UNITED STATES SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

(Mark One)

For the quarterly period ended September 30, 2004

For the transition period from                     to                    

Commission File Number 000-24503

WASHINGTON BANKING COMPANY

(360) 679-3121
(Issuer’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 issuer: (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 an accelerated filer within the meaning of 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 12, 2004 was 5,419,802.

Table of Contents

PART I

Item 1. Financial Statements

WASHINGTON BANKING COMPANY
AND SUBSIDIARIES

See accompanying notes to condensed consolidated financial statements.

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WASHINGTON BANKING COMPANY
AND SUBSIDIARIES

(Continued)

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WASHINGTON BANKING COMPANY
AND SUBSIDIARIES
Condensed Consolidated Statements of Income
Three and Nine months ended September 30, 2004 and 2003 (unaudited)
(Dollars in thousands, except per share data)

See accompanying notes to condensed consolidated financial statements.

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WASHINGTON BANKING COMPANY
AND SUBSIDIARIES

(1)

Comprehensive income for the three months ended September 30, 2004 and 2003 was $1,985 and $1,671, respectively.

(2)

Per share data adjusted to reflect the 15% stock dividend distributed February 26, 2004.

See accompanying notes to condensed consolidated financial statements.

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WASHINGTON BANKING COMPANY
AND SUBSIDIARIES

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WASHINGTON BANKING COMPANY
AND SUBSIDIARIES
Condensed Consolidated Statements of Cash Flows
Nine months ended September 30, 2004 and 2003 (unaudited)
(Dollars in thousands)

See accompanying notes to condensed consolidated financial statements.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

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

     (a) Description of Business

Washington Banking Company (“WBCO”) is a registered bank holding company formed on April 30, 1996. At September 30, 2004, WBCO had two wholly-owned subsidiaries – Whidbey Island Bank (“WIB” or the “Bank”), the Company’s principal subsidiary and Washington Banking Capital Trust I (the “Trust”). On May 26, 2004, WBCO announced plans to close its wholesale lending subsidiary, Washington Funding Group, Inc. (“WFG”) effective June 30, 2004. WFG was formed in January 2003 for the purpose of expanding the Bank’s wholesale mortgage real estate lending platform. During the second quarter of 2004, the Company decided to concentrate corporate resources toward the Bank’s retail operations and close WFG’s operations. Although the wholesale business enhanced the Company’s noninterest income during 2003, the operation of those offices did not provide a satisfactory financial return.

The business of the Bank, WBCO’s principal subsidiary, which is focused in the northern area of Western Washington, consists primarily of attracting deposits from the general public and originating loans. 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.

The Trust, a non-consolidated subsidiary of WBCO, was formed in June 2002 for the exclusive purpose of issuing trust preferred securities and common securities and using the $15,000 in proceeds from the issuance to acquire junior subordinated debentures issued by WBCO.

The Company’s website address is www.wibank.com. Exchange Act reports are available free of charge from the Company’s website. The reports can also be obtained through the Securities and Exchange Commission’s (the “SEC”) EDGAR database at http://www.sec.gov. The contents of the Company’s Internet website are not incorporated into this report or into any other communication delivered to security holders or furnished to the SEC.

     (b) Basis of Presentation

The accompanying interim condensed consolidated financial statements include the accounts of WBCO and two of its subsidiaries, WIB and WFG, (together, the “Company”). The accompanying interim condensed consolidated financial statements have been prepared, without audit, pursuant to the rules and regulations of the SEC. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. These condensed consolidated financial statements should be read in conjunction with the December 31, 2003 audited consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K filed with the SEC on March 24, 2004. 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, 2004 are not necessarily indicative of the results that may be expected for the year ending December 31, 2004. In preparing the 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) Segments

Pursuant to Statement of Financial Accounting Standards (“SFAS”) No. 131, Disclosure about Segments of an Enterprise and Related Information, the Company has evaluated the requirements of this standard and had identified two reportable segments: Whidbey Island Bank and the discontinued operations of Washington Funding Group, Inc., both wholly-owned subsidiaries of Washington Banking Company. Due to the discontinuation of WFG in the second quarter of 2004, the Company currently has only one segment, Whidbey Island Bank and is not required to disclose segment reporting by this standard.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Nine months ended September 30, 2004 and 2003 (unaudited)
(Dollars in thousands, except per share data)

     (d) Reclassifications

Certain amounts in prior year’s financial statements may have been reclassified to conform to the 2004 presentation. These reclassifications had no significant impact on the Company’s financial position or results of operations.

     (e) Recent Financial Accounting Pronouncements

In January 2003, the Financial Accounting Standards Board (“FASB”) issued Interpretation No. 46, Consolidation of Variable Interest Entities, which was replaced by FASB Interpretation No. 46R (“FIN 46R”) in December 2003. FIN 46R became effective in the first quarter of 2004 and defined a variable interest entity (“VIE”) as a corporation, partnership, trust, or any other legal structure used for the business purpose that either does not have equity investors with voting rights or has equity investors that do not provide sufficient financial resources for the entity to support its activities. This interpretation requires a VIE to be consolidated or deconsolidated by a company generally based on the risk of loss or return. Most of the original provisions of Interpretation No. 46 were delayed until March 31, 2004 through the issuance of FIN 46R. The Company has a VIE in the form of a trust set up to issue trust preferred securities and accordingly, the implementation of FIN 46R required the deconsolidation of the Trust. The Company’s adoption of FIN 46R did not have a material impact on the Company’s financial position and results of operations. The restatement of prior years financial statements was not required by FIN 46R and the Company did not restate the prior year’s financial statements.

(2) Earnings Per Share

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

On February 26, 2004, the Company issued a 15% stock dividend to shareholders of record as of February 10, 2004. On October 24, 2002, the Company issued a 10% stock dividend to shareholders of record as of October 8, 2002. All periods presented have been restated to reflect the stock dividends. At September 30, 2004 and 2003, there were options to purchase 360,962 and 419,507 shares of common stock outstanding, respectively. For the three and nine months ended September 30, 2004 and 2003 no shares were antidilutive and therefore all were included in the computation of diluted net income per share.

(3) Trust Preferred Securities

Washington Banking Capital Trust I (the “Trust”), a wholly-owned non-consolidated subsidiary of WBCO, is a statutory business trust created for the exclusive purposes of issuing and selling capital securities and utilizing sale proceeds to acquire junior subordinated debt issued to WBCO. On June 27, 2002, the Trust issued $15,000 of trust preferred securities with a 30-year maturity, callable after the fifth year by Washington Banking Company. The rate adjusts quarterly based on the Three-Month LIBOR plus 3.65%. These securities, within certain limitations, are considered Tier I capital for the purposes of regulatory capital requirements. Accordingly, the junior subordinated debentures are the sole assets of the Trust, and payments under the junior subordinated debentures will be the sole revenues of the Trust. All of the common securities of the Trust are owned by WBCO. Washington Banking Company has fully and unconditionally guaranteed the capital securities along with all obligations of the Trust under the trust agreements. Prior to FIN 46R, the Trust was a consolidated subsidiary of the Company. As a result of the adoption of FIN 46R, the Company deconsolidated the special purpose trust, as the Company is not considered to be the primary beneficiary under this accounting interpretation. Accordingly, on the Company’s Consolidated Statements of Financial Condition, the trust preferred securities that were issued by the Trust have been replaced by the junior subordinated debentures issued to the Trust by WBCO.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Nine months ended September 30, 2004 and 2003 (unaudited)
(Dollars in thousands, except per share data)

The following table sets forth the financial data pertaining to the previously consolidated special purpose trust:

(4) Stock-Based Compensation

The Company recognizes the financial effects of stock-based employee compensation based on the intrinsic value method of accounting prescribed by Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB 25”) and FASB Interpretation No. 44, Accounting for Certain Transactions Involving Stock Compensation (“FIN 44”). Generally, stock options are issued at a price equal to the fair value of the Company’s stock as of the grant date. Under APB 25, options issued in this manner do not result in the recognition of employee compensation in the Company’s financial statements. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value provisions of FASB SFAS 123, Accounting for Stock-Based Compensation.

The following table sets forth the reconciliation of pro forma net income and pro forma earnings per share:

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Nine months ended September 30, 2004 and 2003 (unaudited)
(Dollars in thousands, except per share data)

(5) Subsequent Event

On October 21, 2004, the Board of Directors declared a cash dividend of $0.0725 per share to shareholders of record as of November 8, 2004, which is payable on November 24, 2004.

(6) Commitments

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, 2004. 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, 2004.

As of September 30, 2004 the commitments under these agreements were as follows:

                   Standby letters of credit and financial guarantees $220

At September 30, 2004, the Company is 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 $15,000 at September 30, 2004.

(7) Closing of Subsidiary

The Company closed its Washington Funding Group, Inc. (“WFG”) subsidiary effective June 30, 2004. The subsidiary provided a loan funding source for mortgage loan brokers, primarily in Washington, Oregon and Idaho. Business in process was transferred to the Bank’s Burlington, WA office.

WFG was formed in January 2003 and began operations in April 2003 as a way to expand services and grow revenues. It provided a loan funding source for mortgage brokers. While gain on sale of loans enhanced noninterest income for the third quarter last year, WFG continued to have a negative impact on WBCO’s earnings in spite of efforts to improve WFG’s performance. Whidbey Island Bank will continue to offer retail mortgages and wholesale mortgage funding to brokers as it did before WFG was established.

(8) Investment Securities

Investment securities available for sale include securities that management intends to use as part of its overall asset/liability management strategy and that may be sold in response to changes in interest rates and resultant prepayment risk and other related factors. Securities available for sale are carried at market value, and unrealized gains and losses (net of related tax effects) are excluded from net income but are included as a separate component of comprehensive income. Upon realization, such gains and losses will be included in net income using the specific identification method. The Company transferred its held-to-maturity municipal security portfolio of $14,300 to available-for-sale investments in the second quarter of 2004. Available-for-sale investments are recorded at market value and this transfer caused an increase in accumulated other comprehensive income of $272.

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

Note Regarding Forward-Looking Statements: This 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, the following possibilities: (1) local and national general and economic conditions, including the possible impact of international conflict or further terrorist events, are less favorable than expected or have a more direct and pronounced effect than expected on the Company and adversely affect the Company’s ability to continue its internal growth at historical rates and maintain the quality of its earning assets; (2) changes in interest rates reduce interest margins more than expected or negatively affect liquidity; (3) projected business increases following strategic expansion or the opening or acquisition of new branches are lower than expected; (4) there are greater than expected costs or difficulties related to the integration of acquisitions; (5) there is increased competitive pressure among financial institutions; (6) legislation or regulatory requirements or changes that adversely affect the banking and financial services sector; and (7) the Company is unable to realize the efficiencies it expects to derive from its investment in personnel and infrastructure. However, you should be aware that these factors are not an exhaustive list, and you should not assume that these are the only factors that may cause actual results to differ from expectations. In addition, you should note that we do 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 (“WBCO” or the “Company”) is a registered bank holding company with two wholly-owned subsidiaries: Whidbey Island Bank (the “Bank” or “WIB”) and Washington Banking Capital Trust I (the “Trust”); and one discontinued subsidiary, Washington Funding Group, Inc. (“WFG”). The Company’s principal subsidiary, the Bank, is a Washington state-chartered bank that conducts a full-service community commercial banking business. Its business includes commercial, real estate and construction loan portfolios, and it is active in the consumer banking field, providing personal and consumer-oriented loan programs. The Bank also provides a wide range of deposit services, insured by the Federal Deposit Insurance Corporation (the “FDIC”), for individuals and businesses including checking and savings accounts as well as money market accounts, certificates of deposit, individual retirement accounts, safe deposit boxes and other consumer and business related financial services. The Bank also offers nondeposit managed investment products and services, which are not FDIC insured. These programs are provided through the investment advisory company Elliott Cove Capital Management LLC, DFC Services & DFC Insurance Services. Several Whidbey Island Bank employees have been registered in Washington State as investment advisor representatives. These employees work with individuals, companies and institutions to help them determine their risk preferences in selecting investment portfolios or insurance products. Another nondeposit product offered through the Bank, which is not FDIC insured, is a sweep investment option available through a brokerage account. Prior to the Bank’s affiliation with Elliott Cove, non-FDIC insured investment products were offered through the Bank’s wholly-owned subsidiary, WIB Financial Services, Inc. The Bank’s subsidiary was dissolved in 2004.

The Bank’s primary market area is located in northwestern Washington State between Seattle and the Canadian border. Its geographical expansion to date has been concentrated along the I-5 corridor from Snohomish to Whatcom counties, however, additional areas will be considered if they meet the Company’s criteria.

The Trust, a non-consolidated subsidiary, was formed in June 2002 for the exclusive purpose of issuing trust preferred securities to acquire junior subordinated debentures issued by the Company. Those debentures are the sole

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assets of the Trust and payments on the debt will be the sole revenues of the Trust. The Company has fully and unconditionally guaranteed all obligations of the Trust.

WFG, a wholesale mortgage real estate lending company, was a Washington State corporation formed in January 2003. The primary purpose of this subsidiary was to provide a loan funding source for brokers of mortgage loans. The loans were originated and sold in the name of the Bank. During the second quarter of 2004, the Company decided to concentrate corporate resources toward the Bank’s retail operations and close WFG’s wholesale lending operations. Although the wholesale business enhanced the Company’s noninterest income during 2003, the operation of those offices did not provide a satisfactory financial return.

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. Unemployment levels in the Pacific Northwest over the past few years have been higher than national averages, but the region appears to be showing signs of a slow, but steady economic recovery.

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 enhancing 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. Acquisition of banks or branches may also be used as a means of expansion if appropriate opportunities are presented. Management recognizes that growth requires expenditures of substantial sums to purchase or lease real property and equipment and to hire experienced personnel, and that earnings may be negatively affected. The Company’s primary long-term objectives are to improve profitability and operating efficiencies, to increase market penetration in areas currently served and to continue an expansion strategy in appropriate market areas.

Financial Condition

Total Assets. Total assets grew to $663.0 million at September 30, 2004 from $581.7 million at December 31, 2003, an increase of 14.0%. This increase resulted mainly from growth in the loan portfolio and the investment in bank owned life insurance (“BOLI”), which was funded by deposit growth and the sale of investment securities.

Total Loans. Total loans were $557.7 million at September 30, 2004, an increase of 9.8% from $508.2 million at December 31, 2003. During the quarter, the Company sold $10.0 million of indirect consumer loans. The Company increased its allowance for loan losses to $7.5 million at September 30, 2004 representing 1.36% of loans (excluding loans held for sale), from $6.1 million or 1.22% of loans (excluding loans held for sale) at December 31, 2003. The allowance was increased to keep pace with loan growth and prospective losses inherent in the loan portfolio, while remaining conservative and maintaining adequate coverage.

Total Investment Securities. Total investment securities were $19.1 million and $30.2 million at September 30, 2004 and December 31, 2003, respectively. The decrease of 36.8% was a result of the sale and maturity of investment securities that were not replaced due to the low rate environment coupled with an anticipated increase in loan demand and purchase of a BOLI investment.

Premises and Equipment. Premises and equipment, net of depreciation, were $20.6 million at September 30, 2004 and $19.8 million at December 31, 2003. The Company purchased a building located in Oak Harbor, WA for the purpose of consolidating its back room operating functions. This consolidation has resulted in two surplus commercial properties available for sale. The carrying value of the combined properties is approximately $873,000, and the Company anticipates a nominal gain following the sale of the properties.

The Company has continued its expansion strategy by opening a new grocery store branch in Arlington, WA; leasing space for a future branch site in Friday Harbor, WA; and leasing additional office space in Bellingham, WA.

Other Assets. During the second quarter of 2004, the Bank made a $10.0 million investment in bank owned life insurance (“BOLI”). These policies insure the lives of officers of the Bank, and name the Bank as beneficiary.

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Noninterest income is generated tax-free from the increase in the policies’ underlying investments made by the insurance company. WIB is capitalizing on the ability to partially offset costs associated with employee compensation and benefit programs with the BOLI.

Deposits. Deposits grew 17.4% to $589.0 million at September 30, 2004 from $501.5 million at December 31, 2003. Management’s philosophy is to develop long-term customer relationships. Management believes that the best way to establish customer loyalty is by placing an emphasis on meeting customers’ financial needs and providing exceptional service. Management attributes the Company’s successful deposit growth to its on-going cross-sales efforts, periodic deposit promotions, strategic planning and other means. In addition, many customers continue to seek the security of FDIC-insured deposit vehicles in contrast to the potential volatility of the investment market.

For the quarter ended September 30, 2004, average noninterest-bearing deposits decreased 1.7% from the third quarter 2003, while average interest-bearing deposits increased 13.5% for the same period. Average interest demand and money market deposits represented 45.89% of total average interest-bearing deposits at September 30, 2004 compared to 46.58% a year ago.

Average savings deposits and average CDs represented 10.36% and 43.76%, respectively, of total average interest-bearing deposits at September 30, 2004 compared to 8.86% and 44.56%, respectively, a year ago. All interest- bearing deposit product averages increased during the third quarter of 2004 as management focused on establishing customer relationships and attracting deposits.

Shareholders’ Equity. The Company’s shareholders’ equity increased 7.9% to $47.9 million at September 30, 2004 from $44.4 million at December 31, 2003. The increase reflects earnings, proceeds from stock options exercised, stock option compensation and an increase in unrealized gain on available-for-sale securities, net of tax, offset by the payment of cash dividends during the first nine months of 2004.

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Consolidated Average Balance Sheet and Analysis of Net Interest Income and Expense

The following table sets forth the Company’s consolidated average balance sheet and analysis of net interest income and expense:

(1)		Annualized
(2)		Includes loan fees of $400 and $406 for the three months ended September 30, 2004 and 2003, respectively.
(3)		Interest income on non-taxable investments is presented on a fully taxable-equivalent basis using the federal statutory rate of 34%.
		These adjustments were $31 and $57 for the three months ended September 30, 2004 and 2003, respectively.

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Results of Operations

The Company’s results of operations are dependent to a large degree on net interest income. Interest income and cost of funds are affected significantly by general economic conditions, particularly changes in market interest rates, and by government policies and the actions of regulatory authorities. The Company generates noninterest income generally through service charges and fees, gain on sale of loans and other sources. The Company’s noninterest expenses consist primarily of compensation and employee benefit expense, and occupancy expense.

Net Income. Net income for the third quarter of 2004 increased 6.1% to $1.9 million or $0.33 per diluted share as compared to $1.8 million, or $0.31 per diluted share for the third quarter of 2003. During the third quarter of 2004, the increased loan volumes and the rising rate environment contributed to the Company’s increased net interest margin as compared to the second quarter of 2004. Net income for the nine months ended September 30, 2004 decreased 4.9% to $4.2 million, or $0.75 per diluted share, from $4.4 million, or $0.80 per diluted share, for the nine months ended September 30, 2003. The decrease was due largely to the increase in noninterest expense, the reduction in gain on sale of loans, and the operating losses and costs associated with closing the Washington Funding Group, Inc. subsidiary.

Income from continuing operations for the third quarter of 2004 increased 11.5% to $1.9 million from $1.7 million for the third quarter of 2003. The rising interest rate environment coupled with the income received from service charges contributed to the overall increase in net income.

Income from continuing operations for the nine months ended September 30, 2004 increased 3.7% to $4.6 million, from $4.4 million for the like period one year ago. The Company’s loss from discontinued operations, net of tax, for the nine month period in 2004 was ($370,000) from income of $5,000 for the like period one year earlier.

Net Interest Income. Net interest income for the third quarter of 2004 increased 7.3% to $7.8 million from $7.2 million for the third quarter of 2003. For the first nine months of 2004, net interest income increased 7.3% to $22.2 million from $20.7 million for the like period in 2003. The increase is largely due to interest income from higher loan rates and increased average loan volumes, combined with a decrease in the cost of funds.

Average interest-earning assets for the third quarter increased to $589.3 million at September 30, 2004, compared to $547.1 million at September 30, 2003, a growth of 7.7%, while the average yield on interest-earning assets decreased to 6.82% compared to 6.89% in third quarter of the prior year. The average yield on loans decreased to 7.02% for the quarter ended September 30, 2004 from 7.33% for the third quarter of 2003.

The average cost of interest-bearing liabilities decreased in the third quarter of 2004 to 1.77% from 1.86% for the quarter ended September 30, 2003. Average interest-bearing liabilities for the quarter increased to $510.5 million at September 30, 2004 compared to $457.6 million a year ago, a growth of 11.6%.

The overall result of these changes was an increase in the net interest spread to 5.05% for the quarter ended September 30, 2004 from 5.03% for the quarter ended September 30, 2003. Net interest margin (net interest income divided by average interest-earning assets) decreased to 5.29% in the third quarter of 2004 from 5.33% in the third quarter of 2003.

Noninterest Income. Noninterest income increased $85,000, or 5.9%, in the third quarter of 2004 compared to the like period in 2003. For the first nine months of 2004, noninterest income increased $382,000, or 9.5% compared to the like period in 2003. This increase was primarily due to an increase in service charges and fees on deposits in association with the Bank’s new overdraft product, Whidbey Overdraft Coverage and a gain on sale of securities offset by a decrease in gain on sale of loans.

In the past, selling single-family residential loans to the secondary market contributed significantly to the noninterest income, but slowing of mortgage activity caused a decrease in income from the gain on sale of loans.

Noninterest Expense. Noninterest expense increased $486,000 in the third quarter of 2004, or 9.2% from a year ago. Four major components of noninterest expense — employee compensation, occupancy, consulting and

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professional fees and other noninterest expense — increased 9.5%, 3.4%, 37.3% and 8.0%, respectively, for the quarter compared with the like period in 2003.

For the first nine months of 2004, noninterest expense rose to $17.4 million from $15.5 million one year ago, a 12.2% increase. Employee compensation, occupancy, consulting and professional fees and other noninterest expense increased 12.7%, 10.7%, 42.5% and 9.6%, respectively, compared with the like period in 2003.

The Company experienced a cost increase in employee benefits. Additionally, increased costs associated with insurance, operating fees and advertising have contributed to other noninterest expense, primarily as a result of the expansion of the Company. With the purchase of an office building in Oak Harbor, WA the Company expects to improve operating efficiencies by consolidating back office operations into one building.

The efficiency ratio (noninterest expense divided by the sum of net interest income plus noninterest income) was 62.35% for the third quarter 2004 compared to 61.14% for the like period in 2003. For the first nine months of 2004 and 2003, the efficiency ratio was 65.49% and 62.85%, respectively.

Income Taxes. For the third quarters of 2004 and 2003, the Company recorded an income tax provision of $915,000 and $869,000, respectively. The Company recorded an income tax provision of $2.3 million for the first nine months of 2004 and for the 2003 nine-month period. The overall effective tax rate was approximately 33% and 34% for the three months ended September 30, 2004 and 2003, respectively. For the nine months ended September 30, 2004 and 2003, the overall effective tax rate was approximately 33% and 35%, respectively.

Lending Activities

Loan Portfolio Composition. The Company originates a wide variety of loans including commercial, real estate and consumer loans. The following table sets forth the Company’s loan portfolio composition by type of loan:

Total loans, net, were $550.2 million at September 30, 2004, representing a 9.6% increase from year-end 2003. The majority of the increase was in real estate mortgage and real estate construction loans, which increased 18.5% and 32.6%, respectively, at September 30, 2004 from year-end 2003. Included in real estate mortgages are loans originated and held for sale on the secondary market. At September 30, 2004, loans held for sale were $5.6 million as compared to $8.3 million at December 31, 2003, a decrease of 32.2%. The Company sold $10.0 million of indirect consumer loans during September 2004, which were included in Loans Held for Sale at June 30, 2004. The Company earned a net gain of $84,000 from the sale of those loans. Due to the liability sensitivity of our balance sheet, the Company opted to sell these fixed rate loans without recourse to increase liquidity for core lending activity. Of the remaining loans held for sale, all $5.6 million were originated by the Bank’s retail real estate division, compared to $3.8 million originated by WFG and $4.5 million originated from the Bank’s retail real estate division at December 31, 2003. The majority of the increase in real estate construction loans was due to residential construction, residential land development projects and a few large commercial construction loans.

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The Company makes automobile and recreational vehicle loans for new and used vehicles originated indirectly by selected automobile dealers located in the Company’s market areas. Indirect loans were $98.0 million, or 57.06% of the consumer loan portfolio and 17.57% of the total loan portfolio at September 30, 2004. At December 31, 2003, indirect loans were $105.6 million, or 61.27% of the consumer loan portfolio and 20.79% of the total loan portfolio.

Nonperforming Assets. The following table sets forth an analysis of the composition of the Company’s nonperforming assets:

⁽¹⁾ Excludes loans held for sale

Nonperforming loans decreased to $3.2 million, or 0.58% of loans (excluding loans held for sale), at September 30, 2004 from $4.2 million, or 0.83% of loans (excluding loans held for sale), at December 31, 2003. The current allowance for loan losses of $7.5 million represents 234.78% of nonperforming loans as compared to 147.09% of nonperforming loans at December 31, 2003. The allowance for loan losses is 1.36% of loans (excluding loans held for sale) at September 30, 2004 as compared to 1.22% at December 31, 2003. Impaired loans were $191,000 at the end of the quarter. A loan in the amount of $2.6 million listed as impaired at December 2003 was removed from impaired status during the 2004 second quarter. The loan balance was significantly reduced and the credit is performing.

Provision and Allowance for Loan Losses. The Company recorded a $725,000 provision for loan losses for the third quarter of 2004, compared to $838,000 for the like period a year ago. Net loan charge-offs were $145,000 for the third quarter of 2004, compared with $443,000 for the like period last year.

The Company recorded $2.3 million and $2.4 million provisions for loan losses for the nine months ended September 30, 2004 and 2003, respectively. The Company recorded $935,000 in net loan charge-offs, representing 0.18% of average loans (excluding loans held for sale) during the first nine months of 2004, compared to $1.6 million or 0.36% for the like period in 2003.

Indirect loans may involve greater risk than other consumer loans, including direct automobile loans, due to the nature of third-party transactions. To mitigate these risks, the Company limits its indirect dealer loan purchases primarily to dealerships that are established and well known in their market areas and to applicants that are not classified as sub-prime. In addition, the Company has increased its oversight of the approval process and uses a loan grading system, which limits the risks inherent in dealer originated loans.

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The following table sets forth an analysis of the Company’s indirect and other net charge-offs to average loans:

(1)		Excludes loans held for sale
(2)		Net charge-offs are annualized

Net loan charge-offs attributed to indirect loans were $140,000, representing 83.33% of net consumer charge-offs during the third quarter of 2004, compared to $234,000 or 80.69% of net consumer charge-offs for the like period in 2003. For the nine months ended September 30, 2004, net charge-offs attributed to indirect dealer loans were $675,000, or 75.25% of net consumer charge-offs, as compared with $682,000, or 78.66%, for the like period in 2003.

The allowance for loan losses is maintained at a level considered adequate by management to provide for anticipated loan losses based on management’s assessment of various factors affecting the loan portfolio. This includes a review of problem loans, general business and economic conditions, seasoning of the loan portfolio, bank regulatory examination results and findings of internal credit examiners, loss experience and an overall evaluation of the quality of the underlying collateral. Management reviews the allowance quarterly. The allowance is increased by provisions charged to operations and reduced by loans charged off, net of recoveries.

The following table sets forth the changes in the Company’s allowance for loan losses. The provision is based on an evaluation of defined loan problems, historical ratios of loan losses and other factors that may affect future loan losses in the categories of loans shown:

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While management 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. Management anticipates that normal growth of the loan portfolio may require continued increases in the allowance for loan losses.

Deposits

The Company provides an array of deposit services, including noninterest-bearing checking accounts, interest-bearing checking and savings accounts, money market accounts and certificates of deposit (“CDs”). These accounts generally earn interest at rates established by management based on competitive market factors and management’s desire to increase or decrease certain types or maturities of deposits. The Company does not pay brokerage commissions to attract deposits. It strives to establish customer relationships to attract core deposits in noninterest-bearing transactional accounts and thus reduce its costs of funds.

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The following table sets forth the average balances outstanding and average interest rates for each major category of deposits:

Average balances in noninterest-bearing deposits decreased slightly by 1.7% in the third quarter of 2004 compared to the third quarter of 2003. For the same period, average balances in total interest-bearing deposits increased 13.5%, while the average rate decreased.

Liquidity and Sources of Funds

Sources of Funds. 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. These funds are used for loan originations and deposit withdrawals, to satisfy other financial commitments and to support continuing operations. The Company relies primarily upon customer deposits and investments to provide liquidity. The Company will mainly use such funds to make loans and to purchase securities, the majority of which are issued by federal, state and local governments. Additional funds are available through established Federal Home Loan Bank (“FHLB”) and correspondent bank lines of credit, which the Company may use to supplement funding sources.

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 evaluated potential capital-raising alternatives such as trust preferred securities, issuance of common stock and other sources. Management determined that issuing trust preferred securities would be in the best interest of the Company and on June 27, 2002, the Trust issued $15.0 million of trust preferred securities. Trust preferred securities are held as debt for tax purposes, while the proceeds of the offering count as Tier I capital without increasing the shareholder base, and therefore not diluting earnings per share. Due to FIN 46R, the Trust was deconsolidated in current period financial statements.

Deposits. Total deposits increased 17.4% to $589.0 million at September 30, 2004 from $501.5 million at December 31, 2003. Certificates of deposit are the only deposit group that has stated maturity dates. At September 30, 2004, the Company had $214.5 million in CDs, of which approximately $131.1 million, or 61.11%, are scheduled to mature within one year. Management anticipates that a sizable portion of outstanding CDs will renew upon maturity.

The Company has not accepted brokered deposits. It has made a concerted effort to attract deposits in the market area it serves through competitive pricing and delivery of quality service. Historically, the Company has been able to retain a considerable amount of its deposits as they mature.

Borrowings. At September 30, 2004 the Company had a line of credit with the FHLB of $99.2 million, of which $7.5 million was advanced in short-term borrowings. The Company also had unused lines of credit with correspondent banks in the amount of $27.0 million at September 30, 2004.

Investments. The Company’s total portfolio of investment securities decreased 36.8% to $19.1 million at September 30, 2004 from $30.2 million at December 31, 2003. The Company transferred its held-to-maturity municipal security portfolio of $14.3 million to available-for-sale investments in the second quarter of 2004.

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Available-for-sale investments are recorded at market value and this transfer caused an increase in accumulated other comprehensive income of $272,000. During the second quarter of 2004, $5.8 million of municipal security investments were sold to help reposition the Company’s liability sensitive balance sheet against the anticipation of a rising rate environment. The investment portfolio consists of government agency securities, pass-through securities, corporate securities, municipal securities and preferred stock. No investment exceeds 10% of the shareholders’ equity.

The following table summarizes the amortized cost and market value of securities in the Company’s portfolio by contractual maturity groups: