f10qwbco110609cov.htm - Generated by SEC Publisher for SEC Filing

10-Q 1 f10qwbco110609cov.htm FORM 10-Q f10qwbco110609cov.htm - Generated by SEC Publisher for SEC Filing

UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)
[X] Quarterly report pursuant to Section 13 or l5(d) of the Securities Exchange Act of 1934

For the quarterly period ended September 30, 2009

[ ] Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the transition period from ________ to ________

Commission File Number 000-24503

WASHINGTON BANKING COMPANY
(Exact name of registrant as specified in its charter)


Washington	91-1725825
(State or other jurisdiction of	(I.R.S. Employer
incorporation or organization)	Identification Number)

450 SW Bayshore Drive
Oak Harbor, Washington 98277
(Address of principal executive offices) (Zip Code)

(360) 679-3121
(Registrant’s telephone number, including area code)

(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities 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 [ ]

Indicate by check mark if the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.

See definition of “accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer [ ] Accelerated filer [X] Non-Accelerated filer [ ] Smaller reporting company [ ]

Indicate by check mark if the registrant is a shell company as defined in Rule 12b-2 under the Securities Exchange Act of 1934, as amended.
Yes [ ] No [X ]

The number of shares of the issuer’s Common Stock outstanding at November 2, 2009 was 9,547,946.


	Table of Contents
	PART I – FINANCIAL INFORMATION	Page
Item 1.	Financial Statements

	Condensed Consolidated Statements of Financial Condition -
	September 30, 2009 and December 31, 2008	1

	Condensed Consolidated Statements of Income -
	Three and Nine Months Ended September 30, 2009 and 2008	2

	Condensed Consolidated Statements of Shareholders’ Equity and Comprehensive Income -
	Nine Months Ended September 30, 2009 and 2008	3

	Condensed Consolidated Statements of Cash Flows -
	Nine Months Ended September 30, 2009 and 2008	4

	Notes to Condensed Consolidated Financial Statements	5

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	16
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	28
Item 4.	Controls and Procedures	28

	PART II – OTHER INFORMATION

Item 1.	Legal Proceedings	29
Item 1A.	Risk Factors	29
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	29
Item 3.	Defaults Upon Senior Securities	29
Item 4.	Submission of Matters to a Vote of Security Holders	29
Item 5.	Other Information	29
Item 6.	Exhibits	29

	Signatures	30

PART I – FINANCIAL INFORMATION

Item 1. Financial Statements

WASHINGTON BANKING COMPANY
AND SUBSIDIARIES
Condensed Consolidated Statements of Financial Condition (unaudited)
(Dollars in thousands, except per share data)


		September 30,			December 31,
Assets		2009			2008
Cash and due from banks	$	16,699		$	13,609
($2,076 and $3,496, respectively, are restricted)
Interest-bearing deposits		132			381
Federal funds sold		25,365			—
Total cash, restricted cash, and cash equivalents		42,196			13,990
Investment securities available for sale		56,204			17,798

Federal Home Loan Bank stock		2,430			2,430
Loans held for sale		2,951			2,896

Loans receivable		816,316			823,068
Allowance for loan losses		(15,882	)		(12,250	)
Total loans, net		800,434			810,818
Premises and equipment, net		25,649			24,971
Bank owned life insurance		17,134			16,822
Other real estate owned		5,012			2,226
Other assets		7,656			7,680
Total assets	$	959,666		$	899,631

Liabilities and Shareholders’ Equity
Liabilities:
Deposits
Noninterest-bearing	$	104,761		$	91,482
Interest-bearing		337,944			304,131
Time deposits		369,313			351,546
Total deposits		812,018			747,159
FHLB overnight borrowings		—			11,640
Other borrowed funds		10,000			30,000
Junior subordinated debentures		25,774			25,774
Other liabilities		2,282			4,498
Total liabilities		850,074			819,071
Shareholders’ equity:
Preferred stock, no par value, 26,380 shares authorized
Series A (Liquidation preference $1,000 per share); issued
and outstanding 26,380 at 09/30/09 and none in 2008.		24,911			—
Common stock, no par value. Authorized shares: 13,679,757
issued and outstanding 9,547,946 at 09/30/2009 and
9,510,007 at 12 /31/2008		35,502			33,701
Retained earnings		48,632			46,567
Accumulated other comprehensive income		547			292
Total shareholders’ equity		109,592			80,560
Total liabilities and shareholders’ equity	$	959,666		$	899,631

See accompanying notes to condensed consolidated financial statements.

WASHINGTON BANKING COMPANY
AND SUBSIDIARY
Condensed Consolidated Statements of Income (unaudited)
(Dollars in thousands, except per share data)


		Three Months Ended				Nine Months Ended
		September 30,				September 30,
		2009		2008		2009		2008
Interest income:
Interest and fees on loans	$	13,538	$	14,432	$	39,782	$	44,176
Interest on taxable investment securities		191		88		468		294
Interest on tax exempt investment securities		130		51		292		153
Other		18		6		28		14
Total interest income		13,877		14,577		40,570		44,637
Interest expense:
Interest on deposits		3,201		4,411		10,106		14,247
Interest on other borrowings		94		276		341		939
Interest on junior subordinated debentures		139		286		543		975
Total interest expense		3,434		4,973		10,990		16,161
Net interest income		10,443		9,604		29,580		28,476
Provision for loan losses		2,500		1,075		7,950		3,150
Net interest income after provision for loan losses		7,943		8,529		21,630		25,326
Noninterest income:
Service charges and fees		909		708		2,620		2,145
Electronic banking income		376		356		1,034		1,017
Investment products		38		93		368		260
Bank owned life insurance income		106		11		312		233
Income from the sale of mortgage loans		138		36		708		177
SBA premium income		49		50		83		239
Other		232		621		799		1,236
Total noninterest income		1,848		1,875		5,925		5,307
Noninterest expense:
Salaries and benefits		3,638		3,940		10,499		11,729
Occupancy and equipment		1,099		944		3,203		2,796
Office supplies and printing		198		162		577		402
Data processing		141		155		418		469
Consulting and professional fees		228		107		717		469
Other		2,074		2,270		5,698		4,923
Total noninterest expense		7,378		7,578		21,112		20,788
Income before provision for income taxes		2,413		2,825		6,443		9,846
Provision for income taxes		740		921		1,965		3,183
Net income before preferred dividends		1,673		1,904		4,478		6,663
Preferred stock dividends and discount accretion		414		—		1,185		—
Net income available to common shareholders	$	1,259	$	1,904	$	3,292	$	6,663

Net income available per common share, basic	$	0.13	$	0.20	$	0.35	$	0.70

Net income available per common share, diluted	$	0.13	$	0.20	$	0.35	$	0.70

Average number of common shares outstanding, basic		9,532,000	9,473,000			9,519,000		9,457,000
Average number of common shares outstanding, diluted		9,554,000	9,518,000			9,541,000		9,514,000


See accompanying notes to condensed consolidated financial statements.

WASHINGTON BANKING COMPANY
AND SUBSIDIARY
Condensed Consolidated Statements of Shareholders’ Equity and
Comprehensive Income (unaudited)
(Dollars and share data in thousands)


												Accumulated
		Preferred										other			Total
		stock	Common stock						Retained			comprehensive			shareholders’
		amount	Shares			Amount			earnings			income			equity
Balances at December 31, 2007	$	––	9,454		$	32,812		$	40,652		$	106		$	73,570
Comprehensive income:
Net income		––	––			––			6,662			––			6,662
Net unrealized loss on securities
available for sale, net of tax of $(11)		––	––			––			––			(20	)		(20	)
Total comprehensive income		––	––			––			––			––			6,642
Cash dividend, $0.195 per share		––	––			––			(1,801	)		––			(1,801	)
Stock-based compensation expense		––	––			358			––			––			358
Exercise of common stock- stock options		––	36			174			––			––			174
Cancellation of restricted stock		––	(2	)		––			––			––			––
Tax benefit associated with stock awards		––	––			40			––			––			40
Balances at September 30, 2008	$	––	9,488		$	33,384		$	45,513		$	86		$	78,983


Balances at December 31, 2008	$	––	9,510		$	33,701		$	46,567		$	292		$	80,560
Comprehensive income:
Net income		––	––			––			4,478			––			4,478
Net unrealized gain on securities
available for sale, net of tax of $(94)		––	––			––			––			255			255
Total comprehensive income		––	––			––			––			––			4,733
Issuance of preferred stock to U.S.
Treasury		24,660	––			––			––			––			24,660
Issuance of warrants to U.S. Treasury		––	––			1,720			––			––			1,720
Preferred stock dividends and discount
accretion		251	––			(251	)		(935	)		––			(935	)
Cash dividend, $0.155 per share		––	––			––			(1,478	)		––			(1,478	)
Stock-based compensation expense		––	––			239			––			––			239
Exercise of common stock- stock options		––	39			90			––			––			90
Cancellation of restricted stock		––	(1	)		––			––			––			––
Tax benefit associated with stock awards		––	––			3			––			––			3
Balances at September 30, 2009	$	24,911	9,548		$	35,502		$	48,632		$	547		$	109,592

WASHINGTON BANKING COMPANY
AND SUBSIDIARY
Condensed Consolidated Statements of Cashflows (unaudited)
(Dollars in thousands)


		September 30,
		2009			2008
Cash flows from operating activities:
Net income from continuing operations	$	4,478		$	6,662
Adjustments to reconcile net income to net cash
provided by operating activities:
Accretion (amortization) of investment discounts, net		20			(8	)
Depreciation and amortization		1,327			1,319
Earnings on bank owned life insurance		(312	)		(233	)
Provision for loan losses		7,950			3,150
Net (gain)loss on sale of premises and equipment		(57	)		5
Net gain on sale of other real estate		(51	)		(54	)
Write-downs of other real estate		382			134
Amortization of stock-based compensation		239			358
Excess tax benefit from stock-based compensation		(3	)		(40	)
Net change in assets and liabilities:
Net (increase) decrease in loans held for sale		(55	)		1,352
Decrease (increase) in other assets		(6	)		48
Decrease in other liabilities		(2,215	)		(127	)
Cash provided by operating activities:		11,697			12,566
Cash flows from investing activities:
Purchases of investment securities, available for sale		(44,537	)		(498	)
Purchase of Federal Home Loan Bank Stock		––			(896	)
Maturities/calls/principal payments of investment and
mortgage-backed securities, available for sale		6,503			3,525
Net increase in loan originations, net of principal collections received		(2,848	)		(20,615	)
Purchases of premises and equipment		(2,012	)		(662	)
Proceeds from the sale of other real estate owned		2,125			1,291
Cash flows used by investing activities		(40,769	)		(17,855	)
Cash flows from financing activities:
Net increase in deposits		64,858			25,387
Gross payments on other borrowed funds		(20,000	)		(20,000	)
New borrowings on other borrowed funds		––			40,000
Net decrease in FHLB overnight borrowings		(11,640	)		(20,500	)
Dividends paid on common stock		(1,478	)		(1,801	)
Dividends paid on preferred stock		(935	)		––
Excess tax benefits from stock-based compensation		3			40
Proceeds from issuance of preferred stock		26,380			––
Proceeds from exercise of common stock- stock options		90			174
Cash provided by financing activities		57,278			23,300
Net change in cash and cash equivalents		28,206			18,011
Cash and cash equivalents at beginning of period		13,990			19,052
Cash and cash equivalents at end of period	$	42,196		$	37,063
Supplemental information:
Loans foreclosed and transferred to other real estate owned	$	5,282		$	600
Cash paid for interest		11,188			16,491
Cash paid for income taxes		1,965			3,752
See accompanying notes to condensed consolidated financial statements.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Dollars In Thousands, Except Per Share Data)

(1) Description of Business and Summary of Significant Accounting Policies

(a) Description of Business: Washington Banking Company (the “Company” or “WBCO”) is a registered bank holding company formed on April 30, 1996. At September 30, 2009, WBCO had two wholly-owned subsidiaries –Whidbey Island Bank (“WIB” or the “Bank”), the Company’s principal subsidiary, and Washington Banking Master Trust (the “Trust”). The business of the Bank, which is focused in the northern area of Western Washington, consists primarily of attracting deposits from the general public and originating loans. The region’s economy has evolved from one that was once heavily dependent upon forestry, fishing and farming to an economy with a much more diverse blend of industries including retail trade, services, manufacturing, tourism and a large military base presence. Although the Bank has a diversified loan portfolio, a substantial portion of its borrowers’ ability to repay their loans is dependent upon the economic conditions affecting this area.

(b) Basis of Presentation: The accompanying interim condensed consolidated financial statements include the accounts of WBCO and its subsidiaries described above. The accompanying interim condensed consolidated financial statements have been prepared, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles in the United States of America for complete financial statements. These condensed consolidated financial statements should be read in conjunction with the December 31, 2008 audited consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K filed with the SEC. In management’s opinion, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the nine months ended September 30, 2009 are not necessarily indicative of the results that may be expected for the year ending December 31, 2009. In preparing the condensed consolidated financial statements, estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses are required. Actual results could differ from those estimates.

In preparing these financial statements, the Company has evaluated events and transactions for potential recognition or disclosure through November 6, 2009, the date the financial statements were available to be issued. In management's opinion, all accounting adjustments necessary to accurately reflect the financial position and results of operations on the accompanying financial statements have been made. These adjustments include normal and recurring accruals considered necessary for a fair and accurate presentation. The results for interim periods are not necessarily indicative of results for the full year or any other interim period.

(c) Reclassifications: Certain amounts in prior year’s financial statements may have been reclassified to conform to the 2009 presentation. These reclassifications had no significant impact on the Company’s financial position or results of operations.

(2) Recent Financial Accounting Pronouncements

FASB Accounting Standards Codification:

The Financial Accounting Standards Board (“FASB”) launched the FASB Accounting Standards Codification as the single source of authoritative nongovernmental U.S. generally accepted accounting principles (GAAP).

The Codification is effective for interim and annual periods ending after September 15, 2009. All existing accounting standards documents are superseded as described in FASB Statement No. 168, The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles. All other accounting literature not included in the Codification is nonauthoritative.

An online tutorial available on the Codification website at http://asc.fasb.org
A Codification Question and Answer (Q&A) document at http://www.fasb.org/cod_project/Cod_overview_12- 08.pdf

The Company has applied the standard’s numbering convection to all referenced financial statement standards within the consolidated financial statements.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Dollars In Thousands, Except Per Share Data)

(2) Recent Financial Accounting Pronouncements- (Continued)

Noncontrolling Interests in Consolidated Financial Statements - Topic 810 subtopic 10 Section 65 Paragraph 65-1: Transition Related to FASB Statement No. 160, Noncontrolling Interests in Consolidated Financial Statements—an amendment of ARB No. 51

Section 65-1: The following represents the transition and effective date information related to FASB Statement No. 160, Noncontrolling Interests in Consolidated Financial Statements—an amendment of ARB No. 51:

	a.	Except as noted in item (d), the pending content that links to this paragraph is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008. Earlier adoption is prohibited.

	b.	The pending content that links to this paragraph shall be applied prospectively as of the beginning of fiscal year in that content is initially adopted, except for the presentation and disclosure requirements The presentation and disclosure requirements shall be applied retrospectively for all periods presented, as follows:


		1	The noncontrolling interest shall be reclassified to equity in accordance with paragraph 810-10-45-16.

		2	Consolidated net income shall be adjusted to include the net income attributed to the noncontrolling interest.

		3	Consolidated comprehensive income shall be adjusted to include the comprehensive income attributed to the noncontrolling interest.

		4	The disclosures in paragraphs 810-10-50-1A through 50-1B shall be provided.


	c.	810-10-45-21 requires that the noncontrolling interest continue to be attributed its share of losses even if that attribution results in a deficit noncontrolling interest balance. If, in the year of adoption, an entity’s consolidated net income attributable to the parent would have been significantly different had the prior requirement in paragraph 810-10-45-7 been applied, the entity shall disclose pro forma consolidated net income attributable to the parent and pro forma earnings per share as if the previous prior requirement in paragraph 810-10-45-7 had been applied in the year of adoption.

	d.	Not-for-profit entities (NFPs) shall not apply the pending text that links to this paragraph.

The Company has reviewed the standard and does not expect the standard to have a material impact on its consolidated financial statements.

Business Combinations - Topic 805 subtopic 10 Section 55: 805 Business Combinations 805-10 Overall, 805-10-55 Implementation Guidance and Illustrations.

On December 4, 2007, the FASB issued FASB Statement No. 141 (Revised 2007), Business Combinations. Statement 141R will significantly change the accounting for business combinations. Under Statement 141R, an acquiring entity will be required to recognize all the assets acquired and liabilities assumed in a transaction at the acquisition-date fair value with limited exceptions. Statement 141R will change the accounting treatment for certain specific items, including:

Acquisition costs will be generally expensed as incurred.
Noncontrolling interests (formerly known as “minority interests”) will be valued at fair value at the acquisition date.
Acquired contingent liabilities will be recorded at fair value at the acquisition date and subsequently measured at either the higher of such amount or the amount determined under existing guidance for non-acquired contingencies.
In-process research and development will be recorded at fair value as an indefinite-lived intangible asset at the acquisition date.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Dollars In Thousands, Except Per Share Data)

(2) Recent Financial Accounting Pronouncements- (Continued)

Restructuring costs associated with a business combination will be generally expensed subsequent to the acquisition date.
Changes in deferred tax asset valuation allowances and income tax uncertainties after the acquisition date generally will affect income tax expense.

Statement 141R also includes a substantial number of new disclosure requirements. Statement 141R applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. Earlier adoption is prohibited. Accordingly, a calendar year-end company is required to record and disclose business combinations following existing GAAP until January 1, 2009.

The Company has reviewed the standard and does not expect the standard to have a material impact on its consolidated financial statements.

Subsequent Events – Topic 855 subtopic 10 Section 50: 855 Subsequent Events, 855-10 Overall, 855-10-50 Disclosure

On May 28, 2009, the FASB issued FASB Statement No. 165, Subsequent Events. Statement 165 establishes general standards of accounting for and disclosure of events that occur after the balance sheet date but before the financial statements are issued or are available to be issued.

Although there is no new terminology, the new FASB standard is based on the same principles as those that currently exist in the U.S. auditing standard.
Includes a new required disclosure of the date through which an entity has evaluated subsequent events. Section 855-10-50-1 requires an entity to disclose the date through which subsequent events have been evaluated, as well as whether that date is the date the financial statements were issued or the date the financial statements were available to be issued.
Effective for interim or annual periods ending after June 15, 2009.

The Company adopted the provisions of the standard for the interim period ended June 30, 2009, and the impact of adoption did not have a material impact on its consolidated financial statements.

Consolidation of Variable Interest Entities – FAS 167:

In July 2009, the FASB issued FASB Statement No. 167, Amendments to Interpretation No. 46(R). Statement 167 significantly changes the consolidation rules for VIE’s and has broad applicability across all industries.

Affected arrangements include: consolidation of common structures, such as joint ventures, equity method investments, collaboration arrangements, and co-manufacturing and power purchase arrangements.
Adoption may require significant changes to a company’s accounting policies, financial statement disclosures, data gathering processes, and internal controls. However, the impact of the new guidance is not limited to the financial reporting process and is expected to affect other areas including debt covenant compliance, compensation, and stakeholder communications, to name a few.
Effective for fiscal years (and interim periods in those fiscal years) beginning after November 15, 2009.

As of October 8, 2009, the FASB had not yet incorporated FAS 167 into the Accounting Standards Codification. FASB is expected to issue an Accounting Standards Update in the near future announcing that the guidance in FAS 167 has been added to the Codification. When codified, the guidance will be included in ASC 810, Consolidation.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Dollars In Thousands, Except Per Share Data)

(2) Recent Financial Accounting Pronouncements- (Continued)

The Company has reviewed the standard and does not expect the standard to have a material impact on its consolidated financial statements.

Disclosures about Derivative Instruments and Hedging Activities - Topic 815 subtopic 10 Section 15:

On March 19, 2008, the FASB issued SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities - an Amendment of FASB Statement 133. SFAS 161 enhances required disclosures regarding derivatives and hedging activities, including enhanced disclosures regarding how: (a) an entity uses derivative instruments; (b) derivative instruments and related hedged items are accounted for under SFAS 133, Accounting for Derivative Instruments and Hedging Activities; and (c) derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows. Specifically, SFAS 161 requires:

Disclosure of the objectives for using derivative instruments be disclosed in terms of underlying risk and accounting designation;
Disclosure of the fair values of derivative instruments and their gains and losses in a tabular format;
Disclosure of information about credit-risk-related contingent features; and,
Cross-reference from the derivative footnote to other footnotes in which derivative-related information is disclosed.

SFAS 161 is effective for fiscal years and interim periods beginning after November 15, 2008. Early application is encouraged.

The Company has reviewed the standard and does not expect the standard to have a material impact on its consolidated financial statements.

(3) Earnings Per Share

Basic earnings per share is computed by dividing net income available to common shareholders by the weighted average number shares of common stock outstanding during the period. Diluted earnings per share is computed in the same manner as basic earnings per share except that the denominator is increased to include the number of additional common shares that would have been outstanding if certain shares issuable upon exercise of warrants, options and non-vested restricted stock were included.

The following table reconciles the denominator of the basic and diluted earnings per common share computation:


	Three Months Ended		Nine Months Ended
	September 30,		September 30,
	2009	2008	2009	2008
Weighted average shares-basic	9,532,000	9,473,000	9,519,000	9,457,000
Effect of dilutive securities: stock awards	22,000	45,000	22,000	57,000
Weighted average shares-diluted	9,554,000	9,518,000	9,541,000	9,514,000

At September 30, 2009 and 2008, the following stock awards were antidilutive and therefore not included in the computation of diluted net income per share:


	Three Months Ended		Nine Months Ended
	September 30,		September 30,
Stock awards not included in diluted earnings per share:	2009	2008	2009	2008
Antidilutive TARP CPP stock warrants	492,164	––	492,164	––
Antidilutive stock awards	199,713	232,653	204,713	140,647
Total antidilutive stock awards	691,877	232,653	696,877	140,647

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Dollars In Thousands, Except Per Share Data)

(4) Stock-Based Compensation

(a) Stock Options: The Company measures the fair value of each stock option grant at the date of the grant, using the Black Scholes option pricing model. There were no options issued during the nine months ended September 30, 2009. The weighted average fair value per share of options granted during the nine months ended September 30, 2008 was $2.82 per share. The following assumptions were used in arriving at the fair value of options granted:


	Nine Months Ended
	September 30,
	2009	2008
Risk-free interest rate	––	3.44	%
Dividend yield rate	––	2.90	%
Price volatility	––	40.50	%
Expected life of stock options	––	5 years

The Company recognizes compensation expense for stock option awards on a straight-line basis over the requisite service period of the award. For the nine months ended September 30, 2009 and 2008, the Company recognized $137 and $127, respectively, in stock based compensation expense as a component of salaries and benefits. As of September 30, 2009, there was approximately $552 of total unrecognized compensation cost related to nonvested stock awards.

The following table summarizes information on stock option activity during 2009:


				Weighted	Weighted average		Aggregate
				average exercise	remaining contractual		intrinsic
	Shares			price per share	terms (in years)		value
Outstanding at January 1, 2009	254,214		$	9.87
Granted	––			––
Exercised	(17,260	)		5.21		$	66
Forfeited, expired or cancelled	(7,807	)		12.18
Outstanding at September 30, 2009	229,147		$	10.14	7.21	$	67

Exercisable at September 30, 2009	117,234		$	9.51	6.08	$	67

The aggregate intrinsic value in the table above represents the total pretax intrinsic value (i.e., the difference between the Company’s closing stock price on September 30, 2009 and the exercise price, times the number of shares) that would have been received by the option holders had all the option holders exercised their options on September 30, 2009. This amount changes based upon the fair market value of the Company’s stock.

(b) Restricted Stock Awards: The Company grants restricted stock awards (“RSA”) periodically for the benefit of employees and directors. Recipients of RSA awards do not pay any cash consideration to the Company for the shares and receive all dividends with respect to such shares, whether or not the shares have vested. Restrictions are based on continuous service requirements with the Company.

The following table summarizes information on restricted stock activity during 2009:


				Weighted average	Weighted average remaining
	Shares			grant price per share	contractual terms (in years)
Outstanding at January 1, 2009	10,071		$	13.11
Granted	––			––
Vested	(3,700	)		12.66
Forfeited, expired or cancelled	(1,486	)		13.56
Outstanding at September 30, 2009	4,885		$	13.31	1.15

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Dollars In Thousands, Except Per Share Data)

(4) Stock-Based Compensation- (Continued)

For the nine months ended September 30, 2009 and 2008 the Company recognized $34 and $23, respectively, in restricted stock compensation expense as a component of salaries and benefits. As of September 30, 2009 there was $46 of total unrecognized compensation costs related to nonvested restricted stock awards.

(c) Restricted Stock Units: The Company grants restricted stock units (“RSU”) periodically for the benefit of employees and directors. Recipients of RSU awards receive shares of the Company’s stock upon the lapse of their related restrictions and do not pay any cash consideration to the Company for the shares. Restrictions are based on continuous service requirements with the Company.

The following table summarizes information on restricted stock unit activity during the nine months ended September 30, 2009:



				Weighted average	Weighted average remaining
	Shares			grant price per share	contractual terms (in years)
Outstanding at January 1, 2009	18,711		$	13.25
Granted	12,000			5.48
Vested	(11,722	)		6.18
Forfeited, expired or cancelled	(537	)		15.98
Outstanding at September 30, 2009	18,452			12.61	2.17

For the nine months ended September 30, 2009 and 2008, the Company recognized $68 and $44, respectively, in restricted stock units compensation expense as a component of salaries and benefits. As of September 30, 2009, there was $180 of total unrecognized compensation costs related to nonvested restricted stock units.

(5) Preferred Stock

On January 16, 2009, in exchange for an aggregate purchase price of $26,400, the Company issued and sold to the United States Department of the Treasury pursuant to the Troubled Asset Relief Program (“TARP”) Capital Purchase Program the following: (i) 26,380 shares of the Company’s newly designated Fixed Rate Cumulative Perpetual Preferred Stock, Series A, no par value per share, and liquidation preference of $1,000 per share ($26.4 million liquidation preference in the aggregate); and, (ii) a warrant to purchase up to 492,164 shares of the Company’s common stock, no par value per share, at an exercise price of $8.04 per share, subject to certain anti-dilution and other adjustments. The Warrant may be exercised for up to ten years after it is issued.

In connection with the issuance and sale of the Company’s securities, the Company entered into a Letter Agreement including the Securities Purchase Agreement-Standard Terms, dated January 16, 2009, with the United States Department of the Treasury (the “Agreement”). The Agreement contains limitations on the payment of quarterly cash dividends on the Company’s common stock in excess of $0.065 per share and on the Company’s ability to repurchase its common stock. The Agreement also grants the holders of the Series A Preferred Stock, the Warrant and the common stock to be issued under the Warrant registration rights, and subjects the Company to executive compensation limitations included in the Emergency Economic Stabilization Act of 2008. Participants in the TARP Capital Purchase Program are required to have in place limitations on the compensation of Senior Executive Officers.

The Series A Preferred Stock will bear cumulative dividends at a rate of 5% per annum for the first five years and 9% per annum thereafter, in each case, applied to the $1,000 per share liquidation preference, but will only be paid when, as and if declared by the Company’s Board of Directors out of funds legally available. The Series A Preferred Stock has no maturity date and ranks senior to the Company’s common stock with respect to the payment of dividends and distributions and amounts payable upon liquidation, dissolution and winding up of the Company.

In February 2009, following passage of the American Recovery and Reinvestment Act of 2009, the program terms were changed and the Company is no longer required to conduct a qualified equity offering prior to retirement of the preferred stock, however prior approval of the Company's primary regulator and the U.S. Treasury is required.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Dollars In Thousands, Except Per Share Data)

(5) Preferred Stock- (Continued)

The preferred stock is not subject to any contractual restrictions on transfer. The holders of the preferred stock have no general voting rights, and have only limited class voting rights including, authorization or issuance of shares ranking senior to the preferred stock, any amendment to the rights of the preferred stock, or any merger, exchange or similar transaction which would adversely affect the rights of the preferred stock. If dividends on the preferred stock are not paid in full for six dividend periods, whether or not consecutive, the preferred stock holders will have the right to elect two directors. The right to elect directors will end when full dividends have been paid for four consecutive dividend periods. The preferred stock is not subject to sinking fund requirements and has no participation rights.

On January 13, 2009, the Company’s shareholders approved an amendment to the Company’s Restated Articles of Incorporation setting the specific terms and conditions of the preferred stock and designating such shares as the Series A Preferred Stock. The amendment was filed with the Secretary of State of the State of Washington on January 13, 2009.

In accordance with the relevant accounting pronouncements and a letter from the Securities and Exchange Commission’s (the “SEC”) Office of the Chief Accountant, the Company recorded the preferred stock and detachable warrants within Shareholders’ Equity on the Consolidated Balance Sheets. The preferred stock and detachable warrants were initially recognized based on their relative fair values at the date of issuance. As a result, the preferred stock’s carrying value is at a discount to the liquidation value or stated value. In accordance with the SEC’s Staff Accounting Bulletin No. 68, Increasing Rate Preferred Stock, the discount is considered an unstated dividend cost that shall be amortized over the period preceding commencement of the perpetual dividend using the effective interest method, by charging the imputed dividend cost against retained earnings and increasing the carrying amount of the preferred stock by a corresponding amount. The discount is therefore being amortized over five years using a 6.52% effective interest rate. The total stated dividends (whether or not declared) and unstated dividend cost combined represents a period’s total preferred stock dividend, which is deducted from net income to arrive at net income available to common shareholders on the Consolidated Statements of Income.

As of September 30, 2009, no dividends on the preferred stock were in arrears.

(6) Stock Warrants

On January 16, 2009, in connection with the issuance of the preferred stock, the Company issued a warrant to the U.S. Treasury to purchase up to 492,164 shares of the Company’s common stock, no par value per share, at an exercise price of $8.04 per share, subject to certain customary anti-dilution and other adjustments. The warrants issued are immediately exercisable, in whole or in part, and have a ten year term. The warrants are not subject to any other contractual restrictions on transfer. The Company has granted the warrant holder piggyback registration rights for the warrants and the common stock underlying the warrants and have agreed to take such other steps as may be reasonably requested to facilitate the transfer of the warrants and the common stock underlying the warrants. The holders of the warrants are not entitled to any common stockholder rights. The U.S. Treasury agrees not to exercise voting power with respect to any shares of common stock of the Company issued to it upon exercise of the warrants.

The preferred stock and detachable warrants were initially recognized based on their relative fair values at the date of issuance in accordance with APB Opinion No. 14, Accounting for Convertible Debt and Debt Issued with Stock Purchase Warrants. As a result, the value allocated to the warrants is different than the estimated fair value of the warrants as of the grant date. The following assumptions were used to determine the fair value of the warrants as of the grant date:


Dividend yield		5.00	%
Expected life (years)		10.0
Expected volatility		49.56	%
Risk-free rate		2.80	%
Fair value per warrant at grant date	$	3.27
Relative fair value per warrant at grant date	$	3.49

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Dollars In Thousands, Except Per Share Data)

(7) Fair Value Measurements

The Financial Accounting Standards Board (“FASB”) has issued several significant FASB statements on the measurement and or reporting of financial instruments at fair value. Additionally, recent FASB statements have amended previously issued FASB statements. To add further complexity to an already complex issue, entities have been permitted to determine whether or not to measure certain financial instruments at fair value and report the changes in the fair value of these financial instruments in their statements of income. Furthermore, all entities are required to measure certain financial instruments at fair value and record the changes in fair value of these financial instruments in their statements of comprehensive income.

Key Concepts:

Fair Value: Topic 820, Fair Value Measurements and Disclosures defines fair value as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” The Company 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.
Financial Instrument: Topic 825, Financial Instruments defines a financial instrument “as cash, evidence of an ownership interest in an entity, or a contract that both:

		a.	Imposes on one entity a contractual obligation (1) to deliver cash or another financial instrument to a second entity or (2) to exchange other financial instruments on potentially unfavorable terms with the second entity.

		b.	Conveys to that second entity a contractual right (1) to receive cash or another financial instrument from the first entity or (2) to exchange other financial instruments on potentially favorable terms with the first entity.”

Financial instruments for the Company represent one of two categories:

		1.	Assets: Consisting primarily of cash, short term investments (interest-bearing deposits, federal funds sold), securities and loans.

		2.	Liabilities: Consisting primarily of deposits and various forms of borrowings (overnight borrowings, junior subordinated debentures, other term borrowings)

The Company further defines these financial instruments in the determination of fair value section of this footnote.

Topic 820, Fair Value Measurements and Disclosures: The valuation techniques required by Topic 820 are based upon observable and unobservable inputs. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect the Company’s market assumptions. These two types of inputs create the following fair value hierarchy:

	Level 1:	Quoted prices for identical instruments in active markets.

	Level 2:	Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and, model-derived valuations whose inputs are observable or whose significant value drivers are observable.

	Level 3:	Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the asset or liability. Unobservable inputs are used to measure fair value to the extent that observable inputs are not available. The Company’s own data used to develop unobservable inputs shall be adjusted for market consideration when reasonably available.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Dollars In Thousands, Except Per Share Data)

(7) Fair Value Measurements- (Continued)

Determination of Fair Value

Under Topic 820, the Company bases its fair values on the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. It is the Company’s policy to maximize the use of observable inputs and minimize the use of unobservable inputs when developing fair value measurements, in accordance with the fair value hierarchy in Topic 820.

Fair value measurements for assets and liabilities where there exists limited or no observable market data and, therefore, are based primarily upon the Company’s own estimates, are often calculated based on current pricing policy, the economic and competitive environment, the characteristics of the asset or liability and other such factors. Therefore, the results cannot be determined with precision and may not be realized in an actual sale or immediate settlement of the asset or liability. Additionally, there may be inherent weaknesses in any calculation technique, and changes in the underlying assumptions used, including discount rates and estimates of future cash flows, that could significantly affect the results of current or future values.

Following is a description of valuation methodologies used for assets and liabilities recorded at fair value and for estimating fair value for financial instruments not recorded at fair value (Topic 825 disclosures).

Cash and Cash Equivalents: The carrying value of cash and cash equivalent instruments approximates fair value.

Interest-bearing Deposits: The carrying values of interest-bearing deposits maturing within ninety days approximate their fair values. Fair values of other interest-earning deposits are estimated using discounted cash flow analyses based on current rates for similar types of deposits.

Federal Funds Sold: The carrying value of federal funds sold approximates fair value.

Investments in Debt and Equity Securities: When available, the Company uses quoted market prices to determine the fair value of investment securities. These investments are included in Level 1. When quoted market prices are unobservable, the Company uses quotes from independent pricing vendors based on recent trading activity and other relevant information including market interest rate curves, referenced credit spreads and estimated prepayment rates where applicable. These investments are included in Level 2 and comprise the Company’s portfolio of U.S. agency securities, municipal bonds and one mortgage-backed security.

Loans Held for Sale: The carrying value of loans held for sale approximates fair value.

Loans: The loan portfolio is composed of commercial, consumer, real estate construction and real estate loans. The carrying value of variable rate loans approximates their fair value. The fair value of fixed rate loans is estimated by discounting the estimated future cash flows of loans, sorted by type and security, by the weighted average rate of such loans and rising rates currently offered by the Bank for similar loans.

Impaired Loans: A loan is considered impaired when, based upon currently known information, it is deemed probable that the Company will be unable to collect all amounts due as scheduled according to the original terms of the agreement. Impaired loans are measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate or, as a practical expedient, based on the loan’s observable market price or the fair value of collateral, if the loan is collateral dependent. Impaired loans, which are collateral dependent, are included in the nonrecurring basis table below.

Other Real Estate Owned: Other real estate owned (“OREO”) includes properties acquired through foreclosure. These properties are recorded at the lower of cost or estimated fair value (less estimated cost to sell), based on periodic evaluations. Other real estate owned, which has been recorded at estimated fair value, is included in the nonrecurring basis table below.

Deposits: For deposits with no contractual maturity such as checking accounts, money market accounts and savings accounts, fair values approximate book values. The fair value of certificates of deposit are based on discounted cash flows using the difference between the actual deposit rate and an alternative cost of funds rate, currently offered by the Bank for similar types of deposits.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Dollars In Thousands, Except Per Share Data)

(7) Fair Value Measurements- (Continued)

FHLB Overnight Borrowings: The carrying value of FHLB overnight borrowings approximates fair value.

Trust Preferred Securities: The fair value of junior subordinated debentures is estimated using an internal discounted cash flow model.

Other Borrowed Funds: Other borrowed funds consist of FHLB advances. The carrying amount of FHLB advances is estimated using discounted cash flow analyses based on the Company’s current incremental borrowing rates of similar types of borrowing arrangements.

Off-Balance Sheet Items: Commitments to extend credit represent the principal category of off-balance sheet financial instruments. The fair value of these commitments is not 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 the Company to significant gains or losses.

Topic 820, Fair Value Measurements and Disclosures, Assets and Liabilities Recorded at Fair Value on a Recurring Basis: The following table presents the Company’s assets measured at fair value on a recurring basis for the period ended September 30, 2009:


		Period Ended September 30, 2009
		Level 1		Level 2		Level 3		Total
Investment securities available for sale	$	––	$	56,204	$	––	$	56,204
Total	$	––	$	56,204	$	––	$	56,204

Topic 820, Fair Value Measurements and Disclosures, Assets and Liabilities Recorded at Fair Value on a Nonrecurring Basis: The Company may be required, from time to time, to measure certain assets at fair value on a nonrecurring basis in accordance with GAAP. These adjustments to fair value usually result from application of lower-of-cost-or-market accounting or write-downs of individual assets. The valuation methodologies used to measure these fair value adjustments are described previously in this Note. For assets measured at fair value on a nonrecurring basis, the following table provides the level of valuation assumptions used to determine each adjustment and the carrying value of the related individual assets or portfolios at year end.

The following table presents the Company’s assets measured at fair value on a nonrecurring basis for the period ended September 30, 2009:


		Period Ended September 30, 2009:
										Total losses for
		Carrying value at year end								period ended

		Level 1		Level 2		Level 3		Total
Impaired loans ⁽¹⁾	$	––	$	––	$	2,892	$	2,892	$	(287	)
Other real estate owned ⁽²⁾		––		––		5,012		5,012		(348	)
Total	$	––	$	––	$	7,904	$	7,904	$	(635	)

(1)	Represents the fair value which consists of the carrying value and related specific valuation allowances, which are included in the allowance for loan losses.
(2)	Represents the fair value and related losses of foreclosed real estate and other collateral owned that were measured at fair value based on the underlying collateral subsequent to their initial classification as other real estate owned.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Dollars In Thousands, Except Per Share Data)

(7) Fair Value Measurements- (Continued)

Topic 825, Financial Instruments: The table below is a summary of fair value estimates as of September 30, 2009, for financial instruments, as defined by Topic 825. The carrying amounts in the following table are recorded in the balance sheet under the indicated captions.

In accordance with Topic 825, the Company has not included assets and liabilities that are not financial instruments in our disclosure, such as the value of the premises and equipment, deferred taxes and other liabilities.


		September 30,				December 31,
		2009				2008
				Estimated fair				Estimated fair
		Carrying value		value		Carrying value		value
Financial assets:
Cash and cash equivalents	$	16,699	$	16,699	$	13,609	$	13,609
Interest-earning deposits		132		132		381		381
Federal funds sold		25,365		25,365		––		––
Investment securities- available for sale		56,204		56,204		17,798		17,798
FHLB stock		2,430		2,430		2,430		2,430
Loans held for sale		2,951		2,951		2,896		2,896
Loans		816,316		815,296		823,068		822,840

Financial liabilities:
Deposits	$	812,018	$	808,609	$	747,159	$	752,249
Junior subordinated debentures		25,774		9,213		25,774		16,090
FHLB overnight borrowings		––		––		11,640		11,640
Other borrowed funds		10,000		10,260		30,000		30,399

(8) Subsequent Events

On October 22, 2009, the Company announced that its Board of Directors declared a cash dividend of $0.025 per share to common shareholders of record as of November 3, 2009, payable on November 19, 2009.

(9) Commitments and Guarantees

Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements, including commercial paper, bond financing and similar transactions. Except for certain long-term guarantees, most guarantees expire in one year. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Collateral supporting those commitments, for which collateral is deemed necessary, generally amounted to one hundred percent of the commitment amount at September 30, 2009. The Company routinely charges a fee for these credit facilities. Such fees are amortized into income over the life of the agreement, and unamortized amounts were not significant as of September 30, 2009. As of September 30, 2009 the commitments under these agreements were $2,266.

At September 30, 2009, the Company was the guarantor of trust preferred securities. The Company has issued junior subordinated debentures to a wholly-owned special purpose trust, which has issued trust preferred securities. The sole assets of the special purpose trust are the junior subordinated debentures issued by the Company. Washington Banking Company has fully and unconditionally guaranteed the capital securities along with all obligations of the Trust under the trust agreements. The maximum amount of future payments the Company will be required to make under these agreements is the principal and interest of the trust preferred securities, the principal of which totaled $25,774 at September 30, 2009.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Note Regarding Forward-Looking Statements: This Quarterly Report on Form 10-Q includes forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). These forward-looking statements describe Washington Banking Company’s (the “Company”) management’s expectations regarding future events and developments such as future operating results, growth in loans and deposits, credit quality and adequacy of the allowance for loan losses, and continued success of the Company’s business plan. Readers should not place undue reliance on forward-looking statements, which reflect management’s views only as of the date hereof. The words “will,” “believe,” “expect,” “should,” “anticipate” and words of similar meaning are intended in part to help identify forward-looking statements. Future events are difficult to predict, and the expectations described below are necessarily subject to risk and uncertainty that may cause actual results to differ materially. In addition to discussions about risks and uncertainties set forth from time to time in the Company’s filings with the Securities and Exchange Commission (the “SEC”), factors that may cause actual results to differ materially from those contemplated in such forward-looking statements include, among others: (1) local and national general and economic condition; (2) changes in interest rates and their impact on net interest margin; (3) competition among financial institutions; (4) legislation or regulatory requirements; and (5) the ability to realize efficiencies expected from investment in personnel and infrastructure. However, the reader should be aware that these factors are not an exhaustive list, and it should not be assumed that these are the only factors that may cause actual results to differ from expectations. In addition, the reader should note that the Company does not intend to update any of the forward-looking statements or the uncertainties that may adversely impact those statements.

The following discussion and analysis should be read in conjunction with the financial statements and notes thereto presented elsewhere in this report.

Overview

Washington Banking Company (referred to in this report as the “Company”) is a registered bank holding company with two wholly-owned subsidiaries: Whidbey Island Bank (the “Bank”), the Company’s principal subsidiary and Washington Banking Master Trust (the “Trust”). Headquartered in Oak Harbor, the Company’s market area is primarily northwestern Washington. The market area encompasses distinct economies, and none are particularly dependent upon a single industrial or occupational source. The economies within the market areas have evolved from being heavily dependent upon forestry, fishing and farming to a more diverse blend of industries including retail trade, services, manufacturing, tourism and a large military presence.

The Company’s strategy is one of value-added growth. Management believes that qualitative and sustainable growth of the Company, coupled with maintaining profitability, is currently the most appropriate path to providing good value for its shareholders. To date, the Company’s growth has been achieved organically and it attributes its reputation for focusing on customer service and satisfaction as one of the cornerstones to the Company’s success. The Company’s primary objectives are to improve profitability and operating efficiencies and increase market penetration in areas currently served.

Summary of Critical Accounting Policies

Significant accounting policies are described in Note (1) of the Notes to Consolidated Financial Statements for the year ended December 31, 2008 as filed in Form 10-K. Not all of these accounting policies require management to make difficult, subjective or complex judgments or estimates. Management believes that the following accounting policies could be considered critical under the SEC’s definition.

Allowance for Loan Losses: There have been no material changes in the accounting policy relating to allowance for loan losses as compared to that contained in Note (1) of the Notes to Consolidated Financial Statements for the year ended December 31, 2008 as filed in Form 10-K.

Stock-based Compensation: There have been no material changes in the accounting policy relating to stock-based compensation as compared to that contained in Note (1) of the Notes to Consolidated Financial Statements for the year ended December 31, 2008 as filed in Form 10-K.

Results of Operations Overview

The Company’s net income available to common shareholders decreased to $1.3 million or $0.13 per diluted share, in the third quarter of 2009, compared with $1.9 million or $0.20 per diluted share in the third quarter of 2008. The decrease in net income was principally attributable to a $1.4 million increase in provision for loan losses, from the same period in 2008 and the accrual of $414,000 in preferred dividends on preferred stock issued to the U.S. Treasury under the TARP Capital Purchase Program.

The Company’s net income available to common shareholders for the first nine months of 2009 decreased to $3.3 million or $0.35 per diluted share, compared with $6.7 million or $0.70 per diluted share for the same period last year. The decrease in net income was principally attributable to a $4.8 million increase in provision for loan losses, from the same period in 2008, the accrual of $1.2 million in preferred dividends on preferred stock issued to the U.S. Treasury under the TARP Capital Purchase Program and increases in FDIC fees of $742,000.

Net Interest Income: One of the Company’s key sources of earnings is net interest income. To make it easier to compare results among several periods and the yields on various types of earning assets (some of which are taxable and others which are not), net interest income is presented in this discussion on a “taxable-equivalent basis” (i.e., as if it were all taxable at the same rate). There are several factors that affect net interest income including:

The volume, pricing, mix and maturity of interest-earning assets and interest-bearing liabilities;
The volume of free funds (consisting of noninterest-bearing deposits and other liabilities and shareholders’ equity);
The volume of noninterest-earning assets;
Market interest rate fluctuations; and,
Asset quality.

The following tables set forth various components of the balance sheet that affect interest income and expense and their respective yields or rates:


		Average Balance Sheet and Analysis of Net Interest Income and Yields/Rates
		Three Months Ended						Three Months Ended
		September 30, 2009						September 30, 2008
		Average		Interest	Average			Average		Interest	Average
(Dollars in thousands)		balance		earned/paid	yield			balance		earned/paid	yield

Assets
Loans ⁽¹⁾⁽²⁾	$	821,375	$	13,646	6.59	%	$	820,425	$	14,542	7.05	%
Federal funds sold		28,407		18	0.25	%		883		4	1.62	%
Interest-bearing cash		254		––	0.02	%		472		2	1.83	%
Investments
Taxable		24,467		191	3.10	%		8,717		88	4.03	%
Non-taxable ⁽²⁾		17,572		194	4.38	%		5,207		76	5.78	%
Interest-earning assets		892,075		14,049	6.25	%		835,704		14,712	7.00	%
Noninterest-earning assets		54,649						53,780
Total assets	$	946,724					$	889,483


Liabilities and shareholders’ equity
Deposits:
Interest demand and
money market	$	283,805	$	604	0.84	%	$	260,665	$	951	1.45	%
Savings		45,901		29	0.25	%		41,355		42	.40	%
Time deposits		364,421		2,568	2.80	%		353,522		3418	3.85	%
Total interest-bearing deposits		694,127		3,201	1.83	%		655,542		4,411	2.68	%
Federal funds purchased		11		––	0.51	%		7,338		50	2.69	%
Junior subordinated debentures		25,774		139	2.14	%		25,774		286	4.42	%
Other interest bearing liabilities		10,000		94	3.72	%		26,413		226	3.41	%
Total interest bearing liabilities		729,912		3,434	1.87	%		715,068		4,972	2.77	%
Noninterest-bearing deposits		105,052						92,832
Other liabilities		2,901						3,499
Total liabilities		837,865						811,399
Total shareholders’ equity		108,859						78,084
Total liabilities and shareholders’ equity	$	946,724					$	889,483


Net interest income /spread	$	10,615	4.38	%	$	9,739	4.24	%
Credit for interest-bearing funds			0.34	%			0.40	%
Net interest margin ⁽²⁾			4.72	%			4.64	%

⁽¹⁾Average balance includes nonaccrual loans.
⁽²⁾Interest income on non-taxable investments and loans is presented on a taxable-equivalent basis using the federal statutory rate of 35%. These adjustments were $172 and $134 for the three months ended September 30, 2009 and 2008, respectively. Taxable-equivalent is a Non GAAP performance measurement that management believes provides investors with a more accurate picture of the net interest margin and efficiency ratio for comparative purposes.


		Average Balance Sheet and Analysis of Net Interest Income and Yields/Rates
		Nine Months Ended						Nine Months Ended
		September 30, 2009						September 30, 2008
		Average		Interest	Average			Average		Interest	Average
(Dollars in thousands)		balance		earned/paid	yield			balance		earned/paid	yield

Assets
Loans ⁽¹⁾⁽²⁾	$	825,871	$	40,104	6.49	%	$	818,210	$	44,430	7.25	%
Federal funds sold		16,135		28	0.23	%		469		7	1.94	%
Interest-bearing cash		290		––	0.01	%		378		7	2.50	%
Investments
Taxable		18,423		469	3.40	%		9,208		294	4.27	%
Non-taxable ⁽²⁾		12,099		434	4.80	%		5,245		225	5.73	%
Interest-earning assets		872,818		41,035	6.29	%		833,509		44,963	7.21	%
Non-earning assets		53,929						53,421
Total assets	$	926,747					$	886,930


Liabilities and shareholders’ equity
Deposits:
Interest demand and money market	$	270,359	$	1,738	0.86	%	$	261,923	$	3,234	1.65	%
Savings		44,048		83	0.25	%		41,652		135	0.43	%
Time deposits		360,357		8,285	3.07	%		346,278		10,878	4.20	%
Total interest-bearing deposits		674,764		10,106	2.00	%		649,852		14,247	2.93	%
Federal funds purchased		691		4	0.82	%		14,724		340	3.08	%
Junior subordinated debentures		25,774		543	2.82	%		25,774		975	5.05	%
Other interest-bearing liabilities		16,960		337	2.66	%		23,978		600	3.34	%
Total interest-bearing liabilities		718,189		10,990	2.05	%		714,329		16,162	3.02	%

Noninterest-bearing DDA		99,754						92,850
Other liabilities		2,415						3,561
Total liabilities		820,357						810,739
Total equity		106,389						76,191
Total liabilities and shareholder’s equity	$	926,747					$	886,930

Net interest income /spread			$	30,045	4.24	%			$	28,801	4.18	%
Credit for interest-bearing funds					0.36	%					0.43	%
Net interest margin ⁽²⁾					4.60	%					4.62	%

⁽¹⁾Average balance includes nonaccrual loans.
⁽²⁾Interest income on non-taxable investments and loans is presented on a taxable-equivalent basis using the federal statutory rate of 35%. These adjustments were $464 and $326 for the nine months ended September 30, 2009 and 2008, respectively. Taxable-equivalent is a Non-GAAP performance measurement that management believes provides investors with a more accurate picture of the net interest margin and efficiency ratio for comparative purposes.

Taxable-equivalent net interest income totaled $10.6 million in the third quarter of 2009 compared with $9.7 million during the third quarter of 2008. Changes in net interest income during the third quarter of 2009 reflected a continued growth in average earning assets, average noninterest-bearing deposits and deposit pricing discipline, offset by a decrease on the yield of loans.

Net interest margin (net interest income as a percentage of average interest-earning assets) on a taxable-equivalent basis was 4.72% for the third quarter of 2009, compared to 4.64% for the same period in 2008. The increase in net interest margin in the third quarter of 2009 primarily resulted from the decrease in the Company’s interest expense from the lower costs of interest-bearing deposits, junior subordinated debentures that are indexed to the three month LIBOR, and a reduction in other borrowings outstanding. The increase in the net margin was partially offset by the decreased yield on interest-earning assets of 75 basis points primarily resulting from reductions in the prime rate and holding higher balances in federal funds sold (at 25 basis points). The increased balance of federal funds sold resulted from a significant increase in deposits during the third quarter of 2009. Additionally, the Company did not redeploy these funds into short term investments due to historically low yields available in the bond markets; these low yields did not present an attractive long-term investment alternative.

Taxable-equivalent net interest income totaled $30.1 million in the first nine months of 2009 compared with $28.8 million during the same period in 2008. Changes in net interest income during the first nine months of 2009 reflected a continued growth in average earning assets, average noninterest-bearing deposits and deposit pricing discipline, offset by a decrease on the yield of loans.

Net interest margin on a taxable-equivalent basis was 4.60% for first nine months of 2009, compared to 4.62% for the same period in 2008. The decrease in net interest margin primarily resulted from the decreased yield on interest-earning assets of 92 basis points primarily resulting from reductions in the prime rate and holding higher balances in federal funds sold (at 25 basis points). The decrease in the net interest margin was offset by the decreased yield on interest-bearing liabilities of 97 basis points, resulting from the lower costs of interest expense on interest bearing deposits, junior subordinated debentures that are indexed to the three month LIBOR, and a reduction in other borrowings outstanding.

The following table sets forth the changes in yields or rates and average balances which affected net interest income:


		Three Months Ended									Nine Months Ended
		September 30,									September 30,
		2009 vs. 2008									2009 vs. 2008
		Increase (decrease) due to⁽²⁾:									Increase (decrease) due to⁽²⁾:
		Volume			Rate			Total			Volume			Rate			Total
Assets:
Loans ⁽¹⁾⁽³⁾	$	16		$	(913	)	$	(897	)	$	425		$	(4,751	)	$	(4,326	)
Federal funds sold		15			––			15			22			(1	)		21
Interest-bearing cash		(1	)		(1	)		(2	)		(1	)		(6	)		(7	)
Investments ⁽¹⁾
Taxable		117			(15	)		102			219			(44	)		175
Non-taxable ⁽²⁾		132			(13	)		119			239			(30	)		209
Interest- earning assets	$	279		$	(942	)	$	(663	)	$	904		$	(4,832	)	$	(3,928	)

Liabilities:
Deposits:
Interest demand and money market	$	94		$	(441	)	$	(347	)	$	108		$	(1,604	)	$	(1,496	)
Savings		6			(18	)		(12	)		8			(60	)		(52	)
Time deposits		109			(958	)		(849	)		465			(3,058	)		(2,593	)
Total interest-bearing deposits		209			(1,417	)		(1,208	)		581			(4,722	)		(4,141	)

Fed funds purchased		(28	)		(22	)		(50	)		(191	)		(146	)		(336	)
Junior subordinated debentures		––			(147	)		(147	)		––			(432	)		(432	)
Other interest-bearing liabilities		(156	)		23			(133	)		(155	)		(108	)		(263	)
Total interest-bearing liabilities	$	25		$	(1,563	)	$	(1,538	)	$	235		$	(5,408	)	$	(5,172	)

⁽¹⁾Interest on loans and investments is presented on a fully tax-equivalent basis.
⁽²⁾The changes attributable to the combined effect of volume and interest rates have been allocated proportionately.
⁽³⁾Interest income previously accrued on nonaccrual loans is reversed in the period the loan is placed on nonaccrual status.

Provision for Loan Losses: The provision for loan losses is highly dependent on the Company’s ability to manage asset quality and control the level of net charge-offs through prudent underwriting standards. In addition, decline in general economic conditions could increase future provisions for loan loss and materially impact the Company’s net income. For further discussion of the Company’s asset quality see the Credit Risks and Asset Quality section found in Item 2-Management’s Discussion and Analysis of Financial Condition and Results of Operations.

During the third quarter of 2009, the Company recorded a $2.5 million provision for loan losses compared to $1.1 million for the third quarter in 2008. Net charge-offs for third quarter of 2009 were $1.4 million, a $215,000 increase over the third quarter of 2008. Increases in net charge-offs were due to an increase in real estate loan charge-offs. At September 30, 2009, the allowance for loan losses as a percent of total loans was 1.95% as compared to 1.40% for the same period in 2008.

During the first nine months of 2009, the Company recorded an $8.0 million provision for loan losses compared to $3.2 million in the same period in 2008. Changes in the provision were due to higher net charge-offs of $4.3 million in the first nine months of 2009, compared with $2.8 million in the same period in 2008 and internal downgrades of loans within the portfolio. Increases in net charge-offs were due to an increase in real estate loan charge-offs.

Noninterest Income: Noninterest income remains a key focus of the Company. The Company has focused on diversifying the noninterest income mix. The following table presents the key components of noninterest income:


		Noninterest Income as of:
		Three Months Ended				Nine Months Ended				Three Month			Nine Month
		September 30,				September 30,				Change			Change
(Dollars in thousands)		2009		2008		2009		2008
Service charges and fees	$	909	$	708	$	2,620	$	2,145	$	201		$	475
Electronic banking income		376		356		1,034		1,017		20			17
Investment products		38		93		368		260		(55	)		108
Bank owned life insurance		106		11		312		233		95			79
Income from sale and servicing of SBA loans		49		50		83		239		(1	)		(156	)
Income from sale of mortgage loans		138		36		708		177		102			531
Other income		232		621		800		1,236		(389	)		(436	)
Total noninterest income	$	1,848	$	1,875	$	5,925	$	5,307	$	(27	)	$	618

The changes in noninterest income in the third quarter of 2009 compared to 2008 were related to the following areas:

Increases in service charges and fees are principally attributable to a change in service charges instituted in October of 2008. The full impact of this change is reflected in the income during the third quarter of 2009.
Income from bank owned life insurance increased due to the Company’s decision to change the investment mix during the third quarter of 2008. Due to the deteriorating conditions of the mortgage-backed security market during the third quarter of 2008, the Company renegotiated with the insurance carrier and investment manager to invest in cash assets until suitable alternative investments were found.
Income from the sale of loans increased due to strong residential mortgage refinancing activity in 2009. Additionally, income from the same period in 2008 was negatively impacted by the proposed merger with Frontier Financial Corporation. Under the proposed merger, the department originating real estate loans for sale on the secondary market was to be closed by April 2008.
Other noninterest income decreased due to one-time loan fee adjustment of $342,000 in the third quarter of 2008.

The changes in noninterest income in the first nine months of 2009 compared to 2008 were related to the following areas:

Increases in service charges and fees are principally attributable to a change in service charges instituted in October of 2008. The full impact of this change is reflected in the income in the first nine months of 2009.
Investment products increases are due to increased customer demand for alternative investment products in 2009.
Income from the sale of SBA loans decreased due to lower volumes of SBA loan originations. Additionally, the Company did not sell SBA loans during the first nine months of 2009 due to unfavorable premiums for SBA loans in the secondary financial market.

Income from the sale of loans increased due to strong residential mortgage refinancing activity in 2009. Additionally, income from the same period in 2008 was negatively impacted by the proposed merger with Frontier Financial Corporation. Under the proposed merger, the department originating real estate loans for sale on the secondary market was to be closed by April 2008.

Noninterest Expense: The Company continues to focus on controlling noninterest expenses and addressing long term operating expenses. The Company continued to successfully manage noninterest expense during the first nine months of 2009 as compared to the same period in 2008.


		Noninterest Expense as of:
		Three Months Ended						Nine Months Ended						Three Month			Nine Month
		September 30,						September 30,						Change			Change
(Dollars in thousands)		2009			2008			2009			2008
Salaries and benefits	$	3,791		$	4,076		$	12,237		$	13,139		$	(285	)	$	(902	)
Less: loan origination costs		(153	)		(136	)		(1,738	)		(1,410	)		(17	)		(328	)
Net salaries and benefits (as reported)		3,638			3,940			10,499			11,729			(302	)		(1,230	)
Occupancy expense		1,099			944			3,203			2,796			155			407
Consulting and professional fees		228			107			717			469			121			248
Data processing		141			155			418			469			(14	)		(51	)
Office supplies and printing		198			162			577			402			36			175
FDIC premiums		283			119			1,106			324			164			782
OREO & repossession expense		346			137			829			364			209			465
Other		1,445			2,014			3,763			4,235			(569	)		(472	)
Total noninterest expense	$	7,378		$	7,578		$	21,112		$	20,788		$	(200	)	$	324

The changes in noninterest expense in the third quarter of 2009 compared to 2008 were related to the following areas:

Salaries and benefits decreased due to management’s decision not to accrue a bonus for 2009 and to implement a salary freeze in 2009 for all exempt positions; in the third quarter of 2008 the bonus accrual was $375,000. During the same period, the average number of full time equivalent employees (FTEs) increased to 279 at September 30, 2009 from 259 at September 30, 2008. FTE’s increased between the two periods due to restaffing needs following the terminated merger with Frontier Financial Corporation.
Occupancy expense increased during the third quarter of 2009 due to the additional expense related to a new branch opened in December of 2008 and the lease on a new administrative center which opened in February of 2009.
FDIC premiums had a significant increase during the third quarter of 2009. In February 2009, the FDIC adopted final rules which increase the assessment rates paid on deposits. Assessment rates in 2008, for well-capitalized banks, ranged from $0.05 to $0.07 per $100 of deposits annually. Assessment rates in 2009 will range from $0.12 to $0.16 per $100 of deposits annually. This assessment doubled the Company’s FDIC premiums as compared to 2008.
OREO and repossession expense represents costs the Company incurs in reclaiming, repairing and selling real estate properties and automobiles as well as any write downs or gains and losses on the sale of OREO properties.
The increase in expense during the third quarter of 2009 is primarily related to $180,000 in write downs of OREO properties.

The changes in noninterest expense in the first nine months of 2009 compared to 2008 were related to the following areas:

Salaries and benefits decreased due to management’s decision not to accrue a bonus for 2009 and to implement a salary freeze in 2009 for all exempt positions; in the first nine months of 2008 the bonus accrual was $1.1 million.
During the same period the average number of full time equivalent employees (FTEs) increased to 279 at September 30, 2009 from 259 at September 30, 2008. FTE’s increased between the two periods due to restaffing needs following the terminated merger with Frontier Financial Corporation.
FDIC premiums had a significant increase during the first nine months of 2009. During the second quarter of 2009, the FDIC levied a special one time assessment totaling 5 basis points of deposits on all insured depositories; the assessment totaled $400,000. Additionally, in February 2009, the FDIC adopted final rules which increase the assessment rates paid on deposits. Assessment rates in 2008, for well-capitalized banks, ranged from $0.05 to $0.07 per $100 of deposits annually. Assessment rates in 2009 will range from $0.12 to $0.16 per $100 of deposits annually. This assessment increase doubles the Company’s FDIC premiums as compared to 2008.

OREO and repossession expense represents costs the Company incurs in reclaiming, repairing and selling real estate properties and automobiles. The increase in expense during the first nine months of 2009 is related to $297,000 in repairs on several OREO properties in preparing them for sale and $382,000 in write downs of OREO properties.

Income Taxes: The Company’s consolidated effective tax rates for the third quarter of 2009 and 2008 were 30.67% and 32.60%, respectively. The effective tax rate for the first nine months of 2009 and 2008 were 30.50% and 32.33%, respectively. The quarterly and year-to-date effective tax rates are below the federal statutory rate of 35% principally due to nontaxable income generated from investments in bank owned life insurance, tax-exempt municipal bonds and loans. Additionally, the Company’s year-to-date and quarterly 2009 tax rates reflect a benefit from the New Market Tax Credit Program, whereby a subsidiary of Whidbey Island Bank has been awarded approximately $3.1 million in future federal tax credits. The tax benefits related to these credits will be recognized in the same periods that the credits are recognized on the Company’s income tax returns over the next seven years.

Financial Condition Overview

During 2009, the Company focused on maintaining its loan portfolio and increasing its deposit funding base. Loans at September 30, 2009 were at $816.3 million compared to $823.1 million at December 31, 2008. Deposits at September 30, 2009 increased to $812.1 million compared to $747.2 million at December 31, 2008. Shareholders’ equity increased to $109.6 million at September 30, 2009, primarily due to the issuance of $26.4 million of preferred stock to the U.S. Treasury Department in January 2009.

Loans: Total loans outstanding as of September 30, 2009 were $816.3 million, a decrease of $6.8 million from December 31, 2008. Loan portfolio growth during 2009 was primarily in the commercial real estate loans, which was offset by decreases in construction loans. The Company attempts to balance the diversity of its portfolio, believing that this provides a good means of minimizing risk due to loss and interest rate sensitivity. Active portfolio management has resulted in a diversified portfolio that is not heavily concentrated in any one industry or community.

The following table further details the major components of the loan portfolio:


		Loan Portfolio Composition as of:
		September 30, 2009					December 31, 2008					Change
(Dollars in thousands)		Balance		% of total			Balance		% of total
Commercial	$	90,919		11.2	%	$	94,522		11.5	%	$	(3,603	)
Real estate mortgages:
One-to-four family residential		55,914		6.9	%		58,099		7.1	%		(2,185	)
Multi-family residential & commercial		354,449		43.6	%		327,704		40.0	%		26,745
Total real estate mortgages		410,363		50.4	%		385,803		47.1	%		24,560
Real estate construction:
One-to-four family residential		73,409		9.0	%		101,022		12.3	%		(27,613	)
Multi-family and commercial		38,226		4.7	%		44,401		5.4	%		(6,175	)
Total real estate construction		111,635		13.7	%		145,423		17.7	%		(33,788	)
Consumer:
Indirect		105,358		12.9	%		108,266		13.2	%		(2,908	)
Direct		95,449		11.7	%		86,364		10.5	%		9,085
Total consumer		200,807		24.7	%		194,630		23.7	%		6,177
Subtotal		813,724		100.0	%		820,378		100.0	%		(6,654	)
Deferred loan costs, net		2,592					2,690					(98	)
Less: allowance for loan losses		(15,882	)				(12,250	)				(3,632	)
Total loans, net	$	800,434				$	810,818				$	(10,384	)

Credit Risks and Asset Quality

Credit Risks: The extension of credit, in the form of loans or other credit substitutes, to individuals and businesses is a major portion of the Company’s principal business activity. Company policies and applicable laws and regulations require risk analysis, as well as ongoing portfolio and credit management.

The Company manages its credit risk through lending limits, credit review, approval policies and extensive, ongoing internal monitoring. Through this monitoring process, nonperforming loans are identified. Nonperforming assets consist of nonaccrual loans, restructured loans, past due loans greater than ninety days and other real estate owned. Nonperforming assets are assessed for potential loss exposure on an individual or homogeneous group basis.

The following table summarizes the Company’s nonperforming assets:


		Nonperforming Assets as of:
(Dollars in thousands)		September 30,			December 31,
		2009			2008
Nonaccrual loans	$	3,179		$	1,918
Restructured loans		––			––
Total nonperforming loans		3,179			1,918
Other real estate owned properties		5,012			2,226
Total nonperforming assets	$	8,191		$	4,144
Total impaired loans	$	3,179		$	1,918
Accruing loans past due 90 days or more	$	––		$	1
Potential problem loans⁽¹⁾	$	4,586		$	5,168
Allowance for loan losses	$	15,882		$	12,250
Interest foregone on nonaccrual loans	$	141		$	118
Nonperforming loans to loans		0.39	%		0.23	%
Allowance for loan losses to loans		1.95	%		1.49	%
Allowance for loan losses to nonperforming loans		499.60	%		638.67	%
Nonperforming assets to total assets		0.85	%		0.46	%

¹⁾Potential problem loans represent loans where known information about possible credit problems of borrowers causes management to have serious doubts about the ability of such borrowers to comply with the present loan repayment terms.

Allowance for Loan Losses: The allowance for loan losses is maintained at a level considered adequate by management to provide for loan losses inherent in the portfolio. The Company assesses the allowance on a quarterly basis. The Company's methodology for making such assessments and determining the adequacy of the allowance includes the following key elements:

Specific Allowances. A specific allowance is established when management has identified unique or particular risks that are related to a specific loan that demonstrate risk characteristics consistent with impairment. Specific allowances may also be established to address the unique risks associated with a group of loans or particular type of credit exposure.
Formula Allowance. The formula allowance is calculated by applying loss factors to individual loans based on the assignment of risk ratings, or through the assignment of loss factors to homogenous pools of loans. Changes in risk grades of both performing and nonperforming loans affect the amount of the formula allowance. Loss factors are based on historical loss experience and are adjusted for significant factors that, in management’s judgment, affect the collectibility of the portfolio as of the evaluation date. The adjustments to historical loss rates are a result of our judgment about risks inherent in the portfolio, economic uncertainties, historical loss experience relative to current trends, and other subjective factors. Other considerations include: economic and business conditions that impact our portfolio, loan growth, depth and skill level of lending staff, the interest rate environment, findings from our internal credit review, and bank regulatory examination results.
Unallocated Allowance. The unallocated loan loss allowance represents an amount for imprecision or uncertainty that is inherent in estimates used to determine the allowance, which may change from period to period. Effective January 1, 2009, the Company allocates the credit risk to each loan category and no longer maintains an unallocated allowance for purposes of the table presentation below. In prior years, the unallocated portion of the allowance was associated with the portfolio as a whole, rather than with an individual loan type and was categorized as unallocated. The following table shows the allocation of the allowance for loan losses, by loan type.


		Allocation of the Allowance for Loan Losses as of:
		September 30, 2009				December 31, 2008				September 30, 2008
			% of	% of			% of	% of			% of	% of
(Dollars in thousands)		Amount	Allowance(2)	Loans(1)		Amount	Allowance(2)	Loans(1)		Amount	Allowance(2)	Loans(1)
Balance applicable to:
Commercial	$	1,447	9.1%	11.2%	$	1,124	9.2%	11.5%	$	1,082	9.2%	11.4%
Real estate mortgage		7,739	48.7%	50.4%		5,426	44.3%	47.1%		5,213	44.2%	46.5%
Real estate construction		2,347	14.8%	13.7%		2,258	18.4%	17.7%		2,244	19.0%	18.2%
Consumer		4,349	27.4%	24.7%		3,313	27%	23.7%		3,263	27.6%	23.9%
Unallocated		N/A	N/A%	N/A		129	1.1%	N/A		N/A	N/A	N/A
Total	$	15,882	100%	100%	$	12,250	100%	100%	$	11,802	100%	100%

⁽¹⁾Represents the total of all outstanding loans in each category as a percent of total loans outstanding.
⁽²⁾Represents the total allowance allocated to each loan category as a percent of total allowance for loan losses.

While the Company believes that it uses the best information available to determine the allowance for loan losses, unforeseen market conditions could result in adjustments to the allowance for loan losses, and net income could be significantly affected if circumstances differ substantially from the assumptions used in making the final determination. Based on the assessment of loan quality, the Company believes that the current allowance for loan losses is appropriate under the current circumstances and economic conditions.

Asset Quality: The following table sets forth historical information regarding the Company's allowance for loan losses and net charge-offs:


		Three Months Ended						Nine Months Ended
		September 30,						September 30,
(Dollars in thousands)		2009			2008			2009			2008
Balance at beginning of period	$	14,770		$	11,585		$	12,250		$	11,126
Charge-offs:
Commercial		(63	)		(485	)		(620	)		(1,107	)
Real estate		(1,260	)		(19	)		(2,991	)		(520	)
Consumer
Direct		(218	)		(295	)		(570	)		(604	)
Indirect		(650	)		(638	)		(1,781	)		(1,331	)
Total charge-offs	$	(2,191	)	$	(1,437	)	$	(5,962	)	$	(3,562	)
Recoveries:
Commercial		208			29			474			176
Real estate		362			55			406			59
Consumer
Direct		31			69			104			140
Indirect		202			111			660			399
Total recoveries	$	803		$	264		$	1,644		$	774
Net charge-offs		(1,388	)		(1,173	)		(4,318	)		(2,788	)
Provision for loan losses		2,500			1,075			7,950			3,150
Balance at end of period	$	15,882		$	11,488		$	15,882		$	11,488

Indirect loans net charge-offs to average indirect loans		1.69	%		1.89	%		1.41	%		1.12	%
Other net charge-offs to average other loans		0.52	%		0.36	%		.60	%		0.35	%
Net charge-offs to average loans ⁽¹⁾		0.67	%		0.57	%		.70	%		0.46	%

⁽¹⁾Excludes loans held for sale.

Deposits: Total deposits in the first nine months of 2009 increased $64.9 million to $812.0 million at September 30, 2009. The increase in deposits was in all deposit categories. The following table further details the major components of the deposit portfolio:


		Deposit Composition as of:
		September 30, 2009				December 31, 2008				Change
(Dollars in thousands)		Balance	% of total			Balance	% of total			2009 vs. 2008
Noninterest-bearing demand	$	104,761	12.9	%	$	91,482	12.2	%	$	13,279
NOW accounts		134,190	16.5	%		119,115	15.9	%		15,075
Money market		156,582	19.3	%		143,855	19.3	%		12,727
Savings		47,172	5.8	%		41,161	5.5	%		6,011
Time deposits		369,313	45.5	%		351,546	47.1	%		17,767
Total deposits	$	812,018	100	%	$	747,159	100	%	$	64,859

Wholesale Deposits: The following table further details wholesale deposits, which are included in total deposits shown above:



	Wholesale Deposits as of:
		September 30, 2009				December 31, 2008
(Dollars in thousands)		Balance	% of Total			Balance	% of Total

Brokered time deposits	$	7,500	14.4	%	$	10,000	20.5	%
Mutual fund money market deposits		15,004	28.9	%		26,002	53.4	%
Certificate Deposit Account Registry System deposits		29,443	56.7	%		12,727	26.1	%
Total wholesale deposits	$	51,947	100	%	$	48,729	100	%

Wholesale deposits to total deposits			6.4	%			6.5	%

Brokered time deposits are obtained through intermediary brokers that sell the certificates on the open market. All $7.5 million of the brokered time deposits mature in January 2010; the Company will evaluate alternate funding at maturity.

Mutual fund money market deposits are obtained from an intermediary that provides cash sweep services to broker-dealers and clearing firms. Currently, the Company anticipates limiting the growth of these types of deposits. The deposits are payable upon demand.

Certificate Deposit Account Registry System (“CDARS”) deposits are obtained through a broker and represent a reciprocal agreement, whereby the Company obtains a portion of time deposits from another financial institution, not to exceed $250,000 per customer. In return, the other financial institution obtains a portion of the Company’s time deposits. All CDARS deposits represent direct customer relationships with the Company, but for regulatory purposes are required to be classified as brokered deposits. Deposit maturities range between four weeks and twenty-four months.

Borrowings: Total borrowings outstanding in the first nine months of 2009 decreased $31.6 million to $35.8 million at September 30, 2009. The change in borrowings is attributable to a reduction of $20.0 million in other borrowings from the FHLB and $11.6 million in overnight borrowings. The Company’s sources of funds consist of borrowings from correspondent banks, the FHLB and junior subordinated debentures.

FHLB Overnight Borrowings and Other Borrowed Funds: The Company relies upon advances from the FHLB to supplement funding needs. The FHLB provides credit for member financial institutions in the form of overnight borrowings, short-term and long-term advances. As a member, the Bank is required to own capital stock in the FHLB and is authorized to apply for advances on the pledge of certain of its mortgage loans and other assets (principally, securities which are obligations of, or guaranteed by, the United States) provided certain standards related to creditworthiness have been met. At September 30, 2009, the Company had no outstanding overnight borrowings, and other borrowed funds totaling $10.0 million, with a fixed interest rate of 3.71% maturing in August 2010. The Company had a remaining unused line of credit of $152.4 million, subject to certain collateral and stock requirements.

Federal Reserve Bank Borrowed Funds: The Company has available borrowing capacity with the Federal Reserve Bank of San Francisco. The Federal Reserve requires that the Company pledge certain loans provided certain standards related to creditworthiness have been met. As of September 30, 2009, the Company had no outstanding borrowings. The Company had unused borrowing capacity of $61.2 million, subject to certain collateral requirements.
Federal Funds Purchased: The Company also uses lines of credit at correspondent banks to purchase federal funds for short-term funding. There were no outstanding borrowings as of September 30, 2009. Available borrowings under these lines of credit totaled $60.0 million as of September 30, 2009.
Junior Subordinated Debentures: A wholly-owned subsidiary of the Company issued $25.8 million of trust preferred securities with a quarterly adjustable rate based upon the London Interbank Offered Rate (“LIBOR”) plus 1.56%. The debentures, within certain limitations, are considered Tier 1 capital for regulatory capital requirements.

Capital

Shareholders’ Equity: Shareholders’ equity increased $29.0 million to $109.6 million at September 30, 2009 from $80.6 million at December 31, 2008. The increase in shareholders’ equity was due principally to the issuance of $26.4 million of preferred stock to the U.S. Treasury Department in January 2009. These increases were offset by the payment of preferred stock dividends of $935,000 and common stock cash dividends of $1.5 million.

On January 16, 2009, in exchange for an aggregate purchase price of $26.4 million, the Company issued and sold to the United States Department of the Treasury pursuant to the Troubled Asset Relief Program Capital Purchase Program the following: (i) 26,380 shares of the Company’s newly designated Fixed Rate Cumulative Perpetual Preferred Stock, Series A, no par value per share, and liquidation preference of $1,000 per share ($26.4 million liquidation preference in the aggregate) and (ii) a warrant to purchase up to 492,164 shares of the Company’s common stock, no par value per share, at an exercise price of $8.04 per share, subject to certain anti-dilution and other adjustments. The Warrant may be exercised for up to ten years after it is issued.

The Series A Preferred Stock will bear cumulative dividends at a rate of 5% per annum for the first five years and 9% per annum thereafter, in each case, applied to the $1,000 per share liquidation preference, but will only be paid when, as and if declared by the Company’s Board of Directors out of funds legally available. The Series A Preferred Stock has no maturity date and ranks senior to our common stock with respect to the payment of dividends and distributions and amounts payable upon liquidation, dissolution and winding up of the Company.

The Company used the $26.4 million TARP investment to bolster its capital position and provide additional lending opportunities within its communities.

On September 4, 2009, the Company filed a shelf registration statement for the sale of up to $75.0 million of its securities from time to time. The filing covers the sale of the Company's common stock, preferred stock, warrants, debt securities, units, stock purchase contracts and depositary shares. The Company intends to add the net proceeds from sale of securities under the shelf registration statement to its general funds, where they will also be available for general corporate purposes or such other purposes as described in any prospectus. Also, the Company might temporarily invest the net proceeds in short-term securities.

The Company will hold a special meeting of shareholders on November 12, 2009 to consider and vote upon a proposal to increase the number of authorized shares of common stock from 13.7 million to 35.0 million.

Cash dividends are approved by the Board of Directors in connection with its review of the Company’s capital plan. The cash dividend is subject to regulatory limitation. There is no assurance that future cash dividends will be declared or increased.

Regulatory Capital Requirements: Banking regulations require bank holding companies and banks to maintain a minimum leverage ratio of core capital to adjusted average total assets of at least 4%. In addition, banking regulators have adopted risk-based capital guidelines, under which risk percentages are assigned to various categories of assets and off-balance sheet items to calculate a risk-adjusted capital ratio. Tier I capital generally consists of common shareholders' equity (which does not include unrealized gains and losses on securities), less goodwill and certain identifiable intangible assets, while Tier II capital includes the allowance for loan losses and subordinated debt, both subject to certain limitations.

The FDIC established the qualifications necessary to be classified as a “well-capitalized” bank, primarily for assignment of FDIC insurance premium rates. As the following table indicates, the Company and Bank qualified as “well-capitalized” at September 30, 2009 and December 31, 2008.


	Regulatory Requirements		Actual Ratios
	Adequately-	Well-capitalized	September 30,	December 31,
	capitalized		2009	2008
Total risk-based capital ratio
Company (consolidated)	8%	N/A	16.39%	13.23%
Whidbey Island Bank	8%	10%	16.26%	13.10%
Tier 1 risk-based capital ratio
Company (consolidated)	4%	N/A	15.14%	11.98%
Whidbey Island Bank	4%	6%	15.00%	11.85%
Leverage ratio
Company (consolidated)	4%	N/A	14.16%	11.68%
Whidbey Island Bank	4%	5%	14.04%	11.54%

There can be no assurance that additional capital will not be required in the future due to greater-than-expected growth, unforeseen expenses or revenue shortfalls.

Liquidity and Cash Flows

Whidbey Island Bank: The principal objective of the Bank’s liquidity management program is to maintain the ability to meet day-to-day cash flow requirements of its customers who either wish to withdraw funds or to draw upon credit facilities to meet their cash needs. The Bank monitors the sources and uses of funds on a daily basis to maintain an acceptable liquidity position. In addition to liquidity from core deposits and the repayment and maturities of loans, the Bank can utilize established lines of credit with correspondent banks, sale of investment securities or borrowings from the FHLB.

Washington Banking Company: The Company is a separate legal entity from the Bank and must provide for its own liquidity. Substantially all of the Company’s revenues are obtained from dividends declared and paid by the Bank. There are statutory and regulatory provisions that could limit the ability of the Bank to pay dividends to the Company. However, management believes that such restrictions will not have an adverse impact on the ability of the Company to meet its ongoing cash obligations, which consist principally of debt service on the $25.8 million of outstanding junior subordinated debentures and the payment of preferred dividends on the $26.4 million of outstanding preferred stock.

Consolidated Cash Flows: As disclosed in the Condensed Consolidated Statements of Cash Flows, net cash provided by operating activities was $11.9 million for the first nine months of 2009. Approximately $4.5 million was from net income from continuing operations, a $2.2 million decrease in other liabilities and an $8.0 million increase in provisions for loan losses. Net cash of $40.7 million was used in investing activities during the period, primarily for the purchase of investment securities of $44.5 million. Net cash provided by financing activities was $57.3 million for the first nine months of 2009. Increases in cash came from the issuance of preferred stock to the U.S. Treasury Department of $26.4 million, and the increase in deposits of $64.9 million. These increases were offset by $20.0 million in other borrowing payoffs and $11.6 million in overnight borrowings payoffs.

Capital Resources:

Off-Balance Sheet Items: The Company is a party to financial instruments with off-balance sheet risk. Among the off-balance sheet items entered into in the ordinary course of business are commitments to extend credit and the issuance of letters of credit. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amounts recognized on the balance sheet. Certain commitments are collateralized. As of September 30, 2009 and December 31, 2008, the Company’s commitments under letters of credit and financial guarantees amounted to $2.3 million and $1.8 million, respectively. Since many of the commitments are expected to expire without being drawn upon, these total commitment amounts do not necessarily represent future cash requirements.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

At September 30, 2009, based on the measures used to monitor and manage interest rate risk, there had not been a material change in the Company's interest rate risk since December 31, 2008. Should rates increase, the Company may, or may not be positively impacted due to its current slightly liability sensitive position. For additional information, refer to the Company's Form 10-K for year ended December 31, 2008 filed with the SEC.

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

As of the end of the period covered by this report, management evaluated the effectiveness of the design and operation of its disclosure controls and procedures. The principal executive and financial officers supervised and participated in this evaluation. Based on this evaluation, the chief executive and financial officer each concluded that the Company’s disclosure controls and procedures are effective in timely alerting them to material information required to be included in the periodic reports to the SEC. The design of any system of controls is based in part upon various assumptions about the likelihood of future events, and there can be no assurance that any of the Company’s plans, products, services or procedures will succeed in achieving their intended goals under future conditions. Management found no facts that would require the Company to take any corrective actions with regard to significant deficiencies or material weaknesses.

Changes in Internal Control over Disclosure and Reporting

There was no change in the Company’s internal control over financial reporting that occurred during the quarterly period ended September 30, 2009 that has materially affected, or is reasonably likely to materially affect, the internal control over financial reporting.

PART II – OTHER INFORMATION

Item 1. Legal Proceedings

The Company may be involved in legal proceedings in the regular course of business. At this time, management does not believe that there is pending litigation resulting in an unfavorable outcome of which would result in a material adverse change to the Company’s financial condition, results of operations or cash flows.

Item 1A. Risk Factors

For information regarding risk factors, please refer to Part I, Item 1A in the Company’s Annual Report on Form 10-K for the year ended December 31, 2008. There have been no material changes in the Company’s risk factors from those disclosed in the 2008 Annual Report on Form 10-K.

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

(a) – (c) None

Item 3. Defaults Upon Senior Securities

None

Item 4. Submission of Matters to a Vote of Security Holders

None

Item 5. Other Information

	(a)	Not applicable

	(b)	There have been no material changes in the procedures for shareholders to nominate directors to the Company’s board.

Item 6. Exhibits

Exhibits

	3.1 (a)	Amended and Restated Articles of Incorporation (incorporated by reference to Exhibit 3.1 to the Registrant’s form SB-2 (Registration No. 333-49925) filed April 10, 1998)
	3.1 (b)	Articles of Amendment to Amended and Restated Articles of Incorporation (incorporated by reference to Exhibit 3.2 to the Registrant’s form SB-2 (Registration No. 333-49925) filed April 10, 1998)
	3.1 (c)	Articles of Amendment to Amended and Restated Articles of Incorporation (incorporated by reference to Exhibit 3.1 to the Registrant’s Current Report on Form 8K filed January 20, 2009)
	3.2	Bylaws of the Company (incorporated by reference to Exhibit 4.1 to the Registrant’s Form SB-2 (Registration No. 333-49925) filed April 10, 1998)
	31.1	Certification of Chief Executive Officer required by Rule 13a-14(b) or Rule 15d-14(a) and Section 302 of the Sarbanes Oxley Act of 2002
	31.2	Certification of Chief Financial Officer required by Rule 13a-14(b) or Rule 15d-14(a) and Section 302 of the Sarbanes Oxley Act of 2002
	32.1	Certification of Chief Executive Officer required by Rule 13a-14(b) or Rule 15d-14(b) and Section 906 of the Sarbanes Oxley Act of 2002, 18 U.S.C. Section 1350
	32.2	Certification of Chief Financial Officer required by Rule 13a-14(b) or Rule 15d-14(b) and Section 906 of the Sarbanes Oxley Act of 2002, 18 U.S.C. Section 1350

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.


WASHINGTON BANKING COMPANY



Date: November 6, 2009	By /s/ John L. Wagner

	John L. Wagner
	President and
	Chief Executive Officer


Date: November 6, 2009	By /s/ Richard A. Shields

	Richard A. Shields
	Executive Vice President and
	Chief Financial Officer