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U.S. SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

[  ]   Transition report pursuant to section 13 or 15(d) of the Securities and Exchange act of 1934
                  For the transition period from                                 to                                  

Commission file number 0-23881

COWLITZ BANCORPORATION
(Exact name of registrant as specified in its charter)

927 Commerce Ave., Longview, Washington 98632
(Address of principal executive offices) (Zip Code)

(360) 423-9800
(Registrant's telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the 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 whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act)
Yes[ ] No [X]

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.

Common Stock, no par value on April 30, 2005: 4,174,552 shares

1

Forward-Looking Statements

Management’s discussion and the information in this document and the accompanying financial statements contain forward-looking statements, within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements, which are based on certain assumptions and describe future plans, strategies and expectations of the Company, are generally identifiable by words such as "expect", "believe", "intend", "anticipate", "estimate" or similar expressions, and are subject to risks and uncertainties that could cause actual results to differ materially from those stated. Examples of such risks and uncertainties that could have a material adverse effect on the operations and future prospects of the Company, and could render actual results different from those expressed in the forward-looking statements, include, without limitation: changes in general economic conditions, competition for financial services in the market area of the Company, the level of demand for loans, quality of the loan and investment portfolio, deposit flows, legislative and regulatory initiatives, whether the Company can successfully complete the merger with AEA Bancshares, and monetary and fiscal policies of the U.S. Government affecting interest rates. The reader is advised that this list of risks is not exhaustive and should not be construed as any prediction by the Company as to which risks would cause actual results to differ materially from those indicated by the forward-looking statements. Readers are cautioned not to place undue reliance on these forward-looking statements.

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Part I. FINANCIAL INFORMATION

Item 1. Financial Statements 

COWLITZ BANCORPORATION AND SUBSIDIARY 
CONSOLIDATED STATEMENTS OF CONDITION
(dollars in thousands) 

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COWLITZ BANCORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS'
EQUITY AND COMPREHENSIVE INCOME
(dollars in thousands)

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     COWLITZ BANCORPORATION AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(amounts in thousands, except number of shares and per share amounts)

1. Nature of Operations

Cowlitz Bancorporation (the "Company") was organized in 1991 under Washington law to become the holding company for Cowlitz Bank (the "Bank"), a Washington state chartered bank that commenced operations in 1978. The principal executive offices of the Company are located in Longview, Washington. Cowlitz Bank operates four branches in Cowlitz County in southwest Washington. Outside of Cowlitz County, the Bank does business under the name Bay Bank with branches in Bellevue, Washington, and Portland, Oregon, a loan production office in Vancouver, Washington, and a limited service branch in a retirement center in Wilsonville, Oregon. Cowlitz Bank also provides mortgage banking services through its Bay Mortgage division with offices in Longview, Castle Rock, Kalama, and Vancouver, Washington. During much of 2003, the Company also operated Bay Mortgage and Bay Escrow offices in Bellevue and Seattle, Washington. As part of a strategy to consolidate resources into commercial banking, and reduce reliance on mortgage lending activities, those offices were closed during the fourth quarter of 2003 and the first quarter of 2004.

The Bank offers or makes available a broad range of financial services to its customers, primarily small and medium-sized businesses, professionals, and retail customers. The Bank's commercial and personal banking services include commercial and real estate lending, consumer lending, and trust services. The Bank's goals are to offer exceptional customer service and to invest in the markets it serves through its business practices and community service.

2. Principles of Consolidation

The accompanying consolidated financial statements include the accounts of the Company and its subsidiary. All significant intercompany transactions and balances have been eliminated.

The interim financial statements have been prepared without an audit and in accordance with the instructions to Form 10-Q, generally accepted accounting principals, and banking industry practices. Accordingly, they do not include all the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments, including normal recurring accruals necessary for a fair presentation of results of operations for the interim periods included herein have been made. The results of operations for the three months ended March 31, 2005 are not necessarily indicative of results to be anticipated for the year ending December 31, 2005.

3. Cash and Cash Equivalents

For the purpose of presentation in the statements of cash flows, cash and cash equivalents include cash on hand, amounts due from banks including certificates of deposit, and federal funds sold. Federal funds sold generally mature the day following purchase.

4. Use of Estimates in the Preparation of Financial Statements

Preparation of the consolidated financial statements, in conformity with accounting principles generally accepted in the United States of America, requires management to make certain estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and reported amounts of revenues and expenses during the reporting period. Significant estimates include the allowance for loan losses and the carrying value of the Company's goodwill. Actual results could differ from those estimates.

5. Earnings Per Share

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

Options to purchase 150,000 shares of common stock with exercise price of $12.00 were outstanding at March 31, 2005, but were not included in the computation of diluted earnings per share because the options' exercise price was greater than the average market price of the common shares for the three month period ended March 31, 2005. These options expire in 2010.

Options to purchase 239,966 shares of common stock with exercise prices ranging from $10.99 to $12.00, with an average price of $11.66, were outstanding at March 31, 2004 but were not included in the computation of diluted earnings per share because the options' exercise price was greater than the average market price of the common shares for the three month period ended March 31, 2004. These options expire from 2009-2014.

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     COWLITZ BANCORPORATION AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(amounts in thousands, except number of shares and per share amounts)

6. Subsequent Events

AEA Bancshares Inc., Merger

On May 4, 2005, Cowlitz Bancorporation, parent company of Cowlitz Bank announced the signing of a definitive agreement for the merger of AEA Bancshares, Inc. parent company of Asia-Europe-Americas Bank, into Cowlitz Bancorporation in a stock transaction. Simultaneously, Asia-Europe-Americas Bank will merge into Cowlitz Bank. The all stock transaction is valued between approximately $5.8 million and $6.9 million, depending on the outcome of certain matters prior to closing.

Trust Preferred Securities

On April 29, 2005, Cowlitz Bancorporation completed the issuance of $12 million in trust preferred securities. Under the terms of the pooled transaction, the securities have a maturity of 30 years and are redeemable without penalty after five years. The securities bear a floating rate of 1.75% above the three-month Libor rate. Of the $12 million raised, $8 million was distributed to Cowlitz Bank to maintain capital levels and support future growth.

7. Recently Issued Accounting Standards

In December 2004, the FASB issued Statement No. 123(R), “Share-Based Payment.” This statement replaces existing requirements under SFAS No. 123, “Accounting for Stock-Based Compensation,” and eliminates the ability to account for share-based compensation transactions under APB Opinion No. 25, “Accounting for Stock Issued to Employees.” SFAS No. 123(R) requires stock-based transactions to be recognized as compensation expense in the income statement based on their fair values at the date of grant. The fair value should be estimated using option-pricing models such as the Black-Scholes model or a binomial model. This statement is effective for annual periods beginning after December 15, 2005. At this time, the Company does not believe the future impact on earnings to be a great extent different than what has historically been reported as the pro forma effect to income in Note 8. The impact to operating and financing cash flows is not considered to be material to the consolidated financial statements.

In March 2004, the Financial Accounting Standards Board (FASB) ratified the consensuses reached by the Emerging Issues Task Force (EITF) regarding Issue 03-1, “The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments.” Issue 03-1 provides guidance on recognition and measurement of other-than-temporary impairment and its application to certain investments, including all debt securities and equity securities that are subject to the scope of SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities.”

On September 30, 2004, FASB issued a proposed Board-directed Staff Position, FSP EITF Issue 03-1-a, Implementation Guidance for the Application of Paragraph 16 of EITF Issue 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” The proposed FSP will provide implementation guidance with respect to debt securities that are impaired solely due to interest rates and/or sector spreads and analyzed for other-than-temporary impairment under paragraph 16 of Issue 03-1. The Board has delayed the effective date to provide further implementation guidance. This delay does not suspend the requirement to recognize other-than-temporary impairments as required by existing authoritative literature. The delay of the effective date for paragraphs 10 through 20 of Issue 03-1 will be superceded concurrent with the final issuance of FSB EITF Issue 03-1-a. The Company does not anticipate adoption of this Staff Position will have a material effect on its financial condition or results of operations.

In December 2003, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants issued Statement of Position 03-3 (SOP 03-3), “Accounting for Certain Loans or Debt Securities Acquired in a Transfer,” which addresses the accounting for certain loans acquired in a transfer when it is probable, at acquisition, that the investor will be unable to collect all contractually required payments receivable. SOP 03-3 is to be applied prospectively, effective for loans acquired in years beginning after December 15, 2004. SOP 03-3 requires acquired loans with evidence of credit deterioration to be recorded at fair value and prohibits recording any valuation allowance related to such loans at the time of purchase. This SOP limits the yield that may be accreted on such loans to the excess of the investor’s estimated cash flows over its initial investment in the loan. The excess of contractual cash flows over cash flows expected to be collected is not to be recognized as an adjustment of yield. Subsequent increases in cash flows expected to be collected are recognized prospectively through adjustment of the loan’s yield over its remaining life. Decreases in cash flows expected to be collected are recognized as impairment. Loans carried at fair value, mortgage loans held-for-sale, and loans to borrowers in good standing under revolving credit agreements are excluded from the scope of SOP 03-3. The Company does not anticipate adoption of this Statement of Position will have a material effect on its financial condition or results of operations.

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     COWLITZ BANCORPORATION AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(amounts in thousands, except number of shares and per share amounts)

8. Stock-Based Compensation

SFAS No. 123, “Accounting for Stock-Based Compensation,” requires disclosure about stock-based compensation arrangements regardless of the method used to account for them. As permitted by SFAS No. 123, the Company has decided to apply the accounting provisions of Accounting Principles Board (APB) Opinion No. 25, and therefore discloses the difference between compensation cost included in net income and the related cost measured by the fair value-based method defined by SFAS No. 123, including tax effects, that would have been recognized in the statement of income if the fair value method had been used. Under APB Opinion No. 25, no compensation cost has been recognized for the Company’s stock option plans. Had compensation cost for these plans been determined consistent with SFAS No. 123 and recognized over the vesting period, the Company’s net income and earnings per share would have been reduced to the following pro forma amounts:

The fair value of each option granted is estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions used for the periods ended March 31, 2005 and 2004.

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     COWLITZ BANCORPORATION AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(amounts in thousands, except number of shares and per share amounts)

9. Comprehensive Income

For the Company, comprehensive income primarily includes net income reported on the statements of income and changes in the fair value of available-for-sale investment securities. These amounts are included in “Other Comprehensive Income” on the consolidated statement of changes in shareholders’ equity.

The Company is principally engaged in community banking activities through its branches and corporate offices. Community banking activities include accepting deposits, providing loans and lines of credit to local individuals, businesses and governmental entities, investing in investment securities and money market instruments, and holding or managing assets in a fiduciary agency capacity on behalf of its customers and their beneficiaries. The mortgage banking segment, Bay Mortgage, offers a full line of residential lending products including FHA and VA loans, construction loans, and bridge loans.

The community banking and mortgage banking activities are monitored and reported by Company management as separate operating segments. Despite the closure of Bay Escrow and the Bellevue and Seattle offices of Bay Mortgage during the fourth quarter of 2003, mortgage lending activities in the remaining locations will continue to be reported as a separate operating segment.

The accounting policies for the Company's segment information provided in the following tables are the same as those described for the Company in the summary of significant accounting policies footnote included in the Company's 2004 annual report, except that some operating expenses and the results of discontinued operations are not allocated to segments.

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     COWLITZ BANCORPORATION AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(amounts in thousands, except number of shares and per share amounts)

Summarized financial information for the three months ended March 31, 2005 and 2004, concerning the Company's reportable segments is shown in the following tables:

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Compared to segment information reported during the three months ended March 31, 2005, the mortgage banking segment experienced significantly lower activity during the corresponding periods of 2004. In December 2003 and the first quarter of 2004, the Company reduced the size of its mortgage banking operations by closing its Bay Mortgage offices in Bellevue and Seattle. Reduced demand for mortgage refinance loans and a desire to concentrate resources on the core banking segment were significant factors leading to the decision to scale back the mortgage banking segment.

The banking segment did not record a provision for loan losses for the period ending March 31, 2005. During the three months ended March 31, 2004, the banking segment recorded a provision of $150,000, which was offset by the holding company recovery of $163,000. The recovery was a result of previously charged-off loans in a segment that no longer carried a loan portfolio.

Although mortgage operations have been significantly reduced, and have generated small losses, improved efficiencies and an increase in net interest income in the banking segment more than offset the losses. The banking segment reported net income of approximately $718,000 during the first three months of 2005, compared to $560,000 during the same period of 2004, an increase of $158,000.

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Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Results of Operations for the Three Months Ended March 31, 2005 and 2004

The Company’s net income for the first quarter of 2005 was $642,000 or $0.15 per diluted share, compared to net income of $397,000, or $0.10 per diluted share for the first quarter of 2004. Net income was $245,000 or 62% higher during the three months ended March 31, 2005 compared to the same period of 2004.

Net interest income increased $295,000 in the first quarter of 2005, compared to the same period in 2004. Average earning assets increased $25 million from $234,1 million in the first quarter of 2004 to $259.2 million for the period ending March 31, 2005. Average interest bearing liabilities increased $19.9 million from $169.5 million to $189.5 million during the same period.

The banking segment did not record a provision for loan losses for the period ending March 31, 2005. During the three months ended March 31, 2004, the banking segment recorded a provision of $150,000, which was offset by the holding company recovery of $163,000. The recovery was a result of previously charged-off loans in a segment that no longer carried a loan portfolio.

Financial Condition as of March 31, 2005 and December 31, 2004

At March 31, 2005, total assets were $286.7 million an increase of $13.4 million or 4.9% from December 31, 2004. Liabilities increased to $250.9 as of March 31, 2005 from $237.6 as of December 31, 2004.

The primary increase in assets is reflected in loans with an increase of $8.3 million from December 2004 to March 2005. Cash and cash equivalents increased $7.3 million from December 2004 to March 2005. Total deposits increased $13.2 million of which $7.8 million were in savings and interest-bearing demand deposits.

Critical Accounting Policies

The Company’s most critical accounting policy is related to the allowance for loan losses. The Company utilizes both quantitative and qualitative considerations in establishing an allowance for loan losses believed to be appropriate as of each reporting date.

Quantitative factors include:

• the volume and severity of non-performing loans and adversely classified credits,
• the level of net charge-offs experienced on previously classified loans,
• the nature and value of collateral securing the loans,
• the trend in loan growth and the percentage of change,
• the level of geographic and/or industry concentration,
• the relationship and trend over the past several years of recoveries in relation to charge-offs, and
• other known factors regarding specific loans.

Qualitative factors include

• the effectiveness of credit administration,
• the adequacy of loan review,
• the adequacy of loan operations personnel and processes,
• the effect of competitive issues that impact loan underwriting and structure,
• the impact of economic conditions, and
• the introduction of new loan products or specific marketing efforts.

Changes in the above factors could significantly affect the determination of the adequacy of the allowance for loan losses. Management performs a full analysis, no less often than quarterly, to ensure that changes in estimated loan loss levels are adjusted on a timely basis. For further discussion of this significant management estimate, see “Allowance for Loan Losses.” Another critical accounting policy for the Company is that related to the carrying value of goodwill. Goodwill was recognized as the excess of cost over the fair value of net assets acquired from the purchase of Bay Mortgage, and the Portland, Oregon branch of Bay Bank, formerly Northern Bank of Commerce. Goodwill was amortized using the straight-line method over a 15-year period until December 31, 2001. Effective January 1, 2002, pursuant to Statement of Financial Accounting Standards (SFAS) No. 142, “Goodwill and Other Intangible Assets,” the Bank ceased amortization of goodwill and completed its first of ongoing assessments of goodwill impairment in March 2002. The $852,000 current balance of goodwill is related entirely to the Northern Bank of Commerce purchase. Goodwill impairment will be deemed to exist in the future if the net book value of a reporting unit, considered by the Bank to represent its operating segments, exceeds its estimated fair value.

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Analysis of Net Interest Income

The primary component of the Company’s earnings is net interest income. Net interest income is the difference between interest income, principally from loans and the investment securities portfolio, and interest expense, principally on customer deposits and borrowings. Changes in net interest income, net interest spread, and net interest margin result from changes in asset and liability volume, mix, and changes to rates earned or paid. Net interest spread refers to the difference between the yield on interest-earning assets and the cost of interest-bearing liabilities. Net interest margin is the ratio of net interest income to total interest-earning assets and is influenced by the volume and relative mix of interest-earning assets and interest-bearing liabilities. Volume refers to the dollar level of interest-earning assets and interest-bearing liabilities.

Three months ended March 31, 2005 and 2004

Interest income from certain of the Company’s earning assets is non-taxable. The following tables present interest income and expense, including adjustments for non-taxable interest income, and the resulting tax adjusted yields earned, rates paid, interest rate spread, and net interest margin for the periods indicated.

Comparing the quarter ended March 31, 2005 to the quarter ended March 31, 2004, tax equivalent interest income was $492,000 higher, due to an increase of $25 million in average interest-earning assets. Interest expense increased $197,000 as average interest-bearing liabilities increased $19.9 million. With increasing rates on both interest-earning assets and liabilities, the interest margin remained at 4.96% for both periods.

Prime rate has increased 50 basis points from 5.25% at December 2004 to 5.75% for the period ending March 31, 2005.

Provision for Loan Losses

The amount of the allowance for loan losses is analyzed by management on a regular basis to ensure that it is adequate to absorb losses inherent in the loan portfolio as of the reporting date. When a provision for loan losses is recorded, the amount is based on past charge-off experience, a careful analysis of the current loan portfolio, the level of non-performing and impaired loans, evaluation of future economic trends in the Company's market area, and other factors relevant to the loan portfolio. The quarterly provision recorded as an increase to the allowance for loan losses are based upon estimates of probable losses inherent in the loan portfolio. The loss amount actually realized for these loans can vary significantly from the estimated amounts. See the “Allowance for Loan Losses” discussion for additional detail.

Three months ended March 31, 2005 and 2004

The banking segment recorded no provision for loan losses for the first quarter of 2005 due to the overall strengthening in loan quality. In 2004, the banking segment recorded a provision of $150,000, which was offset by a holding company recovery of $163,000 resulting in a net recovery of $13,000. The recovery was a result of previously charged-off loans in a segment that no longer carried a loan portfolio.

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Total non-interest income declined $190,000 when comparing the quarters ending March 31, 2005, and 2004. In the first quarter of 2004, the mortgage segment recorded $172,000 as gains on loans sold. In the last quarter of 2003, as part of the company’s strategy to consolidate resources into commercial banking, and to reduce reliance on mortgage lending activities, the company reduced the mortgage operation and no longer sells loans on the secondary market. Therefore, income associated with the mortgage segment has decreased.

Consistent with non-interest income discussed above, some decrease in non-interest expense from the quarter ending March 31,2004 is attributed to the reorganization of the Company's mortgage segment during the forth quarter of 2003 and first quarter 2004.

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At March 31, 2005, the Company had 113 full-time equivalent employees compared to 106 at March 31, 2004. Also included in salary expenses are ordinary annual wage increases for many existing employees.

Net occupancy and equipment expenses consist of depreciation on premises and equipment, lease costs, parking, maintenance and repair expenses, utilities and related expenses. When compared to March 31, 2004, there was a decrease of $33,000.

Professional fees include exam and audit expenses, accounting, consulting and legal fees, and other professional fees. The increase in part is due to the out source of the accounting function for the Trust department, and an increase in Human Resource consulting fees.

FDIC regulations set deposit insurance premiums based upon the risks a particular bank or savings association poses to the deposit insurance funds. This system bases an institution's risk category partly upon whether the institution is well capitalized, adequately capitalized or less than adequately capitalized. Each insured depository institution is also assigned to one of three "supervisory" categories based on reviews by regulators, statistical analysis of financial statements and other relevant information. An institution's assessment rate depends upon the capital category and supervisory category to which it is assigned. Annual assessment rates currently range from zero per $100 of domestic deposits for the highest rated institution to $0.27 per $100 of domestic deposits for an institution in the lowest category. During the first three months of 2004, the Bank paid an assessment rate of $0.17 per $100 of domestic deposits. The Bank was not required to pay an assessment rate during the last six months of 2004 and the first three months of 2005, resulting in the lower expense during that period. In addition, under legislation enacted in 1996 to re-capitalize the Savings Association Insurance Fund, the FDIC is authorized to collect assessments against insured deposits to be paid to the Financing Corporation ("FICO") to service FICO debt incurred in the 1980's. The current FICO assessment rate for insured deposits is $0.0144 per $100 of deposits per year. With the elimination of the assessment rate, the Company expects the total FDIC insurance expense to be consistent with the first quarter ended March 31, 2005. Any increase in deposit insurance premiums or FICO assessments could have an adverse effect on Cowlitz Bank's earnings Costs related to the operation and disposition of other real estate owned has declined as the number and value of properties has decreased.

Income Taxes

Three months ended March 31, 2005 and 2004

During the first quarter of 2005 the provision for income taxes was $222,000 compared to $117,000 for the first quarter of 2004.

Loans

Total loans outstanding were $197.7 million and $189.3 million at March 31, 2005 and December 31, 2004, respectively. Unfunded loan commitments such as home equity and other lines of credit, unused available credit on credit cards, and letters of credit, were $54.6 million at March 31, 2005 and $53.6 million at December 31, 2004.

The following table presents the composition of the Company's loan portfolio at the dates indicated:

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Allowance for Loan Losses

The allowance for loan losses represents management's estimate of potential losses as of the date of the financial statements. The loan portfolio is regularly reviewed to evaluate the adequacy of the allowance for loan losses. In determining the level of the allowance, the Company evaluates the amount necessary for specific non-performing loans and estimates losses inherent in other loans. An important element in determining the adequacy of the allowance for loan losses is an analysis of loans by loan risk-rating categories. At a loan’s inception, management evaluates the credit risk by using a risk-rating system. This grading system currently includes eleven levels of risk. Risk ratings range from “1” for the strongest credits to “10” for the weakest. A “10” rated loan would normally represent a loss. All loans rated 7-10 are collectively the Company's “Watch List”. The specific grades from 7-10 are “watch list” (risk-rating 7), “special mention” (risk-rating 7.5), “substandard” (risk-rating 8), “doubtful” (risk-rating 9), and “loss” (risk-rating 10). When indicators such as operating losses, collateral impairment or delinquency problems show that a credit may have weakened, the credit will be downgraded as appropriate. Similarly, as borrowers bring loans current, show improved cash flow, or improve the collateral position of a loan, the credits may be upgraded. Management reviews all credits periodically for changes in such factors. The result is an allowance with four components, specific allowance, general allowance, special allowance, and an unallocated allowance.

Specific Allowance. Loans on the Company's Watch List, as described above, are specifically reviewed and analyzed. Management considers in its analysis expected future cash flows, the value of collateral and other factors that may impact the borrower's ability to pay. When significant conditions or circumstances exist on an individual loan indicating greater risk, specific reserves may be allocated in addition to the general reserve percentage for that particular risk-rating.

General Allowance. All loans are risk-rated 1 to 10. Those that do not require a specific allocation are subject to a general allocation based upon historic loss factors. Management determines these factors by analyzing the volume and mix of the existing loan portfolio, in addition to other factors. Management also analyzes the following:

• the volume and severity of non-performing loans and adversely classified credits;
• the level of net charge-offs experienced on previously classified loans;
• the nature and value of collateral securing the loans; and
• the relationship and trend over the past several years of recoveries in relation to charge-offs.

Special Allowance. From time to time, special reserves will be established to facilitate a change in the Bank’s strategy and other factors. Special allocations are to take into consideration various factors that include, but are not limited to:

• Effectiveness of credit administration;
• Adequacy of loan review;
• Loan operations;
• The trend in loan growth and the percentage of change;
• Concentrations both geographic and industry;
• Competitive issues that impact loan underwriting/structure;
• Economic conditions; and
• Any special marketing or introduction of various loan products.

Unallocated Allowance. Management also attempts to ensure that the overall allowance appropriately reflects a margin for the imprecision necessarily inherent in estimates of expected loan losses.

The quarterly analysis of specific, general, and special allocations of the allowance is the principal method relied upon by management to ensure that changes in estimated loan loss levels are adjusted on a timely basis. The inclusion of historical loss factors in the process of determining the general component of the allowance also acts as a self-correcting mechanism of management's estimation process, as loss experience more remote in time is replaced by more recent experience. In its analysis of the specific, general, and special allocations of the allowance, management also considers regulatory guidance in addition to the Company's own experience.

Loans and other extensions of credit deemed uncollectable are charged to the allowance. Subsequent recoveries, if any, are credited to the allowance. Actual losses may vary from current estimates and the amount of the provision may be either greater than or less than actual net charge-offs when and if they occur. The related provision for loan losses that is charged to income is the amount necessary to adjust the allowance to the level determined through the above process.

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Management's evaluation of the loan portfolio resulted in total allowances for loan losses of $3.8 million at March 31, 2005 and December 31, 2004. The allowance, as a percentage of total loans, declined from 2.00% to 1.94% at March 31, 2005. Management believes the allowance for loan losses at March 31, 2005 is adequate to absorb current potential or anticipated losses. No additional allowance was provided in the first quarter ending March 31, 2005.

The following table shows the components of the allowance for loan loss for the periods indicated:

Based on Management’s assessment of the watch list loans, the unallocated amount of reserves has been decreased by $395,000 from December 31, 2004 to March 31, 2005 and reallocated to specific and special reserves. Reserve for specific loans was increased from 0.00% to 6.69% . Management believes the local economic recovery, excluding new housing construction segments, is still behind the national trend. Coupled with the anticipation of an increasing interest rate environment, additional special reserves have been allocated against potential cash flow strains of the Company’s borrowers.

The allowance for loan losses is based upon estimates of probable losses inherent in the loan portfolio. The amount actually observed for these losses can vary significantly from the estimated amounts. The following table shows the Company’s loan loss performance for the periods indicated.