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EX-32 - PACIFIC FINANCIAL CORPv215284_ex32.htm
EX-23 - PACIFIC FINANCIAL CORPv215284_ex23.htm
EX-21 - PACIFIC FINANCIAL CORPv215284_ex21.htm
EX-31.2 - PACIFIC FINANCIAL CORPv215284_ex31-2.htm
EX-31.1 - PACIFIC FINANCIAL CORPv215284_ex31-1.htm

Washington, D.C.  20549


x  Annual report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the fiscal year ended December 31, 2010; or
¨  Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

Commission file number  000-29829

(Exact Name of Registrant as specified in its Charter)

(State or Other Jurisdiction of
(IRS Employer Identification No.)
Incorporation or Organization)
1101 S. Boone Street
Aberdeen, Washington  98520-5244
(Address of Principal Executive Offices) (Zip Code)

Registrant's telephone number, including area code:  (360) 533-8870

Securities Registered Pursuant to Section 12(b) of the Exchange Act:  None

Securities Registered Pursuant to Section 12(g) of the Exchange Act:
Common Stock, par value $1.00 per share

Indicate by check mark whether the registrant is a well known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes ¨ No  x
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.    Yes ¨ No  x

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 periods that the Registrant was required to file such reports), and (2) has been subject to such requirements for the past 90 days.              Yes x No ¨

Indicate by checkmark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).   Yes ¨ No ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See definition of "large accelerated filer," "accelerated filer" and "smaller reporting company" in rule 12b of the Exchange Act.
Large accelerated filer ¨
Accelerated filer ¨
Non-accelerated filer ¨
Smaller reporting company x

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).Yes ¨ No x

The aggregate market value of the common stock held by non-affiliates of the registrant at June 30, 2010, was $35,537,144.

The number of shares outstanding of the registrant's common stock, $1.00 par value as of February 28, 2011, was 10,121,853 shares.

Portions of the registrant's Proxy Statement filed in connection with its annual meeting of shareholders to be held April 27, 2011 are incorporated by reference into Part III of this Form 10-K.




Forward Looking Information
Item 1.
Item 1A.
Risk Factors
Item 1B.
Unresolved Staff Comments
Item 2.
Item 3.
Legal Proceedings
Item 4.
Item 5.
Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Item 6.
Selected Financial Data
Item 7.
Management's Discussion and Analysis of Financial Condition and Results of Operations
Item 8.
Financial Statements and Supplementary Data
Item 9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
Item 9A.
Controls and Procedures
Item 9B.
Other Information
Item 10.
Directors, Executive Officers and Corporate Governance
Item 11.
Executive Compensation
Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Item 13.
Certain Relationships and Related Transactions and Director Independence
Item 14.
Principal Accountant Fees and Services
Item 15.
Exhibits and Financial Statement Schedules
F-1 – F-37



Forward Looking Information

This document contains forward-looking statements that are subject to risks and uncertainties.  These statements are based on the current beliefs and assumptions of our management, and on information currently available to them.  Forward-looking statements include the information concerning our possible future results of operations set forth under "Management's Discussion and Analysis of Financial Condition and Results of Operations" and statements preceded by, followed by or that include the words "believes," "expects," "anticipates," "intends," "plans," "estimates" or similar expressions.

Any forward-looking statements in this document are subject to risks relating to, among other things, the factors described under the heading "Risk Factors" in Item 1A below, as well as the following:

1.           changing laws, regulations, standards, and government programs, that may limit our revenue sources, eliminate insurance currently available on some deposit products, significantly increase our costs, including compliance and insurance costs, and place additional burdens on our limited management resources or lead us to change our strategies;

2.           poor economic or business conditions, nationally and in the regions in which we do business, that have resulted in, and may continue to result in, among other things, a deterioration in credit quality and/or reduced demand for credit and other banking services, increases in nonperforming assets, and additional workout and other real estate owned (“OREO”) expenses;
3.           decreases in real estate and other asset prices, whether or not due to changes in economic conditions, that may reduce the value of the assets that serve as collateral for many of our loans;

4.           competitive pressures among depository and other financial institutions that may impede our ability to attract and retain depositors, borrowers and other customers, retain our key employees, and/or maintain and improve our net interest margin and income and non-interest income, such as fee income;
5.           our growth strategy, particularly if accomplished through acquisitions, which may not be successful if we fail to accurately assess market opportunities, asset quality, anticipated cost savings, and transaction costs, or experience significant difficulty integrating acquired businesses or assets or opening new branches or lending offices; and

6.           a lack of liquidity in the market for our common stock that may make it difficult or impossible for you to liquidate your investment in our stock or lead to distortions in the market price of our stock.

Our management believes our forward-looking statements are reasonable; however, you should not place undue reliance on them.  Forward-looking statements are not guarantees of performance.  They involve risks, uncertainties and assumptions.  Many of the factors that will determine our future results, financial condition, and share value are beyond our ability to predict or control.  We undertake no obligation to update forward-looking statements.

ITEM 1.  Business
Pacific Financial Corporation (the Company or Pacific) is a bank holding company headquartered in Aberdeen, Washington.  The Company owns one bank, Bank of the Pacific (the Bank), which is also located in Washington.  The Company was incorporated in the State of Washington in February, 1997, pursuant to a holding company reorganization of the Bank.

The Company conducts its banking business through 16 branches located in communities throughout Grays Harbor, Pacific, and Wahkiakum Counties in Southwest Washington, and Whatcom and Skagit Counties in Northwest Washington.  The Company also operates a branch in Gearhart, Oregon.  There were no new branches opened during 2010 or 2009.  One branch in Whatcom County that was acquired as part of Pacific's acquisition of BNW Bancorp, Inc. (BNW) on February 27, 2004, was closed during 2009.

Pacific Financial Corporation is a reporting company with the Securities and Exchange Commission (SEC), and the Company's common stock is listed on the OTC Bulletin Board™ under the symbol PFLC.OB.  Revenue, net income (loss) and total assets for the Company for the years ended December 31, 2010, 2009, and 2008 are presented below:

(dollars in thousands)
For Year Ended December 31,
Net Interest Income
  $ 22,879     $ 21,753     $ 21,715  
Noninterest Income
    8,451       7,025       5,057  
Total Revenue
    31,330       28,778       26,772  
Net Income (Loss)
  $ 1,634     $ (6,338 )   $ 951  
Total Assets
  $ 644,403     $ 668,626     $ 625,835  

For additional selected financial information, please see “Item 6. Selected Financial Data” below.

Pacific's filings with the SEC, including its annual report on Form 10-K, quarterly reports on Form 10-Q, periodic current reports on Form 8-K and amendments to these reports, are available free of charge through links from our website at to the SEC's site at, as soon as reasonably practicable after filing with the SEC.  You may also access our filings with the SEC directly from the EDGAR database found on the SEC's website.  By making reference to our website above and elsewhere in this report, we do not intend to incorporate any information from our site into this report.

The Bank

Bank of the Pacific was organized in 1978 and opened for business in 1979 to meet the need for a regional community bank with local interests to serve the small to medium-sized businesses and professionals in the coastal region of western Washington.  In 2004, the Bank acquired branches in the Bellingham, Washington area by means of a merger with Bank Northwest, and in 2006, the Bank converted a loan production office in Gearhart, Oregon, to a full service branch.  Products and services offered by the Bank include personal and business deposit products and services and various loan and credit products as described in greater detail below.



Deposit Products and Services

The Bank's primary sources of deposits are individuals and businesses in its local markets.  Bank management has made a concerted effort to attract deposits in our local market areas through competitive pricing and delivery of quality products.  The Bank offers a traditional array of deposit products, including non-interest bearing checking accounts, interest-bearing checking and savings accounts, money market accounts, and time certificates of deposits.  These accounts earn interest at rates established by management based on competitive market factors and management’s strategic objectives in regards to the types or maturities of deposit liabilities from time to time.  Services which accompany the deposit products include sweep accounts, wire services, safety deposit boxes, online banking, private banking, and cash management and other treasury management services.  Private banking services provide high net worth clients customized financial solutions to help meet their financial goals.

The Bank provides 24-hour online banking to its customers with access to account balances and transaction histories, plus an electronic check register to make account management and reconciliation easier.  The online banking system is compatible with budgeting software like Intuit's Quicken® or Microsoft's Money®.  In addition, the online banking system includes the ability to transfer funds, make loan payments, reorder checks, and request statement reprints, provides loan calculators and allows for e-mail exchanges with representatives of the Bank.  Also, for a nominal fee customers can request stop payments and pay an unlimited number of bills online.  These services, along with rate and other information, can be accessed through the Bank's website at

In addition to providing accounts and services to local customers, the Bank utilizes brokered deposits from time to time, which are deposits that are acquired from outside the region.  The Bank also participates in the Certificate of Deposit Account Registry Service (“CDARS”) which uses a deposit-matching program to distribute deposit balances in excess of insurance or other limits across participating banks.  Our participation in CDARS is intended to enhance our ability to attract and retain customers and increase deposits by providing additional FDIC coverage to customers.  Due to the nature of the placement of the funds, CDARS deposits are classified as “brokered deposits” by regulatory agencies. Brokered deposits for the three years ended December 31, 2010, 2009 and 2008 were as follows:

Year Ended
Brokered Deposits
Total Outstanding
Percentage of
Total Deposits
  $ 27,220,000     $ 1,984,000     $ 29,204,000       5.4 %
  $ 60,220,000     $ 716,000     $ 60,936,000       10.7 %
  $ 35,000,000     $ 305,000     $ 35,305,000       6.9 %

Due to excess liquidity in 2010, the Company paid off brokered deposits totaling $21,000,000 as they came due during the year.  The increase in brokered deposits at December 31, 2009, was primarily to replace maturing public deposits totaling $21,978,000 that became less attractive due to increased regulatory pledging requirements and to further strengthen on-balance sheet liquidity to take advantage of business opportunities within our markets.  The Bank believes that brokered deposits present similar interest rate risk compared to other time deposits.  In determining whether to take brokered deposits, the Bank considers current market interest rates, profitability to the Bank, and matching deposits and loan products.  Brokered deposits in excess of ten percent of total deposits are subject to additional FDIC assessment premiums.  Our balance of brokered deposits (excluding CDARS) bears interest at 1.00% to 2.55% and matures as follows: 2011 - $24,220,000; 2013 - $2,191,000; and 2014 – $809,000.

The Bank's deposits are insured by the Federal Deposit Insurance Corporation (FDIC) up to applicable legal limits under the Bank Insurance Fund.  The Bank is a member of the Federal Home Loan Bank (FHLB) and is regulated by the Washington Department of Financial Institutions, Division of Banks (Washington Division), and the FDIC.



The Company is not dependent on any individual customers, entities or group of related entities for deposits.  There are no deposit relationships exceeding two percent of total deposits.

Lending Activities

General.  Lending products offered by the Bank include real estate loans, commercial loans, agriculture loans, installment loans, and residential mortgage loans.  The majority of the Company’s loan portfolio is comprised of real estate loans, which constitute $382,950,000, or 80.5%, of total loans outstanding.  Commercial real estate loans represent $216,015,000, or 45.4%, and residential construction, land and other land loans represent $46,256,000, or 9.7% at December 31, 2010.  See "Footnote 4 – Loans" in the audited consolidated financial statements included under Item 14 of this report for balances in each of our lending categories as of December 31, 2010 and 2009.

The Bank originates loans primarily in its local markets.  Loans to borrowers outside of Washington and Oregon total $67,357,000, or 14.2%, of total loans at December 31, 2010.  Of this amount, $51,310,000, or 10.8% of total loans, are government guaranteed loans purchased in the secondary market that were not originated by us.  Additionally, our loan portfolio includes $5,046,000 in loans purchased from and originated by other financial institutions, representing 1.1% of total loans.

Underwriting and Credit Administration.  The Bank's lending activities are guided by policies that are reviewed and approved annually by our board of directors.  These policies address the types of loans, underwriting standards, structure and rate considerations, and compliance with laws, regulations and internal lending limits.  As part of our credit administration process, we routinely engage external loan specialists to perform asset quality reviews.  These reviews consist of sampling loans to review individual borrower loan files for adherence to policy and underwriting standards, proper loan administration, and asset quality.  In addition, the management executive committee and credit administration meet quarterly with loan personnel to review loan risk assessments on loans greater than $500,000 with an internal risk rating of watch or worse.

The loan policy also establishes loan approval authority for certain officers individually.  Loan officer lending authorities range from $5,000 to $500,000 for certain loan officers.  Credit risk officers can approve loans up to $2,000,000.  The chief credit officer and chief executive officer can approve loans up to $3,000,000.  Loans greater than $3,000,000 must be approved by the Loan Committee of the Company's board of directors.  Additionally, loans with a risk rating of substandard or worse, with balances of $2,000,000 or greater, must also be approved by the Loan Committee.  The Bank’s legal lending limit was $14,500,000 at December 31, 2010.  The internal lending limit is $7,500,000 and represents the maximum lending limit to individual borrowers and related entities.  The Bank does not have significant loan concentrations to any individual customer, entity or group of related entities.

The Bank's underwriting policies focus on assessment of each borrower's ability to service and repay the debt, and the availability of collateral to secure the loan.  Depending on the nature of the borrower and the purpose and amount of the loan, the Bank's loans may be secured by a variety of collateral, including real estate, business assets, and personal assets.  The value of our collateral is subject to change.  See the discussion under the subheading "Lending Activities—Classification of Loans" for additional information regarding our periodic evaluation of collateral values.  Analysis of whether to make a loan to a particular borrower requires consideration of (1) the borrower’s character, (2) the borrower’s financial condition as reflected in current financial statements, (3) the borrower’s management capability, (4) the borrower’s industry, and (5) the economic environment in which the loan will be repaid.  Before closing a loan, the Bank’s loan documentation files will include financial statements of the borrower, guarantors, endorsers and co-makers.  Personal and business financial statements must be signed by the borrower and contain, at a minimum, a balance sheet and income information.  Income is verified on loans except homogenous non-real estate consumer loans.  Tax returns are considered an excellent source of financial information.  Applicable credit reports (Dunn & Bradstreet, Equifax or credit bureau reports) are also required on all loans.  Financial statements reviewed by third party accountants are required for commercial loans between $3 million and $5 million.  Audited financial statements are required on commercial credits of $5 million or more.  In addition, in instances where a borrower or guarantor maintains liquidity that is a material factor in loan approval, verification of that liquidity is required.



The Bank generally requires guarantor support on commercial real estate loans, commercial and industrial loans to entities, where applicable, and certain consumer loans.  Loans to closely held corporations will be guaranteed by the major stockholders.  On occasion, it is necessary to make exceptions to this policy for long-standing customers who will not guarantee.  However, these exceptions are kept to the minimum necessary to retain good customers, and must be approved by credit administration.  In addition, as a policy, loans that are to legal entities formed for the limited purpose of the business or project being financed require personal guarantees in support of the loan.  Similarly, the Bank's policy is not to engage in non-recourse financing on commercial and commercial real estate loans.  Before extending credit to a business, the Bank looks closely at its evaluation of the borrower’s management ability, financial history, including cash flow of the borrower and all guarantors (referred to as “global cash flow” in our industry), and the liquidation value of the collateral.  Emphasis is placed on having a comprehensive understanding of the borrower’s and guarantors’ cash flow and on financial due diligence.

The Company's loan portfolio does not include mortgage loans originated as subprime loans, “Alt-A” loans, or no documentation, interest only or option adjustable rate loans.

Commercial Lending.  The Bank's commercial and agricultural loans consist primarily of secured revolving operating lines of credit, equipment financing, accounts receivable and inventory financing and business term loans, some of which may be partially guaranteed by the Small Business Administration or the U.S. Department of Agriculture.  The Company’s credit policies determine advance rates against the different forms of collateral that can be pledged against commercial loans.  Typically, the majority of loans will be limited to a percentage of the underlying collateral values such as equipment, eligible accounts receivable and finished inventory.  Individual advance rates may be higher or lower depending upon the financial strength of the borrower, quality of the collateral and/or term of the loan.

The Bank provides secured and unsecured loans to commercial borrowers.  Unsecured loans totaled $2,390,000 at December 31, 2010, or 0.5% of total loans as of that date.

Commercial Real Estate.  The Bank originates commercial real estate and multifamily loans within its primary market areas.  Owner-occupied commercial real estate loans are preferred. Underwriting standards require that commercial and multifamily real estate loans not exceed 65-80% of the lower of appraised value at origination or cost of the underlying collateral, depending upon specific property type. The cash flow coverage to debt servicing requirement is generally that annual cash flow be a minimum of between 1.25-1.35 times debt service for commercial real estate loans and 1.25 times debt service for multifamily loans.  Cash flow coverage is calculated using a market interest rate.

Commercial real estate and multifamily loans typically involve a greater degree of risk than single-family residential mortgage loans. Payments on loans secured by multifamily and commercial real estate properties are dependent on successful operation and management of the properties and repayment of these loans is affected by adverse conditions in the real estate market or the economy.  The Bank seeks to minimize these risks by scrutinizing the financial condition of the borrower, the quality and value of the collateral, and the management of the property securing the loan.  In addition, the Bank reviews the commercial real estate loan portfolio annually to evaluate the performance of individual loans greater than $500,000 and for potential changes in interest rates, occupancy, and collateral values.  Commercial real estate serving as collateral for loans is characterized as warehouse, small business, retail, or medical.



Non-owner occupied commercial real estate loans are loans in which less than 50% of the property is occupied by the owner and include loans such as apartment complexes, hotels and motels, retail centers and mini-storages.  Repayment of non-owner occupied commercial real estate loans is dependent upon the lease or resale of the subject property.  Loan amortizations range from 10 to 30 years, although terms typically do not exceed 10 years.  Interest rates can be either floating or fixed.  Floating rates are typically indexed to the prime rate or Federal Home Loan Bank advance rates plus a defined margin.  Fixed rates are generally set for periods of three to five years with either a rate reset provision or a payment due at maturity.  Prepayment penalties are sought on term commercial real estate loans.  The penalties are designed to protect the Bank from refinancing of the loan during the early years of the transaction.

Construction Loans.   The Bank originates single-family residential construction loans for custom homes (where the home buyer is the borrower). It has also provided financing to builders for the construction of pre-sold homes and, in selected cases, to builders for the construction of speculative residential property. Because of the higher risks involved in the residential construction industry in today's economic climate, the Bank is not currently engaging in new land acquisition and site development financing.  Limited residential speculative construction financing is being provided for a select and limited group of borrowers, which is designed to facilitate exit from the related loans.

The Bank endeavors to limit construction lending risks through adherence to specific underwriting guidelines and procedures.  Repayment of construction loans is dependent upon the sale of individual homes to consumers or in some cases to other developers.  Terms on construction loans are generally short-term in nature and most loans mature in one to three years.  Interest rates are usually floating and fully indexed to a short-term rate index.  The Bank's credit policies address maximum loan to value, cash equity requirements, repayment accelerations, sell out time frames, inspection requirements, and overall credit strength.

Single-Family Residential Real Estate Lending.    The majority of our one-to-four family residential loans are secured by single-family residences located in our primary market areas. Our underwriting standards require that single-family portfolio loans are generally owner-occupied and do not exceed 80% of the lower of appraised value at origination or cost of the underlying collateral. Terms typically range from 15 to 30 years.  Repayment of these loans comes from the borrower’s personal cash flows and liquidity, and collateral values are a function of residential real estate values in the markets we serve.  These loans include primary residences, second homes, rental homes and home equity loans and home equity lines of credit.

Origination and Sales of Residential Mortgage Loans.  The Bank also originates mortgage loans for sale into the secondary market.  Commitments to sell mortgage loans are generally made during the period between the loan application and the closing of the mortgage loan. Most of these sale commitments are made on a “best efforts” basis whereby the Bank is only obligated to sell the mortgage if the mortgage loan is approved and closed. As a result, management believes that market risk is minimal.  When we sell mortgage loans, we sell the rights to service the loans as well (i.e., collection of principal and interest payments).  Mortgage loans originated for sale are underwritten in accordance with standards of the loan purchaser, as a result, underwriting standards vary.  The Bank’s loans held for sale portfolio does not include mortgage loans originated as subprime loans, “Alt-A” loans, or no documentation or option adjustable rate loans.



Consumer.  Consumer installment loans and other loans represent a small percentage of total outstanding loans and include new and used auto loans, boat loans, and personal lines of credit.

Classification of Loans.    Federal regulations require that the Bank periodically evaluate the risks inherent in its loan portfolios. In addition, the Washington Division and the FDIC have authority to identify problem loans and, if appropriate, require them to be reclassified. There are three classifications for problem loans: Substandard, Doubtful, and Loss. Substandard loans have one or more defined weaknesses and are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected. Doubtful loans have the weaknesses of loans classified as Substandard, with additional characteristics that suggest the weaknesses make collection or recovery in full after liquidation of collateral questionable on the basis of currently existing facts, conditions, and values. There is a high possibility of loss in loans classified as Doubtful. A loan classified as Loss is considered uncollectible and of such little value that continued classification of the credit as a loan is not warranted. If a loan or a portion thereof is classified as Loss, it must be charged-off, meaning the amount of the loss is charged against the allowance for credit losses, thereby reducing that reserve. The Bank also classifies some loans as Watch or Other Loans Especially Mentioned (“OLEM”). Loans classified as Watch are performing assets but have elements of risk that require more monitoring than other performing loans. Loans classified as OLEM are assets that continue to perform but have shown deterioration in credit quality and require close monitoring.

On an ongoing basis, the Bank reviews borrower financial results, collateral values, and compliance with payment terms and covenant requirements in order to identify problems in loan relationships.  When management believes that the collection of all or a portion of principal and interest is no longer probable, the loan is placed on “non-accrual” status, accrual of interest is suspended, previously accrued interest is reversed, and interest payments are applied to principal until the Company determines that all remaining principal and interest can be recovered.  This may occur at any time regardless of delinquency, however it is the policy of the Bank that a loan past due 90 days or more and not in the process of collection be placed on non-accrual status.  Interest income is subsequently recognized only to the extent that cash payments are received until, in management’s judgment, the borrower has the ability to make contractual interest and principal payments, in which case the loan is returned to accrual status.  When all or a portion of the contractual cash flows are not expected to be collected, the loan is considered impaired, and the Company estimates and records impairment based on the estimated net realizable value of the collateral on collateral dependent loans.  The Company does not make additional loans to a borrower or any related interest of the borrower when a loan is past due in principal or interest more than 90 days.

The Company reviews the net realizable values of the underlying collateral for collateral dependent impaired loans on at least a quarterly basis.  To determine the collateral value, management utilizes independent appraisals and internal evaluations.  These valuations are reviewed to determine whether an additional discount should be applied given the age of market information or other factors such as costs to carry and sell an asset.  Currently it is our practice to obtain new appraisals on non-performing collateral dependent loans and/or other real estate owed (“OREO”) every six to nine months.  Based upon the appraisal, the Company will, if an appraisal suggests a reduced value, adjust the recorded loan balance to the lower of cost or market value (less costs to sell) and record a charge-off to the allowance for credit losses or designate a specific reserve within the allowance per accounting principles generally accepted in the United States.  Generally, the Company will record the charge-off rather than designate a specific reserve. This process enables the Company to adequately reserve for non-performing loans within the allowance for credit losses.



OREO is classified as other real estate owned until it is sold. When property is acquired, it is recorded at the estimated fair value (less costs to sell) at the date of acquisition, not to exceed the book value of the underlying loan, and any resulting write-down is charged to the allowance for credit losses. Subsequent write-downs based upon re-evaluation of the property are charged to non-interest expense.  Upon acquisition of a particular property, all costs incurred in maintaining the property are expensed. Costs relating to the development and improvement of the property, however, are capitalized to the extent of the property’s net realizable value.  Due to the drop in real estate prices in our market areas during the last two years, charge-offs to the allowance for credit losses on OREO properties totaled $1,034,000 and $1,573,000, for the years ended December 31, 2010 and 2009, respectively.  In addition, the Company recorded OREO write-downs in non-interest expense in the income statement based upon subsequent re-evaluations totaling $1,272,000, $3,689,000 and $0 for the years ended December 31, 2010, 2009 and 2008, respectively.

Troubled Debt Restructures.    Loans for which the terms have been modified in order to grant a concession to a borrower that is experiencing financial difficulty are identified as Troubled Debt Restructures (“TDRs”). TDRs are considered impaired and are reported as impaired loans.  A restructured loan that is in compliance with its modified terms and yields a market interest rate may be reclassified as a performing loan after 12 months of performance.  TDRs totaled $932,000 and $0 at December 31, 2010 and 2009, respectively and are included in non-accrual loans.  See Note 4 – “Loans” in the audited consolidated financial statements included under Item 15 of this report for more information on TDRs as of December 31, 2010 and 2009.

The Company may renew a loan or grant an extension when the maturity date is imminent and the borrower may be experiencing some level of financial stress but it is not evident at the time of the extension that the loan or a portion of the loan is not collectible.  The Company believes a review of the ultimate outcome of the loan may not be a relevant indicator of whether an extension of a loan should have been reclassified at a particular point in time.  When the Company makes a decision to grant an extension or renew a loan, it does so based on the best information available with respect to the borrower’s ability to repay the loan.  Such extensions are made only after renewed credit analysis and with the approval of the appropriate credit administration personnel who must be independent of the lending officer/relationship manager in a particular loan.

PFC Statutory Trusts I and II

PFC Statutory Trust I and II are wholly-owned subsidiary trusts of the Company formed to facilitate the issuance of pooled trust preferred securities (trust preferred securities).  The trusts were organized in December 2005 and June 2006 in connection with two offerings of trust preferred securities.  During the second quarter 2009, the Company exercised its right to defer interest payments on its trust preferred securities.  At December 31, 2010, the Company had accrued interest payable of $900,000.  For more information regarding the Company's issuance of trust preferred securities, see Note 9 "Junior Subordinated Debentures" to Pacific's audited consolidated financial statements included in Item 15 of this report.


Competition in the banking industry is significant.  Banks face a number of competitors with respect to providing banking services and attracting deposits.  Competition comes from both bank and non-bank sources and from both large national and smaller local institutions.  Many of these institutions, such as Wells Fargo Bank, Bank of America, and Chase Bank, as well as newer bank holding companies like American Express and GMAC, have significantly greater resources than the Company and the Bank.  As a result, competition for deposits, loan, and other products is significant and may continue to increase, particularly in Pacific's larger market in and around Bellingham, Washington.



The Bank competes in Grays Harbor County with well-established thrifts which are headquartered in the area along with branches of large banks with headquarters outside the area.  The Bank also competes with well-established small community banks, branches of large banks, thrifts and credit unions in Pacific and Wahkiakum Counties in the state of Washington and Clatsop County in the state of Oregon.  In Whatcom County and Skagit County, Washington, the Bank also competes with large regional and super-regional financial institutions that do not have a significant presence in the Company's historical market areas.  The Company believes Whatcom County provides opportunities for expansion, but in pursuing that expansion it faces greater competitive challenges than it faces in its historical market areas.

The adoption of the Gramm-Leach-Bliley Act of 1999 (the Financial Services Modernization Act) eliminated many of the barriers to affiliation among providers of financial services and further opened the door to business combinations involving banks, insurance companies, securities or brokerage firms, and others.  This regulatory change has led to further consolidation in the financial services industry and the creation of financial conglomerates which frequently offer multiple financial services, including deposit services, brokerage and others.  When combined with technological developments such as the Internet that have reduced barriers to entry faced by companies physically located outside the Company's market area, changes in the market have resulted in increased competition and can be expected to result in further increases in competition in the future.  Competition in the market for deposits has increased significantly.

Consolidation trends among financial institutions may accelerate as a result of the severe distress throughout the industry and particularly in the state of Washington.  As a result of this distress, there may be opportunities for Pacific to acquire customers, personnel, and perhaps assets or even branches.  The ability to do so will depend on Pacific's financial condition, as well as on its ability to compete successfully with other financial institutions when opportunities arise.  Many competitive institutions have greater resources and better access to capital markets than we do, which may make it difficult for us to compete successfully for opportunities in our geographic area of operations.

Although it cannot guarantee that it will continue to do so, the Company has been able to maintain a competitive advantage in its historical markets as a result of its status as a local institution, offering products and services tailored to the needs of the community.  Further, because of the extensive experience of management in its market area and the business contacts of management and the Company's directors, management believes the Company can continue to compete effectively.

According to the Market Share Report compiled by the FDIC, as of June 30, 2010, the Company held a deposit market share of 27.6% in Pacific County, 49.0% in Wahkiakum County, 26.6% in Grays Harbor County, 3.7% in Whatcom County, 1.3% in Skagit County and 1.4% in Clatsop County (Oregon).


As of December 31, 2010, the Bank employed 222 full time equivalent employees.  Management believes relations with its employees are good.



Supervision and Regulation
The following is a general description of certain significant statutes and regulations affecting the banking industry.  The laws and regulations applicable to the Company and its subsidiaries are primarily intended to protect depositors and borrowers of the Bank and not stockholders of the Company.  Various proposals to change the laws and regulations governing the banking industry are pending in Congress, in state legislatures and before the various bank regulatory agencies and new or amended proposals are expected.  In the current economic climate and regulatory environment, the likelihood of enactment of new banking legislation and promulgation of new banking regulations is significantly greater than it has been in recent years.  The potential impact of new laws and regulations on the Company and its subsidiaries cannot be determined, but any such laws and regulations may materially affect the business and prospects of the Company and its subsidiaries.  Violation of the laws and regulations applicable to the Company and its subsidiaries may result in assessment of substantial civil monetary penalties, the imposition of a cease and desist or similar order, and other regulatory sanctions, as well as private litigation.
The Company
As a bank holding company, the Company is subject to the Bank Holding Company Act of 1956, as amended (BHCA), which places the Company under the primary supervision of the Board of Governors of the Federal Reserve System (the Federal Reserve).  The Company must file annual reports with the Federal Reserve and must provide it with such additional information as it may require.  In addition, the Federal Reserve periodically examines the Company and the Bank.
Bank Holding Company Regulation
General.  The BHCA restricts the direct and indirect activities of the Company to banking, managing or controlling banks and other subsidiaries authorized under the BHCA, and activities that are closely related to banking or managing or controlling banks.  The Company must obtain approval of the Federal Reserve before it: (1) acquires direct or indirect ownership or control of any voting shares of any bank or bank holding company that results in total ownership or control, directly or indirectly, of more than 5% of the outstanding shares of any class of voting securities of such bank or bank holding company; (2) merges or consolidates with another bank holding company; or (3) acquires substantially all of the assets of another bank or bank holding company.  In acting on applications for such prior approval, the Federal Reserve considers various factors, including, without limitation, the effect of the proposed transaction on competition in relevant geographic and product markets, and each transaction party's financial condition, managerial resources, and the convenience and needs of the communities to be served, including the performance record under the Community Reinvestment Act.

Source of Strength.  Under Federal Reserve policy, the Company must act as a source of financial and managerial strength to the Bank.  This means that the Company is required to commit, as necessary, resources to support the Bank, and that under certain conditions, the Federal Reserve may conclude that certain actions of Company, such as payment of cash dividends, would constitute unsafe and unsound banking practices.

Dodd-Frank Act.  In addition, under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”), the FDIC has back-up enforcement authority over a depository institution holding company, such as the Company, if the conduct or threatened conduct of a holding company poses a risk to the Deposit Insurance Fund, subject to certain limitations.
Tie-In Arrangements

The Company and the Bank cannot engage in certain tie-in arrangements in connection with any extension of credit, sale or lease of property or furnishing of services.  For example, with certain exceptions, neither the Company nor the Bank may condition an extension of credit to a customer on either (1) a requirement that the customer obtain additional services provided by it or (2) an agreement by the customer to refrain from obtaining other services from a competitor.


Effects of Government Monetary Policy

Banking is a business which depends on interest rate differentials.  In general, the major portions of a bank's earnings derives from the differences between:  (i) interest received by a bank on loans extended to its customers and the yield on securities held in its investment portfolio; and (ii) the interest paid by a bank on its deposits and its other borrowings (the bank's "cost of funds").  Thus, our earnings and growth are constantly subject to the influence of economic conditions generally, both domestic and foreign, and also to the monetary, fiscal and related policies of the United States and its agencies, particularly the Federal Reserve and the U.S. Treasury.  The nature and timing of changes in such policies and their impact cannot be predicted.
The Bank

The Bank, as an FDIC insured state-chartered bank, is subject to regulation and examination by the FDIC and the Department of Financial Institutions of the State of Washington.  The federal laws that apply to the Bank regulate, among other things, the scope of its business activities, its investments, its reserves against deposits, the timing of the availability of deposited funds and the nature and amount of and collateral for loans.

CRA.  The Community Reinvestment Act (the CRA) requires that the FDIC evaluate the Bank’s record in meeting the credit needs of its local community, including low and moderate income neighborhoods, consistent with the safe and sound operation of those banks.  These factors are also considered in evaluating mergers, acquisitions, and applications to open a branch or facility.  In connection with the FDIC's assessment of the record of financial institutions under the CRA, it assigns a rating of either, "outstanding," "satisfactory," "needs to improve," or "substantial noncompliance" following an examination.  The Bank received a CRA rating of "satisfactory" during its most recent examination.

Insider Credit Transactions.  Banks are also subject to certain restrictions imposed by the Federal Reserve Act on extensions of credit to executive officers, directors, principal shareholders, or any related interests of such persons.  Extensions of credit (i) must be made on substantially the same terms, including interest rates and collateral, and follow credit underwriting procedures that are not less stringent than those prevailing at the time for comparable transactions with persons not covered above and who are not employees and (ii) must not involve more than the normal risk of repayment or present other unfavorable features.  Banks are also subject to certain lending limits and restrictions on overdrafts to such persons.

FDICIA.  Under the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA), each federal banking agency has prescribed, by regulation, noncapital safety and soundness standards for institutions under its authority.  These standards cover internal controls, information systems, and internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, compensation, fees and benefits, such other operational and managerial standards as the agency determines to be appropriate, and standards for asset quality, earnings and stock valuation.  An institution which fails to meet these standards must develop a plan acceptable to the agency, specifying the steps that the institution will take to meet the standards.  Failure to submit or implement such a plan may subject the institution to regulatory sanctions.  Management believes that the Bank meets all such standards and, therefore, does not believe that these regulatory standards will materially affect the Company's business or operations.

Dodd-Frank Act

On July 21, 2010, the Dodd-Frank Act was signed into law and implements far-reaching changes across the financial regulatory landscape, including provisions that, among other things, will:



Centralize responsibility for consumer financial protection by creating a new agency within the Federal Reserve Board, the Bureau of Consumer Financial Protection, with broad rule making, supervision and enforcement authority for a wide range of consumer protection laws that would apply to all banks and thrifts.  Smaller financial institutions, including the Bank, will be subject to the supervision and enforcement of their primary federal banking regulator with respect to the federal consumer financial protection laws.

Require the federal banking regulators to promulgate new capital regulations and seek to make their capital requirements countercyclical, so that capital requirements increase in times of economic expansion and decrease in times of economic contraction.

Provide for new disclosures and other requirements relating to executive compensation and corporate governance.

Change the assessment base for federal deposit insurance from deposits to average total assets minus tangible equity.

Make permanent the $250,000 limit for federal deposit insurance and provide unlimited federal deposit insurance until January 1, 2013 for non interest-bearing demand transaction accounts at all insured depository institutions.

Effective July 21, 2011, repeal the federal prohibitions on the payment of interest on demand deposits, thereby permitting depository institutions to pay interest on business transaction and other accounts.

Require all deposit institution holding companies to serve as a source of financial strength to their depository institution subsidiaries in the event such subsidiaries suffer from financial distress.

Many aspects of the Dodd-Frank Act are subject to rule-making and will take effect over the next 18 months.  These rules will increase regulation of the financial services industry and impose restrictions on the ability of firms within the industry to conduct business consistent with historical practices.  These rules will, as examples, impact the ability of financial institutions to charge certain banking and other fees, allow interest to be paid on demand deposits, impose new restrictions on lending practices and require depository institution holding companies to maintain capital levels at levels not less than the levels required for insured depository institutions.  Compliance with such legislation or regulation may, among other effects, significantly increase our costs, limit our product offerings and operating flexibility, decrease our revenue opportunities, require significant adjustments in our internal business processes, and possibly require us to maintain our regulatory capital at levels above historical levels.

Deposit Insurance
The deposits of the Bank are currently insured to a maximum of $250,000 per depositor and certain self-directed retirement accounts continue to be insured up to $250,000 per depositor, through the Bank Insurance Fund administered by the FDIC.  All insured banks are required to pay semi-annual deposit insurance premium assessments to the FDIC.  In 2008, the FDIC insurance limit on most deposit accounts was temporarily increased from $100,000 to $250,000.  This increase was made permanent in 2010 by the Dodd-Frank Act.  In addition, through December 31, 2012, a depositor’s funds in noninterest bearing transaction accounts and certain other specialized accounts are fully insured.


The FDIC currently assesses deposit insurance premiums on each FDIC-insured institution quarterly based on annualized rates for one of four risk categories applied to its deposits, subject to certain adjustments. Each institution is assigned to one of four risk categories based on its capital, supervisory ratings and other factors. Well capitalized institutions that are financially sound with only a few minor weaknesses are assigned to Risk Category I. Risk Categories II, III and IV present progressively greater perceived risks to the DIF. Under FDIC's current risk-based assessment rules, the initial base assessment rates prior to adjustments range from 12 to 16 basis points for Risk Category I, 22 basis points for Risk Category II, 32 basis points for Risk Category III, and 45 basis points for Risk Category IV.  Initial base assessment rates are subject to adjustments based on an institution's unsecured debt, secured liabilities and brokered deposits, such that the total base assessment rates after adjustments range from 7 to 24 basis points for Risk Category I, 17 to 43 basis points for Risk Category II, 27 to 58 basis points for Risk Category III, and 40 to 77.5 basis points for Risk Category IV.  The FDIC’s regulations include authority to increase or decrease total base assessment rates in the future by as much as three basis points without a formal rulemaking proceeding.

The Dodd-Frank Act required the FDIC to amend its regulations to define the assessment base against which deposit insurance premiums are calculated as a depository institution’s average total consolidated assets minus average tangible equity.  The amended regulations were issued in February 2011, effective in the second quarter of 2011.  The FDIC stated that it set rates using the new assessment base such that the revenues it receives will be approximately the same as under the current assessment base.  Under the new regulations, initial base assessment rates for institutions with less than $10 billion in assets will range from 5 to 9 basis points for Risk Category I, 14 basis points for Risk Category II, 23 basis points for Risk Category III and 35 basis points for Risk Category IV.

The FDIC may make special assessments on insured depository institutions in amounts determined by the FDIC to be necessary to give it adequate assessment income to repay amounts borrowed from the U.S. Treasury and other sources, or for any other purpose the FDIC deems necessary.  During 2009, the FDIC imposed a special assessment of 5 basis points on the amount of each depository institution's assets reduced by the amount of its Tier 1 capital (not to exceed 10 basis points of its assessment base for regular quarterly premiums) as of June 30, 2009, which was collected on September 30, 2009.  Additionally, during the fourth quarter of 2009, the FDIC required each insured institution to prepay on December 30, 2009 the estimated amount of its quarterly assessments for the fourth quarter of 2009 and all quarters through the end of 2012.  The prepaid amount was recorded as an asset with a zero risk weight for regulatory capital purposes.  If events cause actual assessments during the prepayment period to vary from the prepaid amount, institutions will pay excess assessments in cash or receive a rebate of prepaid amounts not exhausted after collection of assessments due on June 13, 2013, as applicable.  Collection of the prepayment does not preclude the FDIC from changing assessment rates or revising the risk-based assessment system in the future.


Dividends from the Bank constitute the major source of liquidity for the Company, from which the Company may cover its expenses, pay interest on its obligations, including its debentures issued in connection with trust preferred securities, and declare and pay dividends to shareholders.  The amount of dividends payable by the Bank to the Company depends on the Bank's earnings and capital position, and is limited by federal and state laws, regulations and policies.  In addition, the Bank is subject to certain restrictions on the amount of dividends that it may declare without prior regulatory approval.

Electronic Funds Transfer Act and Regulation E- Recent Developments.

The electronic Funds Transfer Act (the EFTA) provides a basic framework for establishing the rights, liabilities, and responsibilities of participants in electronic funds transfer (EFT) systems.  The EFTA is implemented by the Federal Reserve's Regulation E which governs transfers initiated through ATMs, point-of-sale terminals, payroll cards, automated clearinghouse (ACH) transactions, telephone bill-payment plans, or remote banking services.  Regulation E was amended to require bank customers in 2010 to opt in (affirmatively consent) to participation in overdraft service programs for ATM and one-time debit card transactions before overdraft fees may be assessed on the customer's account and provides an ongoing right to revoke consent to participation.  For customers who do not affirmatively consent to overdraft service for ATM and one-time debit card transactions, a bank must provide those customers with the same account terms, conditions, and features that it provides to consumers who do affirmatively consent, except for the overdraft service.



Real Estate Concentration Guidance

On December 6, 2008, the federal banking agencies issued guidance on sound risk management practices for concentrations in commercial real estate lending.  The particular focus was on exposure to commercial real estate loans that are dependent on the cash flow from the real estate held as collateral and that are likely to be sensitive to conditions in the commercial real estate market (as opposed to real estate collateral held as a secondary source of repayment or as an abundance of caution).  The purpose of the guidance is not to limit a bank's commercial real estate lending but to guide banks in developing risk management practices and capital levels commensurate with the level and nature of real estate concentrations.  A bank that has experienced rapid growth in commercial real estate lending has notable exposure to a specific type of commercial real estate loan, or is approaching or exceeding the following supervisory criteria may be identified for further supervisory analysis with respect to real estate concentration risk:

Total reported loans for construction, land development and other land representing 100% or more of the bank's capital; or

Total commercial real estate loans representing 300% or more of the bank's total capital.

The strength of an institution's lending and risk management practices with respect to such concentrations will be taken into account in supervisory evaluation of capital adequacy.  At December 31, 2010 and 2009, the Bank was under the guidelines described above.

On March 17, 2008, the FDIC issued a release to re-emphasize the importance of strong capital and loan loss allowance levels and robust credit risk management practices for institutions with concentrated commercial real estate exposures.  The FDIC suggested that institutions with significant construction and development and commercial real estate loan concentrations increase or maintain strong capital levels; ensure that loan loss allowances are appropriately strong; manage construction and development and commercial real estate loan portfolios closely; maintain updated financial and analytical information on their borrowers and collateral; and bolster the loan workout infrastructure.

Capital Adequacy

Federal bank regulatory agencies use capital adequacy guidelines in the examination and regulation of bank holding companies and banks.  If capital falls below minimum levels, the bank holding company or bank may be denied approval to acquire or establish additional banks or non-bank businesses or to open new facilities.

The FDIC and Federal Reserve use risk-based capital guidelines for banks and bank holding companies.  Risk-based guidelines are designed to make capital requirements more sensitive to differences in risk profiles among banks and bank holding companies, to account for off-balance sheet exposure and to minimize disincentives for holding liquid low-risk assets.  Assets and off-balance sheet items are assigned to broad risk categories, each with appropriate weights.  The resulting capital ratios represent capital as a percentage of total risk-weighted assets and off-balance sheet items.  The guidelines are minimums and the Federal Reserve may require that a banking organization maintain ratios in excess of the minimums, particularly organizations contemplating significant expansion.  Current guidelines require all bank holding companies and federally-regulated banks to maintain a minimum total risk-based capital ratio equal to 8%, of which at least 4% must be Tier I capital. Tier I capital for bank holding companies includes common shareholders' equity, certain qualifying preferred stock and minority interests in equity accounts of consolidated subsidiaries, minus certain deductions, including, without limitation, goodwill, other identifiable intangible assets, and deferred tax assets.



The Federal Reserve also employs a leverage ratio, which is Tier I capital as a percentage of total assets minus certain deductions, including, without limitation, goodwill, mortgage servicing assets, other identifiable intangible assets, and certain deferred tax assets, to be used as a supplement to risk-based guidelines.  The principal objective of the leverage ratio is to constrain the maximum degree to which a bank holding company may leverage its equity capital base.  The Federal Reserve requires a minimum leverage ratio of 3%.  However, for all but the most highly rated bank holding companies and for bank holding companies seeking to expand, the Federal Reserve expects an additional cushion of at least 1% to 2%.

Under regulations adopted by the Federal Reserve and the FDIC, each bank holding company and bank is assigned to one of five capital categories depending on, among other things, its total risk-based capital ratio, Tier I risk-based capital ratio, and leverage ratio, together with certain subjective factors. Institutions which are deemed to be undercapitalized depending on the category to which they are assigned are subject to certain mandatory supervisory corrective actions.  Under these guidelines, the Company and the Bank are each considered well capitalized as of the end of the fiscal year.

ITEM 1A.         Risk Factors

The following are material risks that management believes are specific to our business.  This should not be viewed as an all inclusive list or in any particular order.

The current economic recession in the market areas we serve may continue to adversely impact our earnings and could increase the credit risk associated with our loan portfolio.

Substantially all of our loans are to businesses and individuals in the states of Washington and Oregon.  A continuing decline in the economies of our local market areas could have a material adverse effect on our business, financial condition, results of operations and prospects.  In particular, Washington and Oregon have experienced substantial home price declines and increased foreclosures and has experienced above average unemployment rates, as discussed further under “BUSINESS OVERVIEW” in Item 7 of this report.

Further deterioration or sustained weakness in business and economic conditions in the markets in which we do business could have one or more of the following adverse effects on our business:

An increase in loan delinquencies, problem assets and foreclosures;
A decrease in the demand for loans and other products and services;
An increase or decrease in the usage of unfunded commitments; or
A decrease in the value of loan collateral, especially real estate, which in turn may reduce a customer's borrowing power and significantly increase our exposure to particular loans.



A large percentage of our loan portfolio is secured by real estate, in particular commercial real estate.  Continued deterioration in the real estate market or other segments of our loan portfolio would lead to additional losses, which could have a material adverse effect on our business, financial condition and results of operations.

As of December 31, 2010, approximately 80% of our loan portfolio is secured by real estate, the majority of which is commercial real estate.  As a result of increased levels of commercial and consumer delinquencies and declining real estate values, we have experienced increasing levels of net charge-offs and provision for credit losses.  Past due loans represented 1.9% and 3.3% of total loans outstanding at December 31, 2010 and 2009, respectively.  Net charge-offs totaled $4,075,000 for the year ended December 31, 2010 compared to $6,475,000 in the prior year.  Write-downs on other real estate owned resulting from real estate price depreciation totaled $1,272,000 for the year ended December 31, 2010 compared to $3,689,000 in the prior year.  See "Business Overview" in Part II, Item 7 of this report for further discussion on declining real estate values.  Continued increases in commercial and consumer delinquency levels or continued declines in real estate market values would require increased net charge-offs and increases in the allowance for credit losses, which could have a material adverse effect on our business, financial condition and results of operations.

Future credit losses may exceed our allowance for credit losses.

We are subject to credit risk, which is the risk of losing principal or interest due to borrowers' failure to repay loans in accordance with their terms.  A continued or sustained downturn in the economy or the real estate market in our market areas or a rapid change in interest rates will have a negative effect on borrowers' ability to repay loans and on collateral values.  This deterioration in economic conditions could result in losses to the Company in excess of the allowance for credit losses.  To the extent loans are not paid timely by borrowers, the loans are placed on non-accrual, thereby reducing interest income or even requiring reversals of previously recorded income.  To the extent loan charge-offs exceed our financial models, increased amounts will be charged to the provision for credit losses, which would further reduce income.

Our provision for credit losses remains elevated and we may be required to make further increases in our provision for credit losses and to charge-off additional loans in the future, which could adversely affect our results of operations.

For the year ended December 31, 2010, we recorded a provision for credit losses of $3,600,000, compared to $9,944,000 for the year ended December 31, 2009. We also recorded net loan charge-offs of $4,075,000 for the year ended December 31, 2010 compared to $6,475,000 for the year ended December 31, 2009.  Slower sales in certain market areas, home price depreciation and excess inventory in the housing market have been the primary causes of the increase in delinquencies and foreclosures for residential construction and land development loans, which represent 57.7% of our nonperforming assets at December 31, 2010.

Until general economic conditions improve and if current trends in housing and real estate markets continue, we expect that we will continue to experience higher than normal delinquencies and credit losses. As a result, we experience continued elevated levels of provision for credit losses and charge offs, which could have a material adverse effect on our financial condition and results of operations.  Further, our portfolio contains construction and land loans and commercial and commercial real estate loans, all of which have a higher risk of loss than residential real estate loans.



We continue to hold and acquire a significant amount of other real estate owned (“OREO”) properties, which has led to increased operating expenses and vulnerability to additional declines in the market value of real estate in our areas of operations.
We foreclose on and take title to the real estate serving as collateral for many of our loans as part of our business.  During 2010, we continued to acquire OREO and at December 31, 2010, the Bank had 17 OREO properties with an aggregate book value of $6,580,000.  Large OREO balances have led to increased expenses, as we have incurred costs to manage, maintain, improve in some cases, and dispose of our OREO properties.  We expect that our earnings in 2011 will continue to be negatively affected by various expenses associated with OREO, including personnel costs, insurance and taxes, completion and repair costs, valuation adjustments, and other expenses associated with property ownership.  Also, at the time that we foreclose on a loan and take possession of a property we estimate the value of that property using third party appraisals and opinions and internal judgments.  OREO property is valued on our books at the estimated market value of the property, less the estimated costs to sell (or "fair value").  Upon foreclosure, a charge-off to the allowance for credit losses is recorded for any excess between the value of the asset on our books over its fair value.  Thereafter, we periodically reassess our judgment of fair value based on updated appraisals or other factors, including, at times, at the request of our regulators.  Any further declines in our estimate of fair value for OREO will result in additional charges, with a corresponding expense in our statements of income that is recorded under the line item for "OREO Write-downs."  As a result, our results of operations are vulnerable to additional declines in the market for residential and commercial real estate in the areas in which we operate.  The expenses associated with OREO and any further property write downs could have a material adverse effect on our results of operations and financial condition. We currently have $9,999,000 in nonaccrual loans, which may lead to further increases in our OREO balance in the future.

The number of delinquencies and defaults in residential mortgages have created a backlog in U.S. courts and may lead to an increase in the amount of legislative action that might restrict or delay our ability to foreclose and, therefore, delay the collection of payments for single-family residential loans.

Collateral-based loans on which the Bank forecloses could be delayed by an extended foreclosure process, including delays resulting from a court backlog, local or national foreclosure moratoriums or other delays, and these delays could negatively impact our results of operations.  Homeowner protection laws may also delay the initiation or completion of foreclosure proceedings on specified types of residential mortgage loans. Any such limitations are likely to cause delayed or reduced collections.  Significant restrictions on our ability to foreclose on loans, requirements that we forgo a portion of the amount otherwise due on a loan or requirements that we modify a significant number of original loan terms could negatively impact our business, financial condition, liquidity and results of operations.

We face liquidity risks in the operation of our business and our funding sources may prove insufficient to support growth opportunities or repay deposits.

Liquidity is crucial to the operation of the Company and the Bank.  Liquidity risk is the potential that we will be unable to fund increases in assets or meet payment obligations, including obligations to depositors, as they become due because of an inability to obtain adequate funding or liquidate assets.  For example, funding illiquidity may arise if we are unable to attract core deposits or are unable to renew at acceptable pricing long-term or short-term borrowings.  Illiquidity may also arise if our regulatory capital levels decrease, our lenders require additional collateral to secure our repayment obligations, or a large amount of our deposits are withdrawn.

We rely on customer deposits and advances from the FHLB of Seattle and other borrowings to fund our operations.  Although we have historically been able to replace maturing deposits and advances if desired, we may not be able to replace such funds in the future if our financial condition or the financial condition of the FHLB of Seattle or market conditions were to change.  If we are required to rely more heavily on more expensive funding sources to support operations, our revenues may not increase proportionately to cover our costs.  In this case, our net interest margin would be adversely affected, making it even more difficult for our businesses to operate profitably.



Rapidly changing interest rate environments could reduce our net interest margin, net interest income, fee income and net income.

Interest and fees on loans and securities, net of interest paid on deposits and borrowings, are a large part of our net income.  Interest rates are key drivers of our net interest margin and subject to many factors beyond the control of management.  As interest rates change, net interest income is affected.  Rapid increases in interest rates in the future could result in interest expense increasing faster than interest income because of mismatches in financial instrument maturities.  Further, substantially higher interest rates generally reduce loan demand and may hinder loan growth, particularly in commercial real estate lending, an important factor in the Company's revenue over the past two years.  Decreases or increases in interest rates could reduce the spreads between the interest rates earned on assets and the rates of interest paid on liabilities, and therefore decrease net interest income.

An increase in interest rates, change in the programs offered by secondary market investors or our ability to qualify for their programs may reduce our gain on sale of loans held for sale, which would negatively impact our non-interest income.

The sale of residential mortgage loans classified as loans held for sale provides a significant portion of our non-interest income. Changes in programs applicable to the re-sale of residential mortgages or our eligibility to participate in such programs could materially adversely affect our results of operations. Further, in a rising interest rate environment, our originations of mortgage loans held for sale may decrease, resulting in fewer loans that are available to be sold. This would result in a decrease in gain on sale of loans sold and a corresponding decrease in non-interest income. During periods of reduced loan demand, our results of operations may be further adversely affected if we are unable to reduce our expenses proportionately to the decline in the volume of loan originations and sales.

We may elect or be compelled to seek additional capital in the future, but that capital may not be available when it is needed.

We are required by federal and state regulatory authorities to maintain adequate levels of capital to support our operations.  In addition, we may elect to raise capital to support our business or to finance acquisitions, if any.  Our ability to raise additional capital, if needed, will depend on conditions in the capital markets, economic conditions and a number of other factors, many of which our outside our control, and on our financial performance.  Accordingly, we cannot assure you of our ability to raise additional capital, if needed, on terms acceptable to us, or at all.  If we do raise capital, equity financing may be dilutive to existing shareholders and any debt financing may include covenants or other restrictions that limit our operating flexibility.  If we cannot raise additional capital when needed on favorable terms, it may have a material adverse effect on our financial condition, results of operations and prospects.

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

As discussed more fully in the section entitled "Supervision and Regulation," we are subject to extensive regulation, supervision and examination by federal and state banking authorities.  Additional legislation and regulations that could significantly affect our powers, authority and operations may be enacted or adopted in the future.  Further, regulators have significant discretion and authority to prevent or remedy unsafe or unsound practices or violations of laws or regulations in the performance of their supervisory and enforcement duties.  Any failure to comply with laws, regulations or interpretations could result in sanctions by regulatory agencies or damage to our reputation.  Any changes in applicable regulations or federal, state or local legislation, in regulatory policies or interpretations, or in regulatory approaches to compliance and enforcement could have a substantial impact on us and our operations, for example, by leading to additional fees or taxes or restrictions on our operations.  New or changing laws and regulations and related regulatory actions, or the exercise of regulatory authority, could have a material adverse effect on our financial condition and results of operations.



Financial reform legislation recently enacted by Congress will tighten capital standards, create a new Consumer Financial Protection Bureau and impose restrictions and requirements on financial institutions that could have an adverse effect on our business.

Congress recently enacted the Dodd-Frank Act which will significantly change the current bank regulatory structure and affect the lending, deposit, investment, trading and operating activities of financial institutions and their holding companies.  The Dodd-Frank Act requires various federal agencies to adopt a broad range of new rules and regulations, and to prepare numerous studies and reports for Congress.  The federal agencies are given significant discretion in drafting and implementing rules and regulations, and consequently, many of the details and much of the impact of the Dodd-Frank Act may not be known for many months or years.

Certain provisions of the Dodd-Frank Act are expected to have a near term impact on the Company including the elimination of the federal prohibition on paying interest on demand deposits, and a cap on interchange revenue paid on debit card transactions.  Depending on competitive responses, these significant changes could have an adverse impact on the Company’s interest expense, non-interest income and deposit balances.  It is difficult to predict at this time what the specific impact the Dodd-Frank Act and the yet to be written rules and regulations will have on community banks.  However, it is expected that at a minimum they will increase our operating and compliance costs and reduce some revenue opportunities.  Moreover, compliance obligations will expose us to additional reputational risk in the event of noncompliance and could divert management's focus from the business of banking.  The Bureau of Consumer Protection may reshape laws and regulations relating to financial services to consumers, including both consumer lending and deposit relationships.  These rules and regulations and any related enforcement activities may directly impact the operations of depository institutions, including our Bank.

We rely on dividends from subsidiaries for substantially all of our liquidity.

The Company is a separate and distinct legal entity from the Bank.  The Company receives substantially all of its liquidity from dividends from the Bank.  These dividends are the principal source of funds to pay interest and principal on our debt, other expenses, or dividends on our common stock, if any.  Various federal and/or state laws and regulations limit the amount of dividends that the Bank may pay to the holding company, as may the actions of regulators.  In the event the Bank is unable to pay dividends to the Company, it may not be able to service debt, pay any other obligations or pay dividends on common stock.  The Company did not pay a dividend for 2010 or 2009.

The financial services industry is very competitive.

We face competition in attracting and retaining deposits, making loans, and providing other financial services.  Our competitors include other community banks, larger banking institutions, and a wide range of other financial institutions such as credit unions, government-sponsored enterprises, mutual fund companies, insurance companies and other non-bank businesses.  Many of these competitors have substantially greater resources than we have.  For a more complete discussion of our competitive environment, see "Business-Competition" in Item 1 above.  If we are unable to compete effectively, we will lose market share, including deposits, and face a reduction in our income from our lending activities.



Other-than-temporary impairment charges in our investment securities portfolio could result in significant losses and adversely affect our continuing operations.

We closely monitor our investment securities for changes in credit risk. The valuation of our investment securities also is influenced by external market and other factors, including implementation of Securities and Exchange Commission and Financial Accounting Standards Board guidance on fair value accounting, default rates on residential mortgage securities, rating agency actions, and the prices at which observable market transactions occur. The current market environment significantly limits our ability to mitigate our exposure to valuation changes in our investment securities by selling them. Accordingly, if market conditions deteriorate further and we determine our holdings of our private label mortgage backed securities or other investment securities are other-than-temporarily-impaired our results of operations, shareholders' equity, regulatory capital and financial condition could be materially adversely affected.

We may experience future goodwill impairment, which could reduce our earnings.

We performed our test for goodwill impairment for fiscal year 2010, and no impairment was identified.  Our assessment of the fair value of goodwill is based on an evaluation of current purchase transactions, discounted cash flows from forecasted earnings, our current market capitalization, and a valuation of our assets. Our evaluation of the fair value of goodwill involves a substantial amount of judgment. If our judgment was incorrect and an impairment of goodwill was deemed to exist, we would be required to write down our assets resulting in a charge to earnings, which would have a material effect on our results of operations; however, it would have no impact on our liquidity, operations or regulatory capital.

We may be subject to environmental and other liability risks associated with lending activities.

We foreclose on and take title to real estate in the regular course of our business.  Property ownership increases our expenses due to the costs of managing and disposing of properties.  Although environmental site assessments are completed on properties that are considered an environment risk before such properties are accepted as collateral, there remains a risk that hazardous or toxic substances will be found on properties, in which case we may be liable for remediation costs and related personal injury and property damage and the value of the property may be materially reduced.  In general, the costs and financial liabilities associated with property ownership could have a material adverse effect on our results of operations and financial condition.

Our investment in Federal Home Loan Bank stock may become impaired.

At December 31, 2010, we owned $3,182,000 in FHLB stock.  As a condition of membership at the FHLB, we are required to purchase and hold a certain amount of FHLB stock. Our stock purchase requirement is based, in part, upon the outstanding principal balance of advances from the FHLB and is calculated in accordance with the Capital Plan of the FHLB. Our FHLB stock has a par value of $100, is carried at cost, and it is subject to recoverability testing per accounting guidance for the impairment of long-lived assets. The FHLB currently has a risk-based capital deficiency under the regulations of the Federal Housing Finance Agency (the FHFA), its primary regulator, and has suspended future dividends and the repurchase and redemption of outstanding common stock. The FHLB has communicated that it believes the calculation of risk-based capital under the current rules of the FHFA significantly overstates the market risk of the FHLB's private-label mortgage-backed securities in the current market environment and that it has enough capital to cover the risks reflected in its balance sheet. As a result, we have not recorded an other-than-temporary impairment on our investment in FHLB stock. However, continued deterioration in the FHLB's financial position may result in impairment in the value of those securities. We will continue to monitor the financial condition of the FHLB as it relates to, among other things, the recoverability of our investment.



Our common stock is not listed on a securities exchange and trading in our stock on the OTC Bulletin Board is limited, making it difficult for shareholders to sell shares in open-market transactions.

Our common stock trades in very low trading volumes on the OTC Bulletin Board under the trading symbol "PFLC.OB."  As a result, it may be difficult to liquidate your investment in our shares.  Also, because of this lack of liquidity in the market for our common stock, the quoted price of our common stock from time to time may not reflect its fair value as would be determined in an active trading market.

Our directors and executive officers own a significant percentage of our common stock and this concentration of ownership could adversely affect our other shareholders.

Our directors and executive officers beneficially own approximately 16.7% of our common stock.  As a result, these individuals could, as a group, exert a significant degree of influence over our management and affairs and over matters requiring shareholder approval, in addition to the influence they already have as directors and executive officers.  This concentration of ownership may limit the ability of other shareholders to influence corporate matters and, as a result, we may take actions that our other shareholders do not view as beneficial.  For example, this concentration of ownership could have the effect of delaying or preventing a change in control or otherwise discouraging a potential acquirer from attempting to obtain control of our company, which could limit your ability to sell your shares at a premium in connection with a merger or other transaction resulting in a change in control of our company.

We depend on the accuracy and completeness of information about customers and counterparties.

In deciding whether to extend credit or enter into other transactions, we may rely on information furnished by or on behalf of customers and counterparties, including financial statements, credit reports, and other financial information. We may also rely on representations of those customers, counterparties, or other third parties, such as independent auditors, as to the accuracy and completeness of that information. Reliance on inaccurate or misleading financial statements, credit reports, or other financial information could cause us to enter into unfavorable transactions, which could have a material adverse effect on our financial condition and results of operations.

We rely on other companies to provide key components of our business infrastructure.

Third party vendors provide key components of our business infrastructure such as internet connections, network access and core application processing. While we have selected these third party vendors carefully, we do not control their actions. Any problems caused by these third parties, including as a result of their not providing us their services for any reason or their performing their services poorly, could adversely affect our ability to deliver products and services to our customers and otherwise to conduct our business. Replacing these third party vendors could also entail significant delay and expense.

ITEM 1.B.        Unresolved Staff Comments


ITEM 2.            Properties

The Company's administrative offices are located in Aberdeen, Washington.  The building located at 300 East Market Street is owned by the Bank and houses the main branch.  The administrative offices of the Bank and the Company, which are leased from an unaffiliated third party, are located at 1101 S. Boone Street.


Pacific owns the land and buildings occupied by its fourteen branches in Grays Harbor, Pacific, Skagit, Whatcom and Wahkiakum Counties.  The remaining locations operate in leased facilities, which are leased from unaffiliated third parties.  The aggregate monthly lease payment for all leased space is approximately $32,000.
In addition to the land and buildings owned by Pacific, it also owns all of its furniture, fixtures and equipment, including data processing equipment.    The net book value of the Company's premises and equipment was $15,181,000 at December 31, 2010.

Management believes that the facilities are of sound construction and in good operating condition, are appropriately insured and are adequately equipped for carrying on the business of the Bank.
ITEM 3.  Legal Proceedings

The Company and the Bank from time to time are party to various legal proceedings arising in the ordinary course of business.  Management believes that there are no threatened or pending proceedings against the Company or the Bank which, if determined adversely, would have a material effect on its business, financial condition or results of operations.

ITEM 4.  [Reserved]



ITEM 5.  Market for Registrant's Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities

The Company's common stock is presently traded on the OTC Bulletin Board™ under the trading symbol PFLC.OB.  Historically, trading in our stock has been very limited and the trades that have occurred cannot be characterized as amounting to an established public trading market.  As a result, the trading prices of our common stock may not reflect the price that would result if our stock was actively traded at high volumes.

The following are high and low bid prices quoted on the OTC Bulletin Board during the periods indicated.  The quotations reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not represent actual transactions:

Estimated No.
Estimated No.
Shares Traded
Shares Traded
First Quarter
    48,400     $ 4.20     $ 3.65       79,500     $ 7.50     $ 5.50  
Second Quarter
    24,200     $ 4.95     $ 3.65       79,500     $ 6.25     $ 4.50  
Third Quarter
    29,400     $ 4.45     $ 3.85       30,100     $ 5.60     $ 4.10  
Fourth Quarter
    44,700     $ 5.00     $ 4.01       114,400     $ 4.80     $ 3.65  

As of December 31, 2010, there were approximately 1,148 shareholders of record of the Company's common stock.  Mellon Investor Services LLC serves as the transfer agent for our common stock.

The Company did not declare a dividend in 2010 or 2009. The Board of Directors has adopted a dividend policy which is reviewed annually.  There can be no assurance as to whether or when the Company will pay cash dividends again in the future.

Under federal banking law, the payment of dividends by the Company and the Bank is subject to capital adequacy requirements established by the Federal Reserve and the FDIC.  In addition, payment of dividends by either entity is subject to regulatory limitations.  Under Washington general corporate law as it applies to the Company, no cash dividend may be declared or paid if, after giving effect to the dividend, the Company would not be able to pay its liabilities as they become due or its liabilities exceed its assets.  Payment of dividends on the Common Stock is also affected by statutory limitations, which restrict the ability of the Bank to pay upstream dividends to the Company.  Under Washington banking law as it applies to the Bank, no dividend may be declared or paid in an amount greater than net profits then available, and after a portion of such net profits have been added to the surplus funds of the Bank.

See Note 9 "Junior Subordinated Debentures" to Pacific's audited consolidated financial statements included in Item 15 of this report for a discussion of restrictions on the payment of dividends arising out of Pacific's exercise of its right to defer interest payments on its junior subordinated debentures.

Issuer Purchases of Equity Securities

In January 2008, the Company approved a share repurchase program authorizing the purchase of up to 150,000 shares of its common stock.  There were no purchases of common stock by the Company during the year or quarter ended December 31, 2010.  Cumulatively, the Company has purchased 2,300 shares at an average price of $11.50 per share under the plan.  The maximum number of shares that may yet be purchased under the plan total 147,700 at December 31, 2010.  We have no current intention to purchase stock under our share repurchase program.


ITEM 6.  Selected Financial Data

The following selected consolidated five year financial data should be read in conjunction with the Company's audited consolidated financial statements and the accompanying notes presented in this report.  Dollars are in thousands, except per share data.
As of and For the Year Ended December 31,
Operations Data
Net interest income
  $ 22,879     $ 21,753     $ 21,715     $ 24,503     $ 23,867  
Provision for credit losses
    3,600       9,944       4,791       482       625  
Non-interest income
    8,451       7,025       5,057       4,475       4,176  
Non-interest expense
    26,400       29,691       21,591       20,379       18,118  
Provision (benefit) for income taxes
    (304 )     (4,519 )     (561 )     2,086       2,749  
Net income (loss)
    1,634       (6,338 )     951       6,031       6,551  
Net income (loss) per share:
Basic (1)
  $ 0.16     $ (0.74 )   $ 0.13     $ 0.83     $ 0.92  
Diluted (1)
    0.16       (0.74 )     0.13       0.82       0.90  
Dividends declared
                333       4,955       4,893  
Dividends declared per share (1)
                0.05       0.75       0.75  
Dividend payout ratio
                35 %     82 %     75 %
Performance Ratios
Interest rate spread
    4.10 %     3.76 %     4.23 %     4.92 %     5.13 %
Net interest margin(2)
    3.96 %     3.62 %     4.12 %     4.82 %     5.04 %
Efficiency ratio(3)
    84.26 %     103.17 %     80.65 %     70.33 %     64.61 %
Return on average assets
    0.25 %     (0.96 )%     0.16 %     1.08 %     1.26 %
Return on average equity
    2.77 %     (11.63 )%     1.83 %     11.46 %     13.16 %
Balance Sheet Data
Total assets
  $ 644,403     $ 668,626     $ 625,835     $ 565,587     $ 562,384  
Loans, net
    455,064       471,154       478,695       433,904       420,768  
Total deposits
    544,954       567,695       511,307       467,336       466,841  
Total borrowings
    35,328       39,880       60,757       37,446       36,809  
Shareholders’ equity
    59,769       57,649       50,074       50,699       48,984  
Book value per share (1)
    5.90       5.70       6.84       6.98       6.83  
Tangible book value per share(1)
    4.66       4.44       5.08       5.19       4.99  
Equity to assets ratio
    9.28 %     8.62 %     8.00 %     8.96 %     8.71 %
Asset Quality Ratios
Nonperforming loans to total loans
    2.15 %     3.36 %     3.49 %     1.46 %     1.82 %
Allowance for credit losses to total loans
    2.28 %     2.30 %     1.57 %     1.14 %     0.95 %
Allowance for credit losses to nonperforming loans
    106.18 %     68.49 %     44.97 %     78.10 %     52.30 %
Nonperforming assets to total assets
    2.57 %     3.42 %     3.80 %     1.13 %     1.37 %

(1) Retroactively adjusted for a 1.1 to 1 stock split effective January 13, 2009.
(2) Net interest income divided by average earning assets.
(3) Non-interest expense divided by the sum of net interest income and non-interest income.
(4) Shareholder equity divided by shares outstanding.

ITEM 7.  Management's Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis should be read in conjunction with Pacific's audited consolidated financial statements and related notes appearing elsewhere in this report.  In addition, please refer to Pacific's forward-looking statement disclosure included in Part I of this report.


The following are important factors in understanding the Company financial condition and liquidity:

Total assets at December 31, 2010, decreased by $24,223,000, or 3.6%, to $644,403,000 compared to $668,626,000 at the end of 2009.  Decreases in loans and investments available-for-sale were the primary contributors to overall asset decline, which were partially offset by higher interest-earning deposits with banks.

The Bank remains well capitalized with a total risk-based capital ratio of 14.62% at December 31, 2010, compared to 13.07% at December 31, 2009.  Tier one leverage ratio was 9.80% at December 31, 2010, compared to 9.03% at December 31, 2009.
Asset quality continues to improve with non-performing assets decreasing during 2010 by $6,280,000, or 27.5%, to $16,579,000 at December 31, 2010, the lowest level since 2007.  The decrease was primarily in the non-performing construction and land development sector which accounts for $9,572,000, or 57.7%, of nonperforming assets at December 31, 2010, compared to $14,736,000, or 64.5%, at December 31, 2009.
Construction, land acquisition and other land loans declined $18,556,000, or 28.6%, during 2010.  This segment of the portfolio, totaling $46,256,000 at December 31, 2010, accounts for 9.7% of the total loan portfolio at year-end.
Core deposits, which include demand, savings, money market and certificates of deposits less than $100,000, increased during 2010 by $22,571,000, or 5.7%, to $418,651,000 and comprises 76.8% of total deposits at year-end.  The increase in core deposits was offset by planned decreases during 2010 in retail certificates of deposits and brokered certificates of deposits of $24,144,000 and $31,732,000, respectively, resulting in a net decrease overall in total deposits of $22,741,000, or 4.0%, during 2010.

As a result of core deposit growth, lower borrowings and increased interest bearing deposits with banks, the Company's liquidity ratio of approximately 42% at December 31, 2010, translates into over $270 million in available funding for general operations and to meet loan and deposit needs.
The Company's net income for 2010 was $1,634,000, or $0.16 per diluted share, compared to a net loss of $6,338,000, or $0.74 per diluted share, in 2009.  The following are significant components of the Company's results of operations for 2010 as compared to 2009.

Net interest income increased to $22,879,000 compared to $21,753,000 in 2009 due to decreases in rates paid on deposits and a decrease in non-accrual loans.  Net interest margin for 2010 increased 34 basis points to 3.96% compared to 3.62% in 2009.

The provision for credit losses decreased significantly by $6,344,000, or 63.8%, to $3,600,000 for 2010.  The decrease is the result of overall improvement in credit quality as evidenced by decreases in net charge-offs and impaired loans.  Net charge-offs totaled $4,075,000 during 2010 compared to $6,475,000 in 2009.  Impaired loans totaled $14,673,000 at December 31, 2010 compared to $25,738,000 one year ago.  While credit quality has improved during the year, non-performing loans remain elevated compared to long-term historical levels and remain concentrated primarily in the residential construction and land development loan portfolios.

Non-interest income increased $1,426,000, or 20.3%, to $8,451,000 for 2010 due to increased gain on sales of OREO and service charges on deposit accounts, which were partially offset by a decrease in gain on sales of loans.

Non-interest expense decreased $3,291,000, or 11.1%, to $26,400,000 for 2010.  The decrease is primarily attributable to decreases in FDIC assessments, OREO write-downs, professional services and commissions paid on loans sold in the secondary market.

In 2010, return on average assets and return on average equity increased to 0.25% and 2.77%, respectively, compared to (0.96)% and (11.63)%, respectively, in 2009.


Weak economic conditions and ongoing strains in the financial and housing markets which began in 2008 generally continued in 2009 and 2010 and presented an unusually challenging environment for banks.  The banking industry and the securities markets were materially and adversely affected by significant declines in the value of nearly all asset classes and by a lack of liquidity, especially in late 2008.  In addition, the U.S. economy has been in a recession.  The Company’s financial performance generally, and in particular the ability of borrowers to pay interest on and repay principal of outstanding loans and the value of collateral securing those loans, is highly dependent on the economy in our markets.  The continued economic downturn, and more specifically the slowdown in residential real estate sales, has resulted in further uncertainty.  The result has been an increase in loan delinquencies and foreclosures, primarily in our residential construction and land development portfolios as compared to prior periods.  In addition, the Company has experienced elevated charge-offs, significantly higher levels of provision for credit losses and higher nonperforming loan levels compared to the Company’s longer term historical record.

According to the U.S. Bureau of Labor Statistics, the unemployment rate in Washington was 9.3% at December 31, 2010 compared to 9.2% in 2009, 6.5% in 2008 and 4.8% in 2007, and in Oregon the unemployment rate was 10.6% for 2010 and 2009, compared to 8.3% in 2008 and 5.56% in 2007.  The unemployment rate in Oregon is higher than the national unemployment rate of 9.4% at December 31, 2010.  According to the Washington State Employment Security Department unemployment rates in Grays Harbor, Pacific, Skagit, Wahkiakum and Whatcom counties at December 31, 2010 were 13.1%, 11.8%, 10.3%, 13.8% and 8.1%, respectively, compared to 13.4%, 12.1%, 10.8%, 14.2%, and 8.3% in 2009, respectively, and 11.3%, 9.9%, 8.0%, 9.6%, and 6.2%, respectively, in 2008.  Excluding Whatcom County, all Washington counties in which the Company operates have unemployment rates greater than the state and national rates.  According to the Oregon Employment Department, the unemployment rate for Clatsop County increased from 7.2% in 2008 to 9.0% in 2009 and 10.0% at December 31, 2010.

Closed sales activity had been on a declining trend for the last three years; however it is beginning to rebound in 2010 in selective counties within our geographic footprint.  Year over year changes in closed sales activity in Grays Harbor, Skagit and Whatcom counties were 10.3%, 11.3%, and (7.2)%, respectively, during 2010.  Sales prices of single-family homes and condominiums have increased in 2010 in the same counties by 11.0%, 1.2%, and 10.2%, respectively, after consistently declining since 2007.  Limited data is available on sales activity and sales prices for Pacific, Wahkiakum and Clatsop counties.

Commercial real estate has performed better than residential real estate, but is generally affected by a slow economy as well.  As a result, sales of commercial real estate properties have experienced a significant decline, which in Whatcom County totaled $255 million in 2007, compared to $195 million in 2008 and $114 million in 2009.  Sales rebounded slightly in 2010 to $135 million; however, results are still indicative of the high level of illiquidity that exists in the market.  Limited data is available on commercial real estate in the smaller, more rural counties in which we operate.  In this depressed real estate market, the Company has experienced a decline in the values of real estate collateral underlying its loans, including construction real estate and land acquisition and development loans, resulting in increased loan delinquencies and defaults and higher levels of provision for credit losses and net charge-offs.

In late 2009, we determined that in order to achieve long-term growth and accomplish our long-term financial objectives we needed to successfully execute six defined long-term strategies.  These strategies for 2010 and corresponding results in 2010 are as follows:

Improve asset quality by proactively managing problem assets, selectively reducing loan concentrations, selling OREO and managing credit exposures.  Non-performing assets decreased in 2010 to $16,579,000, or 2.57% of total assets, compared to $22,859,000, or 3.42% of non-performing assets in 2009.  Additionally, net charge-offs, provision for credit losses, and OREO write-downs all showed significant improvement as stated above under “EXECUTIVE OVERVIEW” during 2010.

Maintain capital ratios by controlling the asset growth rate, producing positive returns to shareholders and utilizing government guarantees in connection with new loan originations.  Capital ratios increased during the year due to a combination of earnings retention and a decrease in total average assets and an increase in government guaranteed loans.

Improve net interest margin by reinvesting short-term cash and cash equivalents into higher yielding assets, reducing loans on non-accrual status and growing low cost deposits.  Net interest margin increased from 3.62% in 2009 to 3.96% for the year ended December 31, 2010.

Maintain a strong liquidity position through increased core deposit balances and borrowing facilities available through the FHLB and the Federal Reserve Bank (“FRB”).  Interest-bearing cash balances and federal funds sold increased $14.3 million, or 35.6%, during 2010 to $54,330,000.  Credit facilities with the FHLB and FRB are fully secured and remain an important source of liquidity.

Reduce controllable operating expenses through fiscal restraint and increased emphasis on non-interest income.  Non-interest income increased $1,426,000, or 20.3%, to $8,451,000 during 2010 compared to the prior year.  In addition, total non-interest expense decreased $3,291,000, or 11.1%, to $26,400,000 during 2010 compared to the prior year.

Grow core areas of the balance sheet including commercial real estate and commercial loans and retail deposits through the quality and breadth of our branch network, superior sales practices, competitive rates, and an emphasis on customer and employee satisfaction, which would enable us to exploit local market opportunities.  The Company focused on growing demand, money market and savings deposit balances during 2010 which combined increased $33,135,000, or 10.5%, during the year.  This was offset by a planned reduction in brokered deposits and other higher costing retail certificates of deposits totaling $55,876,000.  This change in the mix of our deposits contributed to an improvement in costs of funds as the decline in certificates of deposits was replaced by lower cost deposit products.  Commercial real estate loan balances increased $10,831,000, or 5.3%, during 2010; however commercial and agricultural loan balances decreased $8,550,000, or 9.2%, during the same period.  Pricing for commercial loans has been extremely competitive.  Additionally, there has been a decrease in loan demand during this current economic recession.

Operating strategies for 2011 are as follows:

Continue to improve asset quality through proactive management of problem loans, monitoring existing performing loans, and selling OREO properties.

Increase net interest margin through reinvestment of short-term cash and cash equivalents into higher yielding loans and a reduction in rates paid on junior subordinated debentures.

Increase core deposits and other retail deposits.  Continue to focus on total customer banking relationships and superior customer service.  In addition to our retail branch network, we maintain an excellent suite of cash management services including business remote check deposits, positive pay, payroll services and automated clearing house services that give us a competitive advantage over smaller institutions and enables us to compete with larger banks operating in our market areas.

Expand our presence within our existing market areas with strategic emphasis on northern Clatsop County, Oregon and Skagit County, Washington.  In addition to these areas, we believe the consolidation of problem financial institutions in Western Washington will provide opportunities to increase market share for locally owned community institutions with local decision making authority, such as Bank of the Pacific.

The degree to which we will be able to execute on these strategies will depend to a large degree on the local and national economy, improvement in the local markets for residential real estate, and limited deterioration in the credit quality of our commercial real estate loans.


Years ended December 31, 2010, 2009, and 2008

General.  The following table presents condensed consolidated statements of income for the Company for each of the years in the three-year period ended December 31, 2010.

(dollars in thousands)
Interest and dividend income
  $ 30,860     $ (1,960 )     (6.0 )   $ 32,820     $ (893 )     (2.7 )   $ 33,713  
Interest expense
    7,981       (3,086 )     (27.9 )     11,067       (931 )     (7.8 )     11,998  
Net interest income
    22,879       1,126       5.2       21,753       38       0.2       21,715  
Provision for credit losses
    3,600       (6,344 )     (63.8 )     9,944       5,153       107.6       4,791  
Net interest income after provision for credit losses
    19,279       7,470       63.3       11,809       (5,115 )     (30.2 )     16,924  
Other operating income
    8,451       1,426       20.3       7,025       1,968       38.9       5,057  
Other operating expense
    26,400       (3,291 )     (11.1 )     29,691       8,100       37.5       21,591  
Income (loss) before income taxes
    1,330       12,187       112.3       (10,857 )     (11,247 )     (2,883.8 )     390  
Income taxes (benefit)
    (304 )     4,215       93.3       (4,519 )     (3,958 )     705.5       (561 )
Net income (loss)
  $ 1,634     $ 7,972       125.8     $ (6,338 )   $ (7,289 )     (766.5 )   $ 951  

Net income.  For the year ended December 31, 2010, net income (loss) was $1,634,000 compared to $(6,338,000) in 2009.  Our net income in 2008 was $951,000 for the same period.  The increase in net income for 2010 was primarily due to increased net interest income and decreased provisions for credit losses and OREO write-downs.

Net Interest Income.  The Company derives the majority of its earnings from net interest income, which is the difference between interest income earned on interest earning assets and interest expense incurred on interest bearing liabilities.  The Company's net interest income is affected by the change in the level and mix of interest-earning assets and interest-bearing liabilities, referred to as volume changes.  The Company's net interest income is also affected by changes in the yields earned on assets and rates paid on liabilities, referred to as rate changes.  Interest rates charged on loans are affected principally by the demand for such loans, the supply of money available for lending purposes and competitive factors.  Those factors are, in turn, affected by general economic conditions and other factors beyond the Company's control, such as federal economic policies, legislative tax policies and actions by the Federal Open Market Committee of the Federal Reserve (FOMC).  Interest rates on deposits are affected primarily by rates charged by competitors and actions by the FOMC.

The FOMC heavily influences market interest rates, including deposit and loan rates offered by many financial institutions.  Also, as rates near zero, it becomes more difficult to match decreases in rates on interest earning assets with decreases in rates paid on interest bearing liabilities.  Approximately 78% of the Company's loan portfolio is tied to short-term rates, and therefore, re-price immediately when interest rate changes occur.  The Company's funding sources also re-price when rates change; however, there is a meaningful lag in the timing of the re-pricing of deposits as compared to loans and decreases in interest rates become less easily matched by decreases in deposit rates as rates approach zero.  Because of its focus on commercial lending, the Company will continue to have a high percentage of floating rate loans.  The Company anticipates that the low rate environment will continue to put pressure on yields on loans; however, management expects that decreases in rates paid on deposits and junior subordinated debentures will result in some increase in net interest margin in 2011.

The following table sets forth information with regard to average balances of interest earning assets and interest bearing liabilities and the resultant yields or cost, net interest income, and the net interest margin.
Year Ended December 31,
          Interest                 Interest        
(dollars in thousands)
Earning assets:
Loans (1)
  $ 485,872     $ 28,835       5.93 %   $ 500,796     $ 30,065       6.00 %   $ 471,338     $ 31,385       6.66 %
Investment securities:
    26,451       1,235       4.67       35,085       1,868       5.32       31,090       1,648       5.30  
Tax-Exempt (1)
    24,421       1,498       6.13       25,033       1,580       6.31       19,440       1,193       6.14  
Total investment securities
    50,872       2,733       5.37       60,118       3,448       5.74       50,530       2,841       5.62  
Federal Home Loan Bank Stock
    3,183                   3,135                   2,022       19       0.94  
Federal funds sold and deposits in banks
    37,885       116       0.31       36,610       109       0.30       3,787       44       1.16  
Total earnings assets / interest income
  $ 577,812     $ 31,684       5.48 %   $ 600,659     $ 33,622       5.60 %   $ 527,677     $ 34,289       6.50 %
Cash and due from banks
    10,399                       10,470                       11,454                  
Premises and equipment (net)
    15,580                       16,402                       16,522                  
Other real estate owned
    8,071                       9,327                       1,587                  
Other assets
    43,782                       34,886                       33,361                  
Allowance for credit losses
    (11,413 )                     (9,621 )                     (5,875 )                
Total assets
  $ 644,231                     $ 662,123                     $ 584,726                  
Liabilities and Shareholders' Equity
Interest bearing liabilities:
Savings and interest-bearing demand
  $ 238,123     $ (1,729 )     0.73 %   $ 210,004     $ (1,803 )     0.86 %   $ 204,539     $ (2,903 )     1.42 %
Time certificates
    220,618       (4,845 )     2.20       266,929       (7,461 )     2.80       186,319       (6,891 )     3.70  
Total deposits
    458,741       (6,574 )     1.43       476,933       (9,264 )     1.94       390,858       (9,794 )     2.51  
Short-term borrowings
    7,502       (204 )     2.72       3,107       (26 )     0.84       13,398       (349 )     2.61  
Long-term borrowings
    15,674       (645 )     4.12       31,660       (1,164 )     3.68       26,336       (991 )     3.76  
Secured borrowings
    951       (61 )     6.41       1,326       (75 )     5.66       1,387       (94 )     6.78  
Junior subordinated debentures
    13,403       (497 )     3.71       13,403       (538 )     4.01       13,403       (770 )     5.74  
Total borrowings
    37,530       (1,407 )     3.75       49,496       (1,803 )     3.64       54,524       (2,204     4.04  
Total interest-bearing liabilities/ Interest expense
  $ 496,271     $ (7,981 )     1.61 %   $ 526,429     $ (11,067 )     2.10 %   $ 445,382     $ (11,998 )     2.69 %
Demand deposits
    84,556                       77,282                       82,620                  
Other liabilities
    4,361                       3,900                       4,750                  
Shareholders' equity
    59,043                       54,512                       51,974                  
Total liabilities and shareholders' equity
  $ 644,231                     $ 662,123                     $ 584,726                  
Net interest income (1)
          $ 23,703                     $ 22,555                     $ 22,291          
Net interest income as a percentage of average earning assets
Interest income
                    5.48 %                     5.60 %                     6.50 %
Interest expense
                    1.38 %                     1.84 %                     2.27 %
Net interest income
                    4.10 %                     3.76 %                     4.23 %
Net interest margin (2)
                    3.96 %                     3.62 %                     4.12 %
Tax equivalent adjustment (1)
          $ 824                     $ 802                     $ 576          

(1)  Interest earned on tax-exempt loans and securities has been computed on a 34% tax equivalent basis.
(2)  Net interest income divided by average interest earning assets.

For purposes of computing the average rate, the Company used historical cost balances which do not give effect to changes in fair value that are reflected as a component of shareholders' equity.  Nonaccrual loans and loans held for sale are included in "loans."  Interest income on loans includes loan fees of $575,000, $888,000, and $1,132,000 in 2010, 2009, and 2008, respectively.

Net interest income on a tax equivalent basis totaled $23,703,000 for the year ended December 31, 2010, an increase of $1,148,000, or 5.1%, compared to 2009.  Net interest income on a tax equivalent basis increased 1.2% to $22,555,000 in 2009 compared to 2008.  The Company's tax equivalent interest income decreased 5.8% to $31,684,000 in 2010, from $33,622,000 in 2009 and $34,289,000 in 2008.  The decrease in interest income in 2010 and 2009 was primarily due to the decline in yield earned on our loan and investment portfolios; however, this decline was more than offset by decreases in interest expense during the year.

Average interest earning balances with banks at December 31, 2010, were $37.9 million with an average yield of 0.31% compared to $36.6 million with an average yield of 0.30% for the same period in 2009.  The increase in average interest earning balances with banks is mostly due to the increase in cash balances resulting from sales of investment securities in 2010 and from deposit growth in 2009.  Net interest margin was negatively affected by increased levels of interest bearing cash invested at relatively low yields.

The Company's average loan portfolio decreased $14,924,000, or 3.0%, from year end 2009 to year end 2010, and increased $29,458,000, or 6.2%, from 2008 to 2009.  The decrease in 2010 is due to decreases in construction and land development loans and commercial loans, which were partially offset by an increase in commercial real estate loan balances outstanding.  The increase in average loans in 2009 was the result of new loan volume generated in commercial real estate loans and home equity lines of credit.  Average loan growth in 2010 was slower than historical trends primarily as a result of lower demand for financing in the Bank's market areas due to a sluggish economy.  Overall, loan demand remains soft in the current economic recession.

The Company's average investment portfolio decreased $9,246,000, or 15.4%, from 2009 to 2010, and increased $9,588,000, or 19.0%, from 2008 to 2009.  Interest and dividend income on investment securities for the year ended December 31, 2010 decreased $715,000, or 20.7%, compared to the same period in 2009.  The average yield on investment securities decreased to 5.37% at December 31, 2010, from 5.74% at December 31, 2009 and 5.62% at year-end 2008.  The decrease in 2010 is due primarily to the reduction in rates earned on adjustable rate mortgage-backed securities and the maturity and sale of higher yielding securities that cannot be replaced in the current low rate environment.

The Company's average interest-bearing deposits decreased $18,192,000, or 3.8%, from 2009 to 2010, and increased $86,075,000, or 22.0%, in 2009 from 2008.  The Company attributes the decrease in 2010 to the planned runoff of brokered certificates of deposits which was partially offset by growth in all other deposit categories.  The growth in 2009 was due to increases in brokered certificates of deposits to replace maturing public funds as well as retail deposit growth in the markets we serve.  Even though the Company offers a wide variety of retail deposit products to both consumer and commercial customers, future deposit growth will be challenging as the Company anticipates increased deposit regulations stemming from the Dodd-Frank Act.

Average borrowings decreased during 2010 by $11,966,000, or 24.2%, and decreased by $5,028,000, or 9.2%, during 2009.  Short-term borrowings in 2010 represent FHLB term borrowings which have been reclassified as short-term borrowings due to scheduled maturity dates within one year.  The decrease in average borrowing balances outstanding in 2009 was primarily due to the payoff of short-term borrowings which was funded by growth in lower cost demand, money market and savings accounts.

Interest expense for the year ended December 31, 2010 decreased $3,086,000, or 27.9%, compared to the same period in 2009.  The 2010 average rate paid on deposits declined to 1.43% from 2009 primarily due to a decrease in rates paid on time certificates of deposits.  The decrease in interest expense for borrowings is attributable to maturities of long-term advances and continued rate reductions on $8.2 million in variable rate junior subordinated debentures which is tied to the three month London Interbank Officer Rate, which has decreased considerably since 2008.  The Company's overall cost of interest-bearing liabilities decreased to 1.61% in 2010 from 2.10% and 2.69% in 2009 and 2008, respectively.

The net interest margin increased to 3.96% for the year ended December 31, 2010, up from 3.62% in the prior year.  This was mainly due to an improvement in the average cost of funds to 1.61% at December 31, 2010 from 2.10% one year ago, that was only partially offset by a decline in the Company’s average yield earned on assets from 5.60% for year ended December 31, 2009 to 5.48% for the current period.  In addition, decreasing levels of nonperforming loans placed on nonaccrual status have also positively affected our net interest margin in 2010.  In 2009, the net interest margin decreased 50 basis points to 3.62% in 2009 from 4.12% in 2008 as a result of declining loan yields caused by materially lower market interest rates which we were unable to fully offset by reducing rates paid on deposits and borrowings.  The reversal of interest income on loans placed on non-accrual status also contributed to the margin compression and reduced net interest income in 2009.

The following table presents changes in net interest income attributable to changes in volume or rate.  Changes not solely due to volume or rate are allocated to volume and rate based on the absolute values of each.
2010 compared to 2009
2009 compared to 2008
Increase (decrease) due to
Increase (decrease) due to
(dollars in thousands)
Interest earned on:
  $ (889 )   $ (341 )   $ (1,230 )   $ 2,170     $ (3,490 )   $ (1,320 )
    (422 )     (211 )     (633 )     212       8       220  
    (38 )     (44 )     (82 )     352       35       387  
Total securities
    (460 )     (255 )     (715 )     564       43       607  
Federal Home Loan Bank stock
                      7       (26 )     (19 )
Fed funds sold and interest bearing deposits in other banks
    4       3       7       120       (55 )     65  
Total interest earning assets
    (1,345 )     (593 )     (1,938 )     2,861       (3,528 )     (667 )
Interest paid on:
Savings and interest bearing demand deposits
    (224 )       298         74       (76 )       1,176         1,100  
Time deposits
    1,170       1,446       2,616       (2,516 )     1,946       (570 )
Total borrowings
    447       (51 )     396       194       207       401  
Total interest bearing liabilities
    1,393       1,693       3,086       (2,398 )     3,329       931  
Change in net interest income
  $ 48     $ 1,100     $ 1,148     $ 463     $ (199 )   $ 264  

Non-Interest Income.  Non-interest income was $8,451,000 for 2010, an increase of $1,426,000, or 20.3%, from 2009 when it totaled $7,025,000. The 2009 amount increased $1,968,000, or 38.9%, compared to the 2008 total of $5,057,000.  The increase in 2010 was primarily a result of increased gains on sale of OREO, increased service charges on deposits and increased earnings related to bank owned life insurance (BOLI).  The increase in 2009 was attributable to increased gains on sale of loans held for sale, increased service charges on deposits accounts and net gains on sales of investment securities.

The following table represents the principal categories of non-interest income for each of the years in the three-year period ended December 31, 2010.


(dollars in thousands)
Service charges on deposit accounts
  $ 1,783     $ 134       8.1     $ 1,649     $ 72       4.6     $ 1,577  
Net gain (loss) on sale of other real estate owned
    260       1,678       118.3       (1,418 )     (1,808 )     (463.6 )     390  
Net gains on sales of loans
    4,168       (470 )     (10.1 )     4,638       3,212       225.3       1,426  
Net gains (loss) on sales of securities
    422       (62 )     (12.8 )     484       649       393.3       (165 )
Earnings on bank owned life insurance
    541       52       10.6       489       (118 )     (19.4 )     607  
Other operating income
    1,277       94       7.9       1,183       (39 )     (3.2 )     1,222  
Total non-interest income
  $ 8,451     $ 1,426       20.3     $ 7,025     $ 1,968       38.9     $ 5,057  

Service charges on deposits increased 8.1% and 4.6% during 2010 and 2009, respectively.  The Company continues to emphasize the importance of exceptional customer service and believes this emphasis, together with the implementation of an automated overdraft privilege program in April 2010, contributed to the increase in service charge revenue in 2010.  However, with overdraft regulations requiring opt-in provisions effective August 2010 and pending FDIC legislation regarding overdraft rules, management does not expect future growth in overdraft revenue.

The Company continues to sell long-term fixed and adjustable rate residential real estate loans into the secondary market to generate non-interest income.  The $470,000 decrease in income from gains on sales of loans in 2010 was primarily due to the expiration of government incentive programs during the current period and a decrease in the volume of loans sold.  The $3,212,000 increase in income from gains on sales of loans in 2009 was primarily a result of an increase in the volume of residential mortgage loans sold in the secondary market for the year ended December 31, 2009.  The sale of one-to-four family mortgage loans totaled $215.5 million for the year ended December 31, 2010, as compared to $276.7 million for the year ended December 31, 2009, and $99.7 million for the year ended December 31, 2008.  The increase in 2009 was attributable to historically low interest rates for 30-year fixed rate loans and government incentive programs such as the $8,000 tax credit for first time home buyers, which increased mortgage and refinance activity and was not considered sustainable.  Management expects gains on sale of loans to decrease in 2011 from their peak in 2009 due to recent increases in long-term mortgage rates, thereby reducing refinancing activity, which may be only partially offset by any real estate market stabilization.

Net gains on sale of OREO totaled $260,000 for the year ended December 31, 2010 compared to net losses on the sale of OREO of $1,418,000 for the year ended December 31, 2009.  During 2010, the Company successfully liquidated seventeen properties with a carrying value of $6.9 million.  During the fourth quarter of 2009, the Company completed a bulk sale of 36 improved residential OREO properties for a net loss on sale of $1,418,000.  Management felt this was prudent in view of the one time net operating loss five year carry-back rule that was applicable in 2009 for tax purposes, the improved credit quality of the balance sheet that resulted, and the cost savings resulting from the elimination of burdensome operating and maintenance costs of the properties, including taxes, insurance, and home-owner dues.  In 2008, net gain on sale of OREO included the sale of one commercial lot located in Whatcom County, Washington for a gain of $390,000.
Income from other sources totaled $2,240,000 in 2010, an increase of $84,000 from 2009, or 3.9%, due primarily to increases in visa debit card interchange revenue and earnings on BOLI, which were partially offset by a decrease in net gains on sale of investment securities.  Income from other sources in 2009 increased $492,000, or 29.6%, to $2,156,000 as the result of increases in interchange revenue and miscellaneous fees on loans held for sale which was offset by a decrease in earnings on BOLI due to lower earnings credit rates caused by a market decline in interest rates.

Non-Interest Expense.  Total non-interest expense in 2010 was $26,400,000, a decrease of $3,291,000, or 11.1%, compared to $29,691,000 in 2009.  In 2009, non-interest expense increased $8,100,000, or 37.5%, compared to $21,591,000 in 2008.  The decrease in 2010 was primarily attributable to decreases in FDIC insurance assessments, OREO write-downs, and salaries and employee benefits (including commissions).  The increase in 2009 was due to increases in expenses for FDIC insurance assessments, OREO write-downs and salaries and employee benefits (including commissions).

The following table shows the principal categories of non-interest expense for each of the years in the three-year period ended December 31, 2010.

(dollars in thousands)
Salaries and employee benefits
  $ 13,530     $ (28 )     (0.2 )   $ 13,558     $ 1,177       9.5     $ 12,381  
Occupancy and equipment
    2,766       (13 )     (0.5 )     2,779       (76 )     (2.7 )     2,855  
State taxes
    480       44       10.1       436       70       19.1       366  
Data processing
    1,247       1       0.1       1,246       482       63.1       764  
Professional services
    767       (99 )     (11.4 )     866       (55 )     (6.0 )     921  
FDIC and state assessments
    1,361       (441 )     (24.5 )     1,802       1,588       742.1       214  
OREO write-downs
    1,272       (2,417 )     (65.5 )     3,689       3,689       n/a        
OREO operating expenses
    614       107       21.1       507       419       476.1       88  
Marketing and advertising
    409       14       3.5       395       (133 )     (25.2 )     528  
Other expense
    3,954       (459 )     (10.4 )     4,413       939       27.0       3,474  
Total non-interest expense
  $ 26,400     $ (3,291 )     (11.1