans, deposits and investments, the credit profile of existing loans and the rates received on loans and investment securities and the rates paid on deposits and borrowings. If the interest paid on deposits increases at a faster rate than the interest received on loans and investment securities, Bancorp’s net interest income, and therefore earnings could be adversely affected. Earnings could also be adversely affected if interest received on loans and investments decreases faster than interest paid on deposits.

Competition in our market area may limit Bancorp’s future success.

Commercial banking is a highly competitive business. Bancorp competes with other commercial banks, savings and loan associations, credit unions and finance companies operating in our market area. We are subject to substantial competition for loans and deposits from other financial institutions. Some of our competitors are not subject to the same degree of regulation and restriction as we are. Some of our competitors have greater financial resources than we do. We compete for funds with other financial institutions that, in most cases, are larger and able to provide a greater variety of services than we do and thus may obtain deposits at lower rates of interest. If we are unable to effectively compete in our market area, our business and results of operations could be adversely affected.

We operate in a highly regulated environment and changes of or increases in, or supervisory enforcement of, banking or other laws and regulations or governmental fiscal or monetary policies could adversely affect us.

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

In that regard, sweeping financial regulatory reform legislation was enacted in July 2010. Among other provisions, the new legislation (i) creates a new Bureau of Consumer Financial Protection with broad powers to regulate consumer financial products such as credit cards and mortgages, (ii) creates a Financial Stability Oversight Council comprised of the heads of other regulatory agencies, (iii) will lead to new capital requirements from federal banking agencies, (iv) places new limits on electronic debt card interchange fees, and (v) will require the Securities and Exchange Commission and national stock exchanges to adopt significant new corporate governance and executive ~~compensation reforms. The new legislation and regulations are expected to increase the overall costs of regulatory compliance.~~

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compensation reforms. The new legislation and regulations are expected to increase the overall costs of regulatory compliance.

Further, regulators have significant discretion and authority to prevent or remedy unsafe or unsound practices or violations of laws or regulations by financial institutions and holding companies in the performance of their supervisory and enforcement duties. Recently, these powers have been utilized more frequently due to the serious national, regional and local economic conditions we continue to face. The exercise of regulatory authority may have a negative impact on Bancorp’s financial condition and results of operations. Additionally, Bancorp’s business is affected significantly by the fiscal and monetary policies of the U.S. federal government and its agencies, including the Federal Reserve Board.

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

Our ability to access markets for funding and acquire and retain customers could be adversely affected by the deterioration of other financial institutions or to the extent the financial service industry’s reputation is damaged.

Reputation risk is the risk to liquidity, earnings and capital arising from negative publicity regarding the financial services industry. The financial services industry continues to be featured in negative headlines about the global and national credit crisis and the resulting stabilization legislation enacted by the U.S. federal government. These reports can be damaging to the industry’s image and potentially erode consumer confidence in insured financial institutions, such as our banking subsidiary. In addition, our ability to engage in routine funding and other transactions could be adversely affected by the actions and financial condition of other financial institutions.

Financial services institutions are interrelated as a result of trading, clearing, counterparty or other relationships. As a result, defaults by, or even rumors or questions about, one or more financial services institutions, or the financial services industry generally, could lead to market-wide liquidity problems, losses of depositors, creditor and counterparty confidence and could lead to losses or defaults by us or by other institutions. We could experience material changes in the level of deposits as a direct or indirect result of other banks’ difficulties or failure, which could affect the amount of capital we need.

The FDIC has increased insurance premiums to restore and maintain the federal deposit insurance fund, and there may be additional future premium increases and special assessments.

In 2009, the FDIC imposed a special deposit insurance assessment of five basis points on all insured institutions, and also required insured institutions to prepay estimated quarterly risk-based assessments through 2012.

The Dodd-Frank Act established 1.35% as the minimum deposit insurance fund reserve ratio. The FDIC has determined that the fund reserve ratio should be 2.0% and has adopted a plan under which it will meet the statutory minimum fund reserve ratio of 1.35% by the statutory deadline of September 30, 2020. The Dodd-Frank Act requires the FDIC to offset the effect on institutions with assets less than $10 billion of the increase in the statutory minimum fund reserve ratio to 1.35% from the former statutory minimum of 1.15%. The FDIC has not announced how it will implement this offset or how larger institutions will be affected by it.

Despite the FDIC’s actions to restore the deposit insurance fund, the fund will suffer additional losses in the future due to failures of insured institutions. There can be no assurance that there will not be additional significant deposit insurance premium increases, special assessments or prepayments in order to restore the insurance fund’s reserve ratio. Any significant premium increases or special assessments could have a material adverse effect on the Company’s financial condition and results of operations.

There is little trading activity in Bancorp’s stock.

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

~~There are restrictions on changes in control of Bancorp that could decrease our shareholders’ chance to realize a premium on their shares.~~41

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not known whether significant trading activity will take place for several years, if at all. Accordingly, our shares should be considered as a long-term investment.

There are restrictions on changes in control of Bancorp that could decrease our shareholders’ chance to realize a premium on their shares.

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

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

None

Item 3. Defaults Upon Senior Securities

None

Item 4. Removed and Reserved

None

Item 5. Other Information

None

Item 6. Exhibits

(a) Exhibits.

31.1	Certification of CEO, Pursuant to Exchange Act Rule 13a-14 (as adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002)	~~Certification of CEO, Pursuant to Exchange Act Rule 13a-14 (as adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002)~~
31.2	Certification Chief Financial Officer Pursuant to Exchange Act Rule 13a-14 (as adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002)	~~Certification Chief Financial Officer Pursuant to Exchange Act Rule 13a-14 (as adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002)~~
32	Certifications Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002	~~Certifications Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002~~
101	The following financial information from Skagit State Bancorp’s. Quarterly Report on Form 10-Q for the quarter ended June 30, 2011 is formatted in XBRL: (i) the Unaudited Consolidated Balance Sheets, (ii) the Unaudited Consolidated Statements of Income, (iii) the Unaudited Consolidated Statements of Changes in Shareholder’s Equity and comprehensive Income, (iv) the Unaudited Consolidated Statements of Cash Flows, and (v) the Notes to Unaudited Consolidated Financial Statements, tagged as blocks of text.

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SIGNATURES

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

		SKAGIT STATE BANCORP, INC.
		(Registrant)
Dated:	~~May~~August 1012, 2011	/s/ Cheryl R. Bishop
		Cheryl R. Bishop
		President and Chief Executive Officer
Dated:	~~May~~August 1012, 2011	/s/ Carla F. Tucker
		Carla F. Tucker
		Executive Vice-President
		Chief Financial Officer

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