10-Q 1 v35243e10vq.htm FORM 10-Q e10vq
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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
     
þ   Quarterly report pursuant to Section 13 or l5(d) of the Securities Exchange Act of 1934
For the quarterly period ended September 30, 2007
     
o   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 þ No o
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 o      Accelerated filerþ      Non-Accelerated filero
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 o No þ
     The number of shares of the issuer’s Common Stock outstanding at October 31, 2007 was 9,396,971.
 
 

 

 

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Item 4.     21
   
 
    
       
   
 
    
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Item 1A.     22
Item 2.     22
Item 3.     22
Item 4.     22
Item 5.     22
Item 6.     22
   
 
    
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 EXHIBIT 2.1
 EXHIBIT 31.1
 EXHIBIT 31.2
 EXHIBIT 32.1
 EXHIBIT 32.2

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PART I — FINANCIAL INFORMATION
Item 1. Financial Statements
WASHINGTON BANKING COMPANY
AND SUBSIDIARIES
Condensed Consolidated Statements of Financial Condition (unaudited)
(Dollars in thousands)
                 
    September 30,     December 31,  
    2007     2006  
Assets
                
Cash and due from banks ($4,218 and $3,703, are restricted, respectively,)
   $ 20,984     $ 18,984  
Interest-bearing deposits
     278       761  
Federal funds sold
     4,600       —  
 
            
Total cash, and cash equivalents
     25,862       19,745  
Investment securities available for sale
     16,908       16,790  
 
                
Federal Home Loan Bank stock
     1,984       1,984  
Loans held for sale
     1,504       2,458  
 
                
Loans receivable
     782,095       719,580  
Allowance for loan losses
     (10,755 )     (10,048 )
 
            
Total loans, net
     771,341       709,532  
Premises and equipment, net
     24,586       23,372  
Bank owned life insurance
     16,363       10,930  
Other assets
     8,865       9,734  
 
            
Total assets
   $ 867,413     $ 794,545  
 
            
 
                
Liabilities and Shareholders’ Equity
                
 
                
Liabilities:
                
Deposits
                
Noninterest-bearing
   $ 107,648     $ 96,858  
Interest-bearing
     332,384       303,979  
Time deposits
     326,276       302,930  
 
            
Total deposits
     766,308       703,767  
FHLB overnight borrowings
     —       3,075  
Junior subordinated debentures
     25,774       15,007  
Other liabilities
     3,608       6,303  
Total liabilities
     795,691       728,152  
 
            
Commitments and contingencies
     —       —  
 
                
Shareholders’ equity:
                
Preferred stock, no par value. Authorized 20,000 shares: no shares issued or outstanding
     —       —  
Common stock, no par value. Authorized 13,679,757 shares: issued and outstanding 9,396,875 at 9/30/2007 and 9,388,600 at 12/31/2006
     32,335       33,016  
Retained earnings
     39,365       33,422  
Accumulated other comprehensive income (loss)
     22       (45 )
 
            
Total shareholders’ equity
     71,722       66,393  
 
            
Total liabilities and shareholders’ equity
   $ 867,413     $ 794,545  
 
            
See accompanying notes to condensed consolidated financial statements.

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WASHINGTON BANKING COMPANY
AND SUBSIDIARIES
Condensed Consolidated Statements of Income (unaudited)
(Dollars in thousands, except per share data)
                                 
    Three Months Ended     Nine Months Ended  
    September 30,     September 30,  
    2007     2006     2007     2006  
Interest income:
                                
Interest and fees on loans
   $ 15,959     $ 14,110     $ 45,573     $ 39,679  
Interest on taxable investment securities
     143       108       412       332  
Interest on tax exempt investment securities
     65       77       204       238  
Other
     54       73       153       161  
 
                        
Total interest income
     16,221       14,369       46,342       40,410  
Interest expense:
                                
Interest on deposits
     5,849       4,615       16,652       11,429  
Interest on other borrowings
     147       45       317       423  
Interest on junior subordinated debentures
     469       351       1,291       995  
 
                        
Total interest expense
     6,465       5,010       18,260       12,847  
Net interest income
     9,756       9,359       28,082       27,563  
Provision for loan losses
     800       750       2,200       2,050  
 
                        
Net interest income after provision for loan losses
     8,956       8,609       25,882       25,513  
 
                        
Noninterest income:
                                
Service charges and fees
     749       812       2,362       2,481  
Income from the sale of loans
     192       168       558       499  
SBA premium income
     74       140       335       469  
Other
     908       672       2,425       2,032  
 
                        
Total noninterest income
     1,923       1,792       5,680       5,481  
Noninterest expense:
                                
Salaries and benefits
     4,166       4,245       12,709       12,494  
Occupancy and equipment
     932       907       2,867       2,656  
Office supplies and printing
     146       149       455       470  
Data processing
     185       136       493       340  
Consulting and professional fees
     172       195       441       472  
Other
     1,226       1,123       3,655       3,399  
 
                        
Total noninterest expense
     6,827       6,755       20,620       19,831  
 
                        
Income before provision for income taxes
     4,052       3,645       10,942       11,163  
Provision for income taxes
     1,232       1,003       3,394       3,483  
 
                        
Net income
   $ 2,820     $ 2,642     $ 7,548     $ 7,680  
 
                        
 
                                
Net income per share, basic
   $ 0.30     $ 0.29     $ 0.80     $ 0.83  
 
                        
 
                                
Net income per share, diluted(1)
   $ 0.30     $ 0.28     $ 0.79     $ 0.81  
 
                        
Average number of shares outstanding, basic
     9,323,000       9,240,000       9,392,000       9,216,000  
Average number of shares outstanding, diluted
     9,435,000       9,525,000       9,525,000       9,489,000  
See accompanying notes to condensed consolidated financial statements.

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WASHINGTON BANKING COMPANY
AND SUBSIDIARY
Condensed Consolidated Statements of Shareholders’ Equity
and Comprehensive Income (unaudited)
(Dollars and shares in thousands, except per share data)
                                                 
                                    Accumulated        
                                    other     Total  
    Common stock     Retained     Deferred     comprehensive     Shareholders  
    Shares     Amount     earnings     compensation     income (loss)     equity  
Balances at December 31, 2005 (1)
     9,228     $ 32,492     $ 25,789     $ (386 )   $ (46 )   $ 57,849  
 
                                                
Comprehensive income:
                                                
Net income
     ¾       ¾       7,680       ¾       ¾       7,680  
Net unrealized loss on securities available for sale, net of tax of ($15)
     ¾       ¾       ¾       ¾       (26 )     (26 )
 
                                              
Total comprehensive income
                                             7,654  
 
                                              
Transition adjustment for adoption of SFAS 123(R)
     ¾       (386 )     ¾       386       ¾       ¾  
Cash dividend, $0.15 per share(1)
     ¾       ¾       (1,394 )     ¾       ¾       (1,394 )
Stock based compensation expense
     ¾       190       ¾       ¾       ¾       190  
Issuance of common stock-stock options (1) 1)
     40       136       ¾       ¾       ¾       136  
Issuance of restricted stock (1)
     17       ¾       ¾       ¾       ¾       ¾  
 
                                    
Balances at September 30, 2006
     9,285     $ 32,432     $ 32,075     $ ¾     $ (72 )   $ 64,435  
 
                                    
 
                                                
Balances at December 31, 2006
     9,389     $ 33,016     $ 33,422     $ ¾     $ (45 )   $ 66,393  
Comprehensive income:
                                                
Net income
     ¾       ¾       7,548       ¾       ¾       7,548  
Net unrealized gain on securities available for sale, net of tax of ($37)
     ¾       ¾       ¾       ¾       67       67  
 
                                              
Total comprehensive income
                                             7,615  
 
                                              
Tax benefit associated with stock-based compensation
     ¾       138       ¾       ¾       ¾       138  
Cash dividend, $0.17 per share
     ¾       ¾       (1,605 )     ¾       ¾       (1,605 )
Stock-based compensation
     ¾       250       ¾       ¾       ¾       250  
Common stock repurchased and retired
     (116 )     (1,851 )             ¾       ¾       (1,851 )
Stock options exercised (1)
     126       782       ¾       ¾       ¾       782  
Forfeited and cancelled restricted stock
     (2 )     ¾       ¾       ¾       ¾       ¾  
 
                                    
Balances at September 30, 2007
     9,397     $ 32,335     $ 39,365     $ ¾     $ 22     $ 71,722  
 
                                    
 
(1)   Adjusted to reflect a 5-for-4 stock split distributed by the Company on September 6, 2006 See accompanying notes to condensed consolidated financial statements.

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WASHINGTON BANKING COMPANY
AND SUBSIDIARY
Condensed Consolidated Statements of Cash Flows (unaudited)
(Dollars in thousands)
                 
    Nine Months Ended  
    September 30,  
    2007     2006  
Cash flows from operating activities:
                
Net income from continuing operations
   $ 7,548     $ 7,680  
Adjustments to reconcile net income to net cash provided by operating activities:
                
Amortization (accretion) of investment premiums, net investment
     (6 )     9  
Deferred tax provision (benefit)
     325       (717 )
Depreciation and amortization
     1,331       1,218  
Earnings on bank owned life insurance
     (433 )     (273 )
Provision for loan losses
     2,200       2,050  
Net gain on sale of other real estate
     (78 )     (6 )
Write-downs of other real estate
     ¾       10  
Amortization of stock-based compensation
     250       190  
Excess tax benefit from stock-based compensation
     (138 )     ¾  
Net change in assets and liabilities:
                
Loans held for sale
     954       889  
Other assets
     1,612       (1,646 )
Other liabilities
     (2,694 )     284  
 
            
Cash flows from operating activities:
     10,871       9,688  
 
            
 
                
Cash flows from investing activities:
                
Purchases of available-for-sale securities
     (2,635 )     (2,948 )
Maturities/calls/principal payments of available-for-sale securities
     2,628       4,461  
Net increase in loans
     (65,846 )     (84,687 )
Purchases of premises and equipment
     (2,545 )     (2,728 )
Purchases of bank owned life insurance
     (5,000 )     ¾  
Proceeds from the sale of other real estate owned and premises and equipment
     947       65  
 
            
Cash flows used by investing activities
     (72,451 )     (85,837 )
 
            
 
                
Cash flows from financing activities:
                
Net increase in deposits
     62,541       63,231  
Gross payments on other borrowed funds
     ¾       (26,845 )
New borrowings on other borrowed funds
     ¾       16,845  
Net increase in FHLB overnight borrowings
     (3,075 )     3,000  
Gross payments on junior subordinated debentures
     (15,007 )     ¾  
New borrowings on junior subordinated debentures
     25,774       ¾  
Dividends paid on common stock
     (1,605 )     (1,394 )
Common stock repurchased and retired
     (1,851 )     ¾  
Excess tax benefits from stock-based compensation
     138       ¾  
Proceeds from issuance of common stock; stock options
     782       136  
 
            
Cash flows from financing activities
     67,697       54,973  
 
            
Net change in cash and cash equivalents
     6,117       (21,176 )
 
            
Cash and cash equivalents at beginning of period
     19,745       42,027  
 
            
Cash and cash equivalents at end of period
   $ 25,862     $ 20,851  
 
            
 
                
Supplemental information:
                
Loans foreclosed and transferred to other real estate owned
   $ 1,838     $ 432  
Cash paid for interest
     18,290       12,213  
Cash paid for income taxes
     2,660       4,010  
See accompanying notes to condensed consolidated financial statements.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Nine months ended September 30, 2007 and 2006 (unaudited)
(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, 2007 WBCO has 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, 2006 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, 2007 are not necessarily indicative of the results that may be expected for the year ending December 31, 2007. 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.
(c) Reclassifications: Certain amounts in prior year’s financial statements may have been reclassified to conform to the 2007 presentation. These reclassifications had no significant impact on the Company’s financial position or results of operations.
(2) Recent Financial Accounting Pronouncements
In February 2007, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (including an amendment of FASB Statement No. 115). This Statement permits entities to choose to measure many financial instruments and certain other items at fair value. The objective is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. This Statement is effective for entities’ first fiscal year that begins after November 15, 2007. The Company did not early adopt and has not determined if it will adopt the fair value option of the standard beginning on January 1, 2008.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Nine months ended September 30, 2007 and 2006 (unaudited)
(Dollars in thousands, except per share data)
(3) Earnings Per Share
The following table reconciles the denominator of the basic and diluted earnings per share computation:
                                 
    Three Months Ended   Nine Months Ended
    September 30,   September 30,
    2007   2006   2007   2006
Weighted average shares-basic
     9,323,000       9,240,000       9,392,000       9,216,000  
Effect of dilutive securities: stock awards
     112,000       285,000       133,000       273,000  
 
                                
Weighted average shares-diluted
     9,435,000       9,525,000       9,525,000       9,489,000  
 
                                
At September 30, 2007 and 2006, there were options to purchase 249,606 and 430,756 shares of common stock outstanding, respectively. For the three and nine months ended September 30, 2007, 82,277 and 74,013 options, respectively, were antidilutive and therefore excluded from the computation of diluted net income per share. There were no antidilutive options for the three and nine months ended September 30, 2006.
(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. The weighted-average fair value per share of options granted during the nine months ended September 30, 2007 and 2006 was $5.11 and $5.98 per share, respectively. The following assumptions were used in arriving at the fair value of options granted:
                 
    Nine Months Ended
    September 30,
    2007   2006
Risk-free interest rate
     4.59 %     4.95 %
Dividend yield rate
     1.50 %     1.40 %
Price volatility
     33.00 %     38.13 %
Expected life of stock options
   5 years   7 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, 2007 and 2006, the Company recognized $77 and $70, respectively, in stock based compensation expense as a component of salaries and benefits. As of September 30, 2007 there was approximately $375 of total unrecognized compensation cost related to non-vested stock awards.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Nine months ended September 30, 2007 and 2006 (unaudited)
(Dollars in thousands, except per share data)
                                 
            Weighted   Weighted average   Aggregate
            average exercise   remaining contractual   intrinsic
    Shares   price per share   terms (in years)   value
Outstanding at January 1, 2007
     331,145     $ 6.06                  
Granted
     56,586       15.98                  
Exercised
     (127,817 )     5.24             $ 1,316  
Forfeited, expired or cancelled
     (10,308 )     8.90                  
 
                                
Outstanding at September 30, 2007
     249,606     $ 8.55       5.11     $ 2,922  
 
                                
 
                                
 
                                
Exercisable at September 30, 2007
     161,511     $ 5.24       3.06     $ 2,414  
 
                                
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, 2007 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, 2007. This amount changes based upon the fair market value of the Company’s stock.
(b) Restricted Stock Awards: The Company grants restricted stock periodically for the benefit of employees and directors. Recipients of restricted stock 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.
The following table summarizes information on restricted stock activity during the nine months ended September 30 2007:
                         
            Weighted average   Weighted average remaining
    Shares   grant price per share   contractual terms (in years)
Outstanding at January 1, 2007
     50,123     $ 12.64          
Granted
     2,536       15.80          
Vested
     (18,836 )     12.27          
Forfeited, expired or cancelled
     (3,696 )     12.52          
 
                        
Outstanding at September 30, 2007
     30,127     $ 13.14       2.19  
 
                        
For the nine months ended September 30, 2007 and 2006 the Company recognized $146 and $121, respectively, in restricted stock compensation expense as a component of salaries and benefits. As of September 30, 2007 there was $308 of total unrecognized compensation costs related to non-vested restricted stock.
(c) Restricted Stock Units: The Company grants restricted stock units periodically for the benefit of employees and directors. Recipients of restricted stock units 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.
The following table summarizes information on restricted stock unit activity during the nine months ended September 30 2007:
                         
            Weighted average   Weighted average remaining
    Shares   grant price per share   contractual terms (in years)
Outstanding at January 1, 2007
     ¾     $ ¾          
Granted
     18,293       15.98          
Vested
     ¾       ¾          
Forfeited, expired or cancelled
     (478 )     15.98          
 
                        
Outstanding at September 30, 2007
     17,815     $ 15.98       4.18  
 
                        

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Nine months ended September 30, 2007 and 2006 (unaudited)
(Dollars in thousands, except per share data)
For the nine months ended September 30, 2007 the Company recognized $27, in restricted stock unit compensation expense as a component of salaries and benefits. As of September 30, 2007 there was $257 of total unrecognized compensation costs related to non-vested restricted stock units.
(5) Income Taxes
The Company adopted FIN 48, Accounting for Uncertainty in Income Taxes, on January 1, 2007. FIN 48 is an interpretation of SFAS No. 109, Accounting for Income Taxes, and it seeks to reduce the diversity in practice associated with certain aspects of measurement and recognition in accounting for income taxes. In addition, FIN 48 provides guidance on derecognition, classification, interest and penalties, and accounting in interim periods and requires expanded disclosure with respect to uncertainty in income taxes. As a result of the implementation of FIN 48, the Company recognized no material adjustments in the liability for unrecognized income tax benefits, all of which would affect the Company’s effective income tax rate if recognized.
Income tax expense attributable to income for the three and nine months ended September 30, 2007 and 2006 consisted of the following:
                                 
    Three Months Ended September 30,     Nine Months Ended September 30,  
    2007     2006     2007     2006  
Federal:
                                
Current tax expense
   $ 1,194     $ 1,023     $ 3,069     $ 4,200  
Deferred tax expense (benefit)
     38       (20 )     325       (717 )
 
                        
Total
   $ 1,232     $ 1,003     $ 3,394     $ 3,483  
 
                        
The Company’s effective tax rate varies from the federal income tax statutory rates of 35.0% in 2007 and 34.4% in 2006. A reconciliation of the differences for the three and nine months ended September 30, 2007 and 2006 is as follows:
                                 
    Three Months Ended September 30,     Nine Months Ended September 30,  
    2007     2006     2007     2006  
Income tax expense at federal statutory rates
   $ 1,389     $ 1,273     $ 3,827     $ 3,874  
Federal tax credits
     (100 )     (300 )     (300 )     (300 )
Tax-exempt securities
     (109 )     (73 )     (289 )     (222 )
Other items
     52       103       156       131  
 
                        
Total
   $ 1,232     $ 1,003     $ 3,394     $ 3,483  
 
                        
The effective tax rate for 2007 is impacted by Federal tax credits related to the New Markets Tax Credit program whereby a subsidiary of Whidbey Island Bank has been awarded $3,100 in future Federal tax credits which are available through 2012. Tax benefits related to these credits will be recognized for financial reporting purposes in the same periods that the credits are recognized in the Company’s income tax returns. The Company believes that it will comply with the various regulatory provisions of the New Markets Tax Credit program in 2007, and therefore has reflected the impact of the credits in its estimated annual effective tax rate for 2007.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Nine months ended September 30, 2007 and 2006 (unaudited)
(Dollars in thousands, except per share data)
The components of deferred income tax included in other assets in the accompanying consolidated financial statements at September 30, 2007 and December 31, 2006 are as follows:
                 
    September 30,     December 31,  
    2007     2006  
Deferred tax assets:
                
Loan loss allowances
   $ 3,764     $ 3,517  
Deferred compensation
     360       404  
Other
     47       20  
Market value adjustment of investment securities available for sale
     —       25  
 
            
Total deferred tax assets
     4,171       3,966  
 
            
 
                
Deferred tax liabilities:
                
Deferred loan fees
     1,935       1,552  
Premises and equipment
     423       433  
Investment in partnership
     152       140  
FHLB stock
     245       152  
Prepaid expenses
     143       111  
Other
     68       23  
Market value adjustment of investment securities available for sale
     12       ¾  
 
            
Total deferred tax liabilities
     2,978       2,411  
 
            
Deferred tax assets, net
   $ 1,193     $ 1,555  
 
            
There was no valuation allowance for deferred tax assets as of September 30, 2007 or December 31, 2006. The Company has determined that it is not required to establish a valuation allowance for the deferred tax assets as management believes it is more likely than not that the deferred tax assets will be realized in the normal course of business.
(6) Subsequent Event
On October 25, 2007, the Company announced that its Board of Directors declared a cash dividend of $0.06 per share to shareholders of record as of November 9, 2007, payable on November 28, 2007.
(7) Merger with Frontier Financial Corporation
On September 26, 2007, the Company announced that its Board of Directors had entered into a definitive merger agreement with Frontier Financial Corporation (NASDAQ: FTBK). The terms of the agreement, provide, subject to certain conditions, for a merger of the Company with and into Frontier Financial Corporation and the merger of the Bank with and into Frontier Bank, a wholly owned subsidiary of Frontier Financial Corporation.
The transaction is expected to close in the first quarter of 2008, pending approval of the Company’s shareholders, regulatory approvals and satisfaction of other customary closing conditions.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Nine months ended September 30, 2007 and 2006 (unaudited)
(Dollars in thousands, except per share data)
(8) 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 amounts to one hundred percent of the commitment amount at September 30, 2007. 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 are not significant as of September 30, 2007. As of September 30, 2007 the commitments under these agreements were $1,239.
At September 30, 2007, 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 $25,000 at September 30, 2007.

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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, continued success of the Company’s business plan and the strength of the local economy. The words “will,” “believe,” “expect,” “should,” “anticipate” and words of similar construction 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 and adversely. 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; and (6) successful completion of the previously announced merger with Frontier Financial, closing of which remains subject to customary closing conditions. 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.
On September 26, 2007, the board of directors announced that the Company had entered into a definitive merger agreement with Frontier Financial Corporation (NASDAQ: FTBK) which provides, subject to certain conditions, for a merger of the Company with and into Frontier Financial Corporation and the Bank will merge with and into Frontier Bank, a wholly owned subsidiary of Frontier Financial Corporation. At announcement date the cash and stock transaction was valued at approximately $191.1 million, or $21.40 per share, subject to certain conditions.
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, 2006 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, 2006 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, 2006 as filed in Form 10-K.

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Results of Operations Overview
The Company’s net income increased to $2.8 million or $0.30 per diluted share, in the third quarter of 2007, compared with $2.6 million or $0.28 per diluted share in the third quarter of 2006. Return on average equity decreased to 16.18% in the third quarter of 2007, compared with 16.69% in the corresponding quarter of 2006.
For the first nine months of 2007, net income decreased 2% to $7.5 million and diluted earnings per share decreased to $0.79, compared with $7.7 million or $0.81 per diluted share for the same period last year. Return on average equity decreased 218 basis points to 14.74% for the first nine months of 2007, compared with 16.92% last year.
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

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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, 2007     September 30, 2006  
    Average     Interest     Average     Average     Interest     Average  
(Dollars in thousands)   balance     earned/paid     yield     balance     earned/paid     yield  
Assets
                                                
Loans (1) (2)
   $ 773,145     $ 16,091       8.26 %   $ 697,972     $ 14,130       8.03 %
Federal funds sold
     3,899       47       4.80 %     4,740       63       5.31 %
Interest-bearing cash
     371       7       7.13 %     759       10       5.10 %
Investments Taxable
     12,388       143       4.57 %     11,744       108       3.65 %
Non-taxable (2)
     6,443       95       5.84 %     7,271       114       6.24 %
 
                                    
Interest-earning assets
     796,246       16,382       8.16 %     722,486       14,425       7.92 %
Noninterest-earning assets
     57,662                       52,534                  
 
                                            
Total assets
   $ 853,908                     $ 775,020                  
 
                                            
                                                 
Liabilities and shareholders’ equity
                                                
Deposits:
                                                
Interest demand and money market
   $ 278,977     $ 1,898       2.70 %   $ 238,097     $ 1,258       2.10 %
Savings
     44,873       78       0.69 %     55,947       111       0.79 %
CDs
     315,003       3,873       4.88 %     289,908       3,246       4.44 %
 
                                    
Total interest-bearing deposits
     638,853       5,849       3.63 %     583,952       4,615       3.14 %
 
                                    
Federal funds purchased
     3,482       53       6.08 %     2,267       31       5.45 %
Junior subordinated debentures
     25,774       469       7.22 %     15,007       351       9.28 %
Other interest-bearing liabilities
     6,413       94       5.78 %     978       14       5.56 %
 
                                    
 
                                                
Total interest bearing liabilities
     674,522       6,465       3.80 %     602,204       5,011       3.30 %
 
                                                
Noninterest-bearing DDA
     104,989                       103,643                  
Other liabilities
     4,489                       6,383                  
Total liabilities
     784,000                       712,230                  
 
                                            
Total shareholders’ equity
     69,908                       62,790                  
 
                                            
Total liabilities and shareholders’ equity
   $ 853,908                     $ 775,020                  
 
                                            
 
                                                
Net interest income /Spread
           $ 9,917       4.36 %           $ 9,414       4.62 %
 
                                            
Credit for noninterest-bearing funds
                     0.58 %                     0.55 %
 
                                            
Net interest margin (2)
                    4.94 %                     5.17 %
 
                                            
 
(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 $162 and $57 for the three months ended September 30, 2007 and 2006, 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 was $9.9 million for the third quarter of 2007, up $503,000 from the same period in 2006. The increase was primarily the result of an increase in interest-earning assets, offset by a decrease in the net interest margin. Average earning assets in the current quarter increased $73.8 million over the third quarter of 2006 due to higher loan volumes. The net interest margin for the third quarter of 2007 was 4.94%, a decrease of 0.23% from the comparable period in 2006. The decrease was due to the average cost of interest bearing liabilities increasing more than the average yield on interest earning assets. The yield on earning assets in the current quarter increased 0.24% over the comparable period in the prior year due primarily to higher average loan yields while the average cost of interest bearing liabilities increased 0.50% due primarily to increased costs associated with CDs and Money Market accounts (MMA). During 2007 the Company introduced new high-balance, high-yield MMAs that attracted significant deposits. MMAs averaged $132.1 million in the third quarter of 2007 compared with $90.0 million in the comparable period of 2006. These accounts pay a variable rate of interest associated with short-term market rates.

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    Average Balance Sheet and Analysis of Net Interest Income and Yields/Rates  
    Nine Months Ended     Nine Months Ended  
    September 30, 2007     September 30, 2006  
    Average     Interest     Average     Average     Interest     Average  
(Dollars in thousands)   balance     earned/paid     yield     balance     earned/paid     yield  
Assets
                                                
Loans (1) (2)
   $ 748,356     $ 45,972       8.21 %   $ 669,746     $ 39,754       7.94 %
Federal funds sold
     2,765       104       5.02 %     3,509       132       5.01 %
Interest-bearing cash
     1,191       49       5.46 %     781       29       5.01 %
Investments Taxable
     12,362       412       4.46 %     12,783       332       3.47 %
Non-taxable (2)
     6,685       299       5.98 %     7,460       353       6.33 %
 
                                    
Interest-earning assets
     771,359       46,835       8.12 %     694,279       40,600       7.82 %
Non-earning assets
     55,061                       50,079                  
 
                                            
Total assets
   $ 826,420                     $ 744,358                  
 
                                            
                                                 
Liabilities and shareholders’ equity
                                                
Deposits:
                                                
Interest demand and money market
   $ 264,736     $ 5,171       2.61 %   $ 225,963     $ 3,007       1.78 %
Savings
     47,062       253       0.72 %     56,233       330       0.78 %
Time deposits
     310,147       11,228       4.84 %     268,156       8,092       4.03 %
 
                                    
Total interest-bearing deposits
     621,945       16,652       3.58 %     550,352       11,429       2.78 %
 
                                    
Federal funds purchased
     4,200       180       5.73 %     6,198       239       5.15 %
Junior subordinated debentures
     22,146       1,291       7.79 %     15,007       995       8.86 %
Other interest-bearing liabilities
     3,333       137       5.49 %     5,592       185       4.41 %
 
                                    
 
                                                
Total interest-bearing liabilities
     651,624       18,260       3.75 %     577,149       12,848       2.98 %
 
                                                
Noninterest-bearing DDA
     100,872                       100,827                  
Other liabilities
     5,430                       5,705                  
Total liabilities
     757,926                       683,681                  
 
                                            
Total equity
     68,493                       60,677                  
 
                                            
Total liabilities and shareholder’s equity
   $ 826,420                     $ 744,358                  
 
                                            
 
                                                
Net interest income /Spread
           $ 28,575       4.37 %           $ 27,752       4.83 %
 
                                            
Credit for noninterest-bearing funds
                     0.58 %                     0.51 %
 
                                            
Net interest margin (2)
                    4.95 %                     5.34 %
 
                                            
 
(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 $494 and $190 for the nine months ended September 30, 2007 and 2006, 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 was $28.6 million for the first nine months of 2007, up $819,000 from the same period in 2006. The increase was primarily the result of an increase in interest-earning assets, offset by a decrease in the net interest margin. Average interest-earning assets in 2007 increased $77.1 million over 2006 due to higher loan volumes. The net interest margin for 2007 was 4.95%, a decrease of 0.39% from the comparable period in 2006. The decrease was due to the average cost of interest bearing liabilities increasing more than the average yield on interest earning assets. The yield on earning assets in 2007 increased 0.30% over the comparable period in the prior year due primarily to higher average loan yields while the average cost of interest bearing liabilities increased 0.77% due primarily to increased costs associated with CDs and Money Market accounts (MMA). During 2007 the Company introduced new high-balance, high-yield MMAs that attracted significant deposits. MMAs averaged $119.3 million in 2007 compared with $87.7 million in the 2006. These accounts pay a variable rate of interest associated with short-term market rates.

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The following table shows how changes in yields or rates and average balances affected net interest income for the third quarters of 2007 and 2006, as well as the first nine months of 2007 and 2006:
                                                 
    Three Months Ended     Nine Months Ended  
    September 30     September 30  
    2007 vs. 2006     2007 vs. 2006  
    Increase (decrease) due to (2):     Increase (decrease) due to(2):  
    Volume     Rate     Total     Volume     Rate     Total  
 
                                                
Assets:
                                                
Loans (1) (3)
   $ 1,556     $ 405     $ 1,961     $ 4,792     $ 1,426     $ 6,218  
Federal funds sold
     (10 )     (6 )     (16 )     (28 )     —       (28 )
Interest-bearing cash
     (15 )     12       (3 )     17       3       20  
Investments (1)
                                                 
Taxable (included invest in sub)
     6       28       34       (11 )     91       80  
Non-taxable(2)
     (12 )     (7 )     (19 )     (35 )     (19 )     (54 )
 
                                    
Total interest earning assets
   $ 1,525     $ 432     $ 1,957     $ 4,735     $ 1,501     $ 6,236  
 
                                    
Liabilities:
                                                
Deposits:
                                                
Interest demand and money market
   $ 239     $ 401     $ 640     $ 581     $ 1,584     $ 2,165  
Savings
     (20 )     (13 )     (33 )     (51 )     (27 )     (78 )
Time deposits
     294       333       627       1,378       1,758       3,136  
Total interest bearing deposits
                                                
 
                                                
Fed Funds Purchased
     19       4       23       (90 )     32       (58 )
Junior subordinated debentures
     171       (53 )     118       397       (100 )     297  
Other interest-bearing liabilities
     79       1       80       (121 )     73       (48 )
 
                                    
Total interest-bearing liabilities
   $ 782     $ 673     $ 1,455     $ 2,094     $ 3,320     $ 5,414  
 
                                    
 
(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.
Noninterest Income: Noninterest income in the third quarter of 2007 increased 7% to $1.9 million compared to $1.8 million in the corresponding quarter of 2006. Changes in noninterest income were primarily due to increases from the sale of loans of $24,000, investment product sales of $34,000 and bank owned life insurance (“BOLI”) of $89,000 as compared to the same period in 2006. These increases were offset by declines in SBA premiums of $66,000, and service charges and fees of $63,000.
Noninterest income of $5.7 million for the first nine months of 2007 increased 4%, compared with $5.5 million in the same period last year. Changes in noninterest income in the first nine months of 2007 were primarily due to increases in income from the sale of loans of $59,000, electronic banking fees of $145,000, and income from BOLI of $160,000 as compared to the first nine months of 2006. Additionally, the Company recognized a gain of $78,000 on the sale of a foreclosed property. These increases were offset by declines in SBA premiums of $134,000 and service charge and fees of $119,000 as compared to last year.
Noninterest Expense: Noninterest expense in the third quarter of 2007 increased $72,000 to $6.8 million compared to the corresponding quarter of 2006. Increases in noninterest expense were primarily due to increases in FDIC premiums of $50,000, data processing expense of $49,000 and occupancy expense of $25,000 due to the addition of a new branch in the fourth quarter of 2006. These increases were offset by declines in salaries and benefits of $79,000 and consulting and professional fees of $23,000 as compared to the same period in 2006. The Company’s efficiency ratio decreased to 57.65% for the third quarter of 2007 compared to 60.28% for the corresponding quarter in 2006.

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Noninterest expense for the first nine months of 2007 was $20.6 million, a 4% increase over last year. The increase was principally attributed to an increase in salaries and benefits of $215,000, occupancy and equipment of $211,000, and advertising expense of $175,000. Additionally, data processing costs for the Company increased $153,000 as compared to last year due to costs related to electronic check processing. The efficiency ratio increased for the first nine months of 2007 to 60.28% compared to 59.67% in the first nine months of 2006.
Income Taxes: The Company’s consolidated effective tax rates for the third quarters of 2007 and 2006 were 30.4% and 27.5%, respectively. The effective tax rate for the first nine months of 2007 was 31.0%, and 31.2% for the corresponding period in 2006. The effective tax rates are below the federal statutory rate of 35.0% principally due to nontaxable income generated from investments in bank owned life insurance, tax-exempt municipal bonds and loans. Additionally, the Company’s tax rate reflects 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 which are available through 2012. 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.
Financial Condition Overview
Total assets were $867.4 million at September 30, 2007, an increase of $72.9 million from December 31, 2006. During the first nine months of 2007 the Company continued to focus on growing the loan and deposit portfolios. Loans at September 30, 2007 grew 9% to $782.1 million compared to December 31, 2006. Deposits at September 30, 2007 were $766.3 million, an increase of 9% from December 31, 2006.
Loans: Total loans outstanding as of September 30, 2007 were $782.1 million, an increase of $62.5 million from December 31, 2006. Loan portfolio growth during 2007 was primarily in the areas of commercial loans, commercial real estate loans and indirect consumer loans. Active loan 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, 2007     December 31, 2006     Change  
(Dollars in thousands)   Balance     % of total     Balance     % of total          
Commercial
   $ 103,004       13.2 %   $ 82,990       11.6 %   $ 20,014  
 
                                        
Real estate mortgages:
                                        
One-to-four family residential
     53,543       6.9 %     54,509       7.6 %     (966 )
Multi-family residential & commercial
     276,244       35.4 %     249,109       34.7 %     27,135  
 
                              
Total real estate mortgages
     329,788       42.3 %     303,618       42.3 %     26,170  
Real estate construction:
                                        
One-to-four family residential
     97,287       12.5 %     96,107       13.3 %     1,180  
Multi-family and commercial
     44,464       5.7 %     46,329       6.5 %     (1.865 )
 
                              
Total real estate construction
     141,751       18.2 %     142,436       19.8 %     (685 )
Consumer:
                                        
Indirect
     117,384       15.1 %     104,794       14.6 %     12,590  
Direct
     87,439       11.2 %     83,741       11.7 %     3,698  
 
                              
Total consumer
     204,824       26.3 %     188,535       26.3 %     16,289  
 
                              
Subtotal
     779,366       100 %     717,579       100.0 %     61,787  
 
                              
Deferred loan fees, net
     2,730               2,001               729  
 
                              
Total loans, net
   $ 782,095             $ 719,580             $ 62,515  
 
                              

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Allowance for Loan Losses: The allowance for loan losses at September 30, 2007 was $10.8 million or 1.38% of total loans and 812.27% of total non-performing loans. This compares with an allowance of $10.1 million or 1.40% of total loans and 276.19% of total non-performing loans at December 31, 2006.
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 evaluation of the allowance is based on a continuing assessment of nonperforming assets, recent and historical loss experience, and other factors, including regulatory guidance and economic factors. 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. The Company anticipates that normal growth of the loan portfolio will require continued increases in the allowance for loan losses. The following table details the activity of the allowance for loan losses:
                                 
    Three Months Ended     Nine Months Ended  
    September 30     September 30  
(Dollars in thousands)   2007     2006     2007     2006  
Balance at beginning of period
   $ 10,526     $ 9,606     $ 10,048     $ 8,810  
 
                                
Charge-offs:
                                
Commercial
     (312 )     (285 )     (928 )     (751 )
Real estate
     (20 )     —       (20 )     (86 )
Consumer:
                                
Direct
     (241 )     (67 )     (526 )     (261 )
Indirect
     (200 )     (161 )     (598 )     (562 )
 
                        
Total charge-offs
   $ (773 )   $ (513 )   $ (2,072 )   $ (1,660 )
 
                        
Recoveries:
                                
Commercial
     64       12       168       313  
Real estate
     2       3       75       5  
Consumer:
                                
Direct
     53       37       136       158  
Indirect
     82       90       200       309  
 
                        
Total recoveries
   $ 202     $ 142     $ 579     $ 785  
 
                        
Net charge-offs
     (571 )     (371 )     (1,493 )     (875 )
Provision for loan losses
     800       750       2,200       2,050  
 
                        
Balance at end of period
   $ 10,755     $ 9,985     $ 10,755     $ 9,985  
 
                        
 
                                
Indirect net charge-offs to average indirect loans
     0.42 %     0.29 %     0.49 %     0.35 %
Other net charge-offs to average other loans (1)
     0.27 %     0.20 %     0.23 %     0.15 %
Net charge-offs to average loans (1)
     0.29 %     0.21 %     0.27 %     0.17 %
 
(1)   Excludes loans held for sale.
The changes in the allocation of the allowance for loan losses in the first nine months of 2007 were due primarily to changes in the loan portfolio and its mix, changes in the risk grading of loans, and charge-off and recovery activity.
During the third quarter of 2007, the Company recorded a $800,000 provision for loan losses compared to $750,000 for the third quarter in 2006. Net charge-offs for third quarter of 2007 were $571,000, a $200,000 increase over the third quarter of 2006.
During the first nine months of 2007, the Company recorded a $2.2 million provision for loan losses compared to $2.1 million for the corresponding period in 2006. Net charge-offs for the first nine months of 2007 increased $618,000 to $1.5 million, compared with $875,000 in the same period last year.

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The table below details the Company’s allocation of the allowance for loan losses by loan type and remaining unallocated allowances:
                                                                         
    Allocation of the Allowance for Loan Losses as of:  
    September 30, 2007     December 31, 2006     September 30, 2006  
            % 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
   $ 954       8.9 %     13.2 %   $ 782       7.8 %     11.6 %   $ 786       7.9 %     11.5 %
Real estate mortgage
     3,541       32.9 %     42.3 %     3,303       32.9 %     42.3 %     3,250       32.5 %     41.3 %
Real estate construction
     1,709       15.9 %     18.2 %     1,781       17.7 %     19.8 %     1,898       19.0 %     21.3 %
Consumer
     2,756       25.6 %     26.3 %     2,593       25.8 %     26.3 %     2,541       25.4 %     25.9 %
Unallocated
     1,795       16.7 %     N/A       1,589       15.8 %     N/A       1,510       15.2 %     N/A  
             
Total
   $ 10,755       100 %     100 %   $ 10,048       100.0 %     100.0 %   $ 9,985       100.0 %     100.0 %
             
 
(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.
Nonperforming Assets: The table below shows the composition of the Company’s nonperforming assets:
                 
    Nonperforming Assets as of:  
    September 30,     December 31,  
(Dollars in thousands)   2007     2006  
Nonaccrual loans
   $ 1,324     $ 3,638  
Restructured loans
     —       —  
 
            
Total nonperforming loans
     1,324       3,638  
Other real estate owned
     1,332       363  
 
            
Total nonperforming assets
   $ 2,656     $ 4,001  
 
            
Total impaired loans
   $ 2,656     $ 4,001  
Accruing loans past due ³ 90 days
     —       30  
Potential problem loans
     —       —  
Allowance for loan losses
   $ 10,755     $ 10,048  
 
                
Nonperforming loans to loans
     0.17 %     0.51 %
Allowance for loan losses to nonperforming loans
     812.27 %     276.19 %
Allowance for loan losses to nonperforming assets
     404.91 %     251.13 %
Nonperforming assets to total assets
     0.31 %     0.50 %

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Deposits: In the first nine months of 2007, the Company made a concerted effort to attract deposits through competitive pricing and delivery of quality service. Total deposits in the first nine months of 2007 increased 9%, or $62.5 million. Money market accounts were the largest portion of the deposit growth, a $45.3 million increase for the period. The following table further details the major components of the deposit portfolio:
                                         
            Deposit Composition as of:        
    September 30, 2007     December 31, 2006     Change  
(Dollars in thousands)   Balance     % of total     Balance     % of total     2007 vs. 2006  
Noninterest-bearing demand
   $ 107,648       14.0 %   $ 96,858       13.8 %   $ 10,790  
NOW accounts
     140,854       18.4 %     152,087       21.6 %     (11,233 )
Money market
     147,195       19.2 %     101,856       14.5 %     45,339  
Savings
     44,335       5.8 %     50,036       7.1 %     (5,701 )
Time deposits
     326,276       42.6 %     302,930       43.0 %     23,346  
 
                              
Total deposits
   $ 766,308       100.0 %   $ 703,767       100.0 %   $ 62,541  
 
                              
Other Borrowings: Total borrowings outstanding in the first nine months of 2007 increased $7.7 million, to $25.8 million at September 30, 2007. The change in borrowings is attributable to reductions in overnight borrowings with the Federal Home Loan Bank (“FHLB”) and issuance of additional junior subordinated debentures by the Company.
FHLB Borrowings: The Company utilizes 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. At September 30, 2007, the Company had no outstanding borrowings with the FHLB.
Junior Subordinated Debentures: On April 2, 2007, a newly created wholly-owned subsidiary of the Company issued $10.3 million of trust preferred securities with a quarterly adjustable rate based upon the London Interbank Offered Rate (“LIBOR”) plus 1.56%. Additionally, on June 29, 2007, the Company prepaid $15.0 million of outstanding trust preferred securities with a quarterly adjustable rate of LIBOR plus 3.65%. On the same day, the Company replaced the called securities with another issuance of $15.0 million of trust preferred securities with a quarterly adjustable rate of LIBOR plus 1.56%. The debentures, within certain limitations, are considered Tier 1 capital for regulatory capital requirements.
Capital
Shareholders’ Equity: Total shareholders’ equity increased 8% to $71.7 million at September 30, 2007 from $66.4 million at December 31, 2006. Increases in shareholders equity were principally due to $7.5 million of net income for the first nine months of 2007, and proceeds from the exercise of stock awards of $782,000. These increases were offset by the payment of cash dividends of $1.6 million and repurchase of Company stock of $1.9 million.
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.

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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, 2007 and December 31, 2006:
                                 
    Regulatory Requirements   Actual Ratios
    Adequately-   Well-   September 30,   December 31,
    capitalized   capitalized   2007   2006
Total risk-based capital ratio
                                
 
                                
Company (consolidated)
     8 %     N/A       12.46 %     11.52 %
Whidbey Island Bank
     8 %     10 %     11.92 %     11.19 %
 
                                
Tier 1 risk-based capital ratio
                                
 
                                
Company (consolidated)
     4 %     N/A       11.08 %     10.27 %
Whidbey Island Bank
     4 %     6 %     10.67 %     9.94 %
 
                                
Leverage ratio
                                
 
                                
Company (consolidated)
     4 %     N/A       11.19 %     10.24 %
Whidbey Island Bank
     4 %     5 %     10.78 %     9.92 %
There can be no assurance that additional capital will not be required in the near future due to greater-than-expected growth, unforeseen expenses or revenue shortfalls, or otherwise.
Liquidity and Cash Flows
Liquidity: The principal objective of the liquidity management program is to maintain the Bank’s ability to meet the day to day cash flow requirements of its customers who either wish to withdraw funds or draw upon credit facilities to meet their needs.
Management monitors the sources and uses of funds on a daily basis to maintain an acceptable liquidity position. The Company’s sources of funds are customer deposits, loan repayments, current earnings, cash and demand balances due from other banks, federal funds, short-term investments, investment securities available for sale and trust preferred securities. The Company’s strategy includes maintaining a “well-capitalized” status for regulatory purposes, while maintaining a favorable liquidity position and proper asset/liability mix. With this strategy in mind, management anticipates that the Bank will rely primarily upon customer deposits and investments to provide liquidity in 2007. These funds will be used for loan originations and deposit withdrawals, to satisfy other financial commitments and to support continuing operations. Additional funds are available through established FHLB and correspondent bank lines of credit, which the Bank may use to supplement funding sources.
Consolidated Cash Flows: As disclosed in the Condensed Consolidated Statements of Cash Flows, net cash provided by operating activities was $10.9 million for the first nine months of 2007. Net cash of $72.5 million was used in investing activities consisting principally of $65.8 million in net loan growth. The $67.7 million of cash provided by financing activities consisted principally of $62.5 million in net deposit growth and $25.8 million in new borrowings on trust preferred securities which were offset by $18.1 million in net repayments of borrowings, $1.6 million in dividends to shareholders and $1.9 million in shares repurchased.
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, 2007 and December 31, 2006, the Company’s commitments under letters of credit and financial guarantees amounted to $1.2 million and $2.0 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.

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Item 3. Quantitative and Qualitative Disclosures about Market Risk
At September 30, 2007, 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, 2006. Should rates decrease, the Company may, or may not be negatively impacted due to its current slightly asset sensitive position. For additional information, refer to the Company’s Form 10-K for year ended December 31, 2006 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. In addition, there have been no significant changes in the internal controls or in other factors known to management that could significantly affect the internal controls subsequent to the most recent evaluation. 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, 2007 that has materially affected, or is reasonably likely to materially affect, the internal control over financial reporting.

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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
In addition to the risk factor set forth below, please refer to Part 1, Item 1A in the Company’s Annual Report on Form 10-K for the year ended December 31, 2006 for additional risk factors.
If the merger is not approved, the Company may experience adverse consequences.
Management has expended substantial time and effort in negotiating the merger agreement with Frontier Financial Corporation and the related arrangements connected with the merger agreement. Moreover, the Company’s board of directors has agreed to certain arrangements intended to avert any unsolicited attempt to gain control of the Company during the pendency of the merger transaction, including certain breakup fees and expense reimbursements. Additionally, the merger reflects a substantial aspect of management’s strategic planning for the Company’s future. Were the merger not to be consummated, the Company would be forced to make substantial adjustments in its strategic plans, which would require additional management time and effort and which might not be successful. Therefore, if the merger is not consummated, the Company may experience adverse impacts on its strategic direction and its operating capabilities, and these impacts may be material. Finally, the termination or abandonment of the merger would likely have an adverse impact upon investors’ views as to the attractiveness of the Company’s common stock, which would likely result in a reduced market price for the Company’s common stock, and such reduction may be material.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
     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
     
2.1
  Agreement and Plan of Merger, dated as of September 26, 2007, between Frontier Financial Corporation and Washington Banking Company
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

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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
WASHINGTON BANKING COMPANY
             
Date: November 8, 2007
  By   /s/ Michal D. Cann    
 
           
 
      Michal D. Cann    
 
      President and Chief Executive Officer    
 
           
 
            
Date: November 8, 2007
  By   /s/ Richard A. Shields    
 
           
 
      Richard A. Shields Executive Vice President and    
 
      Chief Financial Officer    

23