WASHINGTON BANKING CO - FORM 10-Q

Attached files

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EX-32.2 - CFO SOX SECTION 906 CERTIFICATION - WASHINGTON BANKING CO	ex32-2.htm
EX-32.1 - CEO SOX SECTION 906 CERTIFICATION - WASHINGTON BANKING CO	ex32-1.htm
EX-31.1 - CEO SOX SECTION 302 CERTIFICATION - WASHINGTON BANKING CO	ex31-1.htm
EX-31.2 - CFO SOX SECTION 302 CERTIFICATION - WASHINGTON BANKING CO	ex31-2.htm

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended March 31, 2011

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

For the transition period from ________ to ________

Commission File Number 000-24503

WASHINGTON BANKING COMPANY

(Exact name of registrant as specified in its charter)

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

450 SW Bayshore Drive

Oak Harbor, Washington 98277

(Address of principal executive offices) (Zip Code)

(360) 679-3121

(Registrant’s telephone number, including area code)

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

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes [X] No [ ]

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 229.405 of this chapter) 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 the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer [ ]

Accelerated filer [X]

Non-Accelerated filer [ ]

Smaller reporting company [ ]

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

The number of shares of the issuer’s Common Stock outstanding at May 3, 2011 was 15,333,027.

PART I - FINANCIAL INFORMATION
				Page
Item 1.	Financial Statements
		Condensed Consolidated Statements of Financial Condition (unaudited)
			March 31, 2011 and December 31, 2010	1

		Condensed Consolidated Statements of Income (unaudited)
			Three Months Ended March 31, 2011 and 2010	2

		Condensed Consolidated Statements of Shareholders' Equity and Comprehensive
			Income (unaudited) Three Months Ended March 31, 2011 and 2010	3

		Condensed Consolidated Statements of Cash Flows (unaudited)
			Three Months Ended March 31, 2011 and 2010	4

		Notes to Condensed Consolidated Financial Statements		6

Item 2.	Management's Discussion and Analysis of Financial Condition and Results of Operations			36

Item 3.	Quantitative and Qualitative Disclosures about Market Risk			56

Item 4.	Controls and Procedures			56

PART II - OTHER INFORMATION

Item 1.	Legal Proceedings			57

Item 1A.	Risk Factors			57

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds			57

Item 3.	Defaults Upon Senior Securities			57

Item 4.	(Removed and Reserved)			57

Item 5.	Other Information			57

Item 6.	Exhibits			58

	Signatures			59

Table of Contents

WASHINGTON BANKING COMPANY AND SUBSIDIARY

Condensed Consolidated Statements of Condition (unaudited)

(Dollars in thousands, except per share data)

	March 31,			December 31,
	2011			2010
Assets
Cash and due from banks	$	24,349		$	19,766
($5,274 and $2,748, respectively, are restricted)
Interest-bearing deposits		102,237			61,186
Federal funds sold		1,100			735
Total cash, restricted cash and cash equivalents		127,686			81,687
Investment securities available for sale, at fair value		183,378			199,556
Federal Home Loan Bank stock		7,576			7,576
Loans held for sale		3,455			10,976
Non-covered loans, net of allowance for loan losses		807,498			815,481
Covered loans, net of allowance for loan losses		340,290			364,817
Total loans, net of allowances for loan losses		1,147,788			1,180,298
Premises and equipment, net		37,715			37,847
Bank owned life insurance		17,282			17,202
Goodwill and other intangible assets, net		7,383			7,540
Non-covered other real estate owned		4,845			4,122
Covered other real estate owned		28,826			29,766
FDIC indemnification asset		96,863			107,896
Other assets		20,590			20,021
Total assets	$	1,683,387		$	1,704,487
Liabilities and Shareholders' Equity
Liabilities:
Deposits
Noninterest-bearing demand	$	188,583		$	184,098
Interest-bearing		1,305,930			1,308,122
Total deposits		1,494,513			1,492,220

Junior subordinated debentures		25,774			25,774
Other liabilities		5,975			4,847
Total liabilities		1,526,262			1,522,841
Commitments and contingencies (See Note 14)
Shareholders' Equity:
Preferred stock, no par value; 26,380 shares authorized
Series A (liquidiation preference $1,000 per share); no shares issued
and outstanding at March 31, 2011 and 26,380 at December 31, 2010		-			25,334
Common stock, no par value; 35,000,000 shares authorized; 15,333,073 and
15,321,277 shares issued and outstanding at March 31, 2011 and
December 31, 2010, respectively		83,869			85,264
Retained earnings		73,533			71,307
Accumulated other comprehensive loss		(277	)		(259	)
Total shareholders' equity		157,125			181,646
Total liabilities and shareholders' equity	$	1,683,387		$	1,704,487

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WASHINGTON BANKING COMPANY AND SUBSIDIARY

Condensed Consolidated Statements of Income (unaudited)

(Dollars in thousands, except per share data)

	Three Months Ended
	March 31,
	2011			2010
Interest income:
Interest and fees on non-covered loans	$	12,640		$	13,085
Interest and fees on covered loans		8,310			-
Interest on taxable investment securities		793			413
Interest on tax-exempt investment securities		210			158
Other		45			36
Total interest income		21,998			13,692
Interest expense:
Interest on deposits		2,591			2,503
Interest on other borrowed funds		-			91
Interest on junior subordinated debentures		120			117
Total interest expense		2,711			2,711
Net interest income		19,287			10,981
Provision for loan losses, non-covered loans		3,000			2,150
Net interest income after provision for loan losses		16,287			8,831
Noninterest income:
Service charges and fees		993			735
Electronic banking income		556			367
Investment products		222			50
Bank owned life insurance income		80			82
Income from the sale of mortgage loans		338			141
SBA premium income		121			46
Change in FDIC indemnification asset		(1,316	)		-
Gain on disposition of covered assets		2,218			-
Other		520			322
Total noninterest income		3,732			1,743
Noninterest expense:
Salaries and benefits		6,819			4,329
Occupancy and equipment		1,667			1,027
Office supplies and printing		330			210
Data processing		470			211
Consulting and professional fees		444			268
Intangible amortization		157			-
Merger related expenses		119			-
FDIC premiums		589			252
Non-covered OREO and repossession expenses		300			193
Covered OREO and repossession expenses		770			-
Other		2,391			1,285
Total noninterest expense		14,056			7,775
Income before provision for income taxes		5,963			2,799
Provision for income taxes		1,887			804
Net income before preferred dividends		4,076			1,995
Preferred stock dividends and discount accretion		1,084			414
Net income available to common shareholders	$	2,992		$	1,581
Net income available per common share, basis	$	0.20		$	0.10
Net income available per common share, diluted	$	0.19		$	0.10
Average number of common shares outstanding, basis		15,329,000			15,297,000
Average number of common shares outstanding, diluted		15,467,000			15,430,000

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WASHINGTON BANKING COMPANY AND SUBSIDIARY

Condensed Consolidated Statements of Shareholders’ Equity and

Comprehensive Income (unaudited)

(Dollars and shares in thousands, except per share data)

												Accumulated
	Preferred											other			Total
	stock			Common stock					Retained			comprehensive			shareholders'
	amount			Shares		Amount			earnings			income (loss)			equity
Balance at December 31, 2009	$	24,995			15,298	$	84,814		$	49,463		$	249		$	159,521
Comprehensive income:
Net income		-			-		-			1,995			-			1,995
Net change in unrealized gain
(net of tax expense of $168)		-			-		-			-			307			307
Total comprehensive income																2,302
Preferred stock dividend and accretion		85			-		-			(414	)		-			(329	)
Cash dividends on common stock,
$0.025 per share		-			-		-			(382	)		-			(382	)
Stock-based compensation expense		-			-		77			-			-			77
Issuance of common stock under stock plans		-			5		3			-			-			3
Balance at March 31, 2010	$	25,080			15,303	$	84,894		$	50,662		$	556		$	161,192

Balance at December 31, 2010	$	25,334			15,321	$	85,264		$	71,307		$	(259	)	$	181,646
Comprehensive income:
Net income		-			-		-			4,076			-			4,076
Net change in unrealized gain
(net of tax expense of $9)		-			-		-			-			(18	)		(18	)
Total comprehensive income																4,058
Redemption of preferred stock issued to
U.S. Treasury		(26,380	)		-		-			-			-			(26,380	)
Repurchase of warrant issued to U.S. Treasury		-			-		(1,625	)		-			-			(1,625	)
Preferred stock dividend and accretion		1,046			-		-			(1,084	)		-			(38	)
Cash dividends on common stock,
$0.05 per share		-			-		-			(766	)		-			(766	)
Stock-based compensation expense		-			-		218			-			-			218
Issuance of common stock under stock plans		-			12		7			-			-			7
Tax benefit associated with stock awards		-			-		5			-			-			5
Balance at March 31, 2011	$	-			15,333	$	83,869		$	73,533		$	(277	)	$	157,125

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WASHINGTON BANKING COMPANY AND SUBSIDIARY

Condensed Consolidated Statements of Cash Flows (unaudited)

(Dollars in thousands)

	Three Months Ended
	March 31,
	2011			2010
Cash flows from operating activities:
Net income	$	4,076		$	1,995
Adjustments to reconcile net income to net cash provided by
operating activities:
Amortization of investment security discounts, net		173			93
Depreciation		493			388
Intangible amortization		157			-
Provision for loan losses, non-covered loans		3,000			2,150
Earnings on bank owned life insurance		(80	)		(82	)
Net gain on sale of premises and equipment		(85	)		-
Net loss on sale of non-covered other real estate owned		-			7
Origination of loans held for sale		(32,640	)		(17,670	)
Proceeds from sales of loans held for sale		40,161			17,605
Deferred taxes		1,991			(6	)
Change in FDIC indemnification asset		1,316			-
Stock-based compensation		218			77
Excess tax benefit from stock-based compensation		(5	)		-
Net change in assets and liabilities:
Net (increase) decrease in other assets		(2,546	)		67
Net increase in other liabilities		1,128			143
Net cash provided by operating activities		17,357			4,767

Cash flows from investing activities:
Purchases of investment securities, available for sale		(3,000	)		(21,706	)
Maturities/calls/principal payments of investment and
mortgage-backed securities available for sale		18,978			6,703
Net decrease (increase) in non-covered loans and covered loans		21,900			(10,153	)
Purchases of premises and equipment		(770	)		(565	)
Proceeds from the sale of premises and equipment		494			-
Proceeds from sale of non-covered other real estate owned		289			213
Proceeds from sale of covered other real estate owned		7,611			-
Capitalization of non-covered other real estate owned improvements		-			(118	)
Capitalization of covered other real estate owned improvements		(73	)		-
Net proceeds from FDIC indemnification asset		9,717			-
Net cash provided by (used in) investing activities	$	55,146		$	(25,626	)

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WASHINGTON BANKING COMPANY AND SUBSIDIARY

Condensed Consolidated Statements of Cash Flows (continued) (unaudited)

(Dollars in thousands)

	Three Months Ended
	March 31,
	2011			2010
Cash flows from financing activities:
Net increase (decrease) in deposits	$	2,293		$	(1,031	)
Redemption of preferred stock		(26,380	)		-
Repurchase of common stock warrant		(1,625	)		-
Proceeds from exercise of stock options		7			3
Excess tax benefits from stock-based compensation		5			-
Dividends paid on preferred stock		(38	)		(329	)
Dividends paid on common stock		(766	)		(382	)
Net cash used in financing activities		(26,504	)		(1,739	)

Net change in cash and cash equivalents		45,999			(22,598	)
Cash and cash equivalents at beginning of period		81,687			101,841
Cash and cash equivalents at end of period	$	127,686		$	79,243

Supplemental disclosures of cash flow information:
Cash paid during the period for:
Interest	$	2,846		$	2,821
Income taxes	$	1,200		$	1,100

Supplemental disclosures about noncash investing and financing activities:
Change in fair value of investment securities available for sale, net of taxes	$	(18	)	$	307
Transfer of non-covered loans to non-covered other real estate owned	$	1,012		$	490
Transfer of covered loans to covered other real estate owned	$	6,598		$	-

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WASHINGTON BANKING COMPANY AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

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

(a) Description of Business: Washington Banking Company (the “Company” or “WBCO”) is a registered bank holding company formed on April 30, 1996. At March 31, 2011, WBCO had two wholly-owned subsidiaries – Whidbey Island Bank (“WIB” or the “Bank”), the Company’s principal subsidiary, and Washington Banking Master Trust (the “Trust”). The business of the Bank, which is focused in the northern area of Western Washington, consists primarily of attracting deposits from the general public and originating loans. The region’s economy has evolved from one that was once heavily dependent upon forestry, fishing and farming to an economy with a much more diverse blend of industries including retail trade, services, manufacturing, tourism and a large military base presence. Although the Bank has a diversified loan portfolio, a substantial portion of its borrowers’ ability to repay their loans is dependent upon the economic conditions affecting this area.

(b) Basis of Presentation: The accompanying interim condensed consolidated financial statements include the accounts of WBCO and its subsidiaries described above. The accompanying interim condensed consolidated financial statements have been prepared, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles in the United States of America for complete financial statements. These condensed consolidated financial statements should be read in conjunction with the December 31, 2010 audited consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K filed with the SEC.

In preparing these financial statements, the Company has evaluated events and transactions subsequent to March 31, 2011 for potential recognition or disclosure. In management’s opinion, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the three months ended March 31, 2011, are not necessarily indicative of the results that may be expected for the year ending December 31, 2011. In preparing the condensed consolidated financial statements, estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses are required. Actual results could differ from those estimates.

(c) Reclassifications: Certain amounts in prior year’s financial statements may have been reclassified to conform to the 2011 presentation. These reclassifications had no significant impact on the Company’s financial position or results of operations.

(d) Significant Accounting Policies: The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect amounts reported in the consolidated financial statements and the accompanying notes. Changes in these estimates and assumptions are considered reasonably possible and may have a material impact on the consolidated financial statements and thus actual results could differ from the amounts reported and disclosed herein. A more detailed description of the Company’s significant accounting policies are described in Note (1) of the Notes to Consolidated Financial Statements for the year ended December 31, 2010, as filed on Form 10-K.

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WASHINGTON BANKING COMPANY AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(2) Recent Financial Accounting Pronouncements

On April 5, 2011, the FASB issued Accounting Standards Update (“ASU”) 2011-02, A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring (Topic 310), which modifies guidance for identifying restructurings of receivables that constitute a troubled debt restructuring. This ASU is effective for interim and annual reporting periods beginning after June 15, 2011, and should be applied retrospectively to the beginning of the annual period of adoption. For purposes of measuring impairment on newly identified troubled debt restructurings, the amendments should be applied prospectively for the first interim or annual period beginning on or after June 15, 2011. The Company is currently evaluating the impact, if any, upon the adoption of the standard.

(3) Business Combinations

On April 16, 2010, the Bank acquired certain assets and assumed certain liabilities of City Bank, Lynnwood, Washington, from the Federal Deposit Insurance Corporation (“FDIC”), as receiver of City Bank, in an FDIC-assisted transaction. As part of the Purchase and Assumption Agreement, the Bank and the FDIC entered into loss share agreements (each, a “loss share agreement” and collectively, the “loss share agreements”). The Bank will share in the losses, which begins with the Bank incurring the first 2% of losses, on the covered assets. After the first 2% of losses on covered assets, the FDIC will absorb 80% of losses and share in 80% of loss recoveries on 100% of the covered loan portfolio. The loss share agreement for commercial and single family residential mortgage loans are in effect for five years and ten years, respectively, from the April 16, 2010 acquisition date and the loss recovery provisions for such loans are in effect for eight years and ten years, respectively, from the acquisition date.

In April 2020, approximately ten years following the acquisition date, the Bank is required to make a payment to the FDIC in the event that losses on covered assets under the loss share agreements have been less than the stated threshold level. The payment amount will be 50% of the excess, if any, of (i) 20% of the intrinsic loss estimate ($111.0 million) minus (ii) the sum of (a) 25% of the asset discount (or 25% of the asset discount of ($50.7 million)), plus (b) 25% of cumulative loss share payments (as defined in the Agreement), plus (c) the cumulative servicing amount received by the Bank from the FDIC on covered assets. At December 31, 2010, the Bank estimated that there was no liability under this provision.

The Bank purchased certain assets of City Bank from the FDIC including (at fair value) approximately $321.6 million in loans, $280.0 million of cash and cash equivalents and $9.1 million in investment securities. The Bank also assumed liabilities with fair value of approximately $650.1 million in deposits, $50.1 million in FHLB advances and $17.8 million in other liabilities. The expected net reimbursements under the loss share agreements were recorded at estimated fair value of $84.4 million on the acquisition date. In addition to assuming certain liabilities in the transaction, the Company issued an equity appreciation instrument to the FDIC as part of the consideration. This instrument was valued at $2.1 million when issued. On April 27, 2010, the FDIC exercised its equity appreciation instrument. The application of the acquisition method of accounting resulted in the recognition of goodwill of $4.9 million, which has been reported in the Condensed Consolidated Statements of Financial Condition.

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WASHINGTON BANKING COMPANY AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(3) Business Combinations (continued)

On September 24, 2010, the Bank assumed certain deposit liabilities and acquired certain assets of North County Bank, Arlington, Washington from the FDIC as receiver for North County Bank and entered into a Purchase and Assumption Agreement with the FDIC. As part of the Agreement, the Bank and the FDIC entered into a loss sharing arrangement covering future losses incurred on acquired or “covered” loans and other real estate owned (“OREO”). On single family loans and OREO, the FDIC will absorb: (i) 80% of losses on the first $7.8 million of losses incurred; (ii) 0% of losses on $7.8 million to $12.3 million of losses incurred; and (iii) 80% of losses above $12.3 million of losses incurred. On commercial and non-single family loans and OREO, the FDIC will absorb: (i) 80% of losses on the first $33.9 million of losses incurred; (ii) 0% of losses on $33.9 million to $47.9 million of losses incurred; and (iii) 80% of losses above $47.9 million of losses incurred. The FDIC will share in loss recoveries on the covered loan and OREO portfolio.

In September 2020, approximately ten years following the acquisition date, the Bank is required to make a payment to the FDIC in the event that losses on covered assets under the loss share agreements have been less than the stated threshold level. The payment amount will be 50% of the excess, if any, of (i) 20% of the intrinsic loss estimate ($46.9 million) minus (ii) the sum of (a) 20% of the net loss amount, plus (b) 25% of the asset discount bid ($62.5 million), plus (c) 3.5% of total loss share assets at acquisition. At December 31, 2010, the Bank estimated a liability of $2.0 million under this provision.

The Bank purchased certain assets of North County Bank from the FDIC including (at fair value) approximately $133.1 million in loans, $71.3 million of cash and cash equivalents, $21.3 million in investment securities and $12.4 million in OREO. The Bank also assumed liabilities with fair values of approximately $257.8 million in deposits and $9.5 million in other liabilities. The expected reimbursements under the loss share agreements were recorded at estimated fair value of $39.0 million on the acquisition date. The application of the acquisition method of accounting resulted in a net after-tax gain of $13.0 million, which was reported as a component of noninterest income, at the time of acquisition.

Merger-related expenses of $119 thousand have been incurred in connection with the acquisitions of City Bank and North County Bank for the three months ended March 31, 2011, and have been recognized as a separate line item on the Condensed Consolidated Statements of Income. Merger related expenses include conversion expense, severance and professional and consulting services.

The Company refers to the acquired loan portfolios and other real estate owned as “covered loans” and “covered other real estate owned”, respectively, and these are presented as separate line items in the Condensed Consolidated Statement of Condition. Collectively, these balances are referred to as “covered assets.”

The assets acquired and liabilities assumed from the City Bank and North County Bank acquisitions have been accounted for under the acquisition method of accounting (formerly the purchase method). The assets and liabilities, both tangible and intangible, were recorded at estimated fair values as of the acquisition date. The fair values of the assets acquired and liabilities assumed were determined based on the requirements of FASB ASC 805. The foregoing fair value amounts are subject to change for up to one year after the closing date of the acquisitions as additional information relating to closing date fair values becomes available. The amounts are also subject to adjustments based upon final settlement with the FDIC. In addition, the tax treatment of FDIC-assisted acquisitions is complex and subject to interpretations that may result in future adjustments of deferred taxes as of the acquisition date. The terms of the agreements provide for the FDIC to indemnify the Bank against claims with respect to liabilities of City Bank and North County Bank not assumed by the Bank and certain other types of claims identified in the agreements. The application of the acquisition method of accounting resulted in the recognition of goodwill of $4.9 million in the City Bank acquisition and a pre-tax bargain purchase gain of $19.9 million in the North County Bank acquisition as of the acquisition dates.

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WASHINGTON BANKING COMPANY AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(3) Business Combinations (continued)

A summary of the net assets (liabilities) received from the FDIC and the estimated fair value adjustments are presented below:

(dollars in thousands)	City Bank			North County Bank
	April 16, 2010			September 24, 2010
Cost basis net assets (liabilities)	$	(54,943	)	$	11,217
Cash payment received from the FDIC		99,445			46,860
Net assets acquired before fair value adjustments		44,502			58,077

Fair value adjustments:
Covered loans		(126,378	)		(67,360	)
Covered other real estate owned		(551	)		(6,842	)
Core deposit intangible		3,293			50
FDIC indemnification asset		84,393			39,000
Visa Class B common stock		2,025			-
Other assets		(597	)		(89	)
Deposits		(6,000	)		(956	)
FHLB advances		(103	)		-
Other liabilities		(3,271	)		(1,955	)
FDIC equity appreciation instrument		(2,131	)		-
Pre-tax bargain purchase gain (goodwill) on acquisition		(4,818	)		19,925
Deferred income tax liability		(51	)		(6,974	)
Bargain purchase gain (goodwill) on acquisition	$	(4,869	)	$	12,951

In FDIC-assisted transactions, only certain assets and liabilities are transferred to the acquirer and, depending on the nature and amount of the acquirer’s bid, the FDIC may be required to make a cash payment to the acquirer. In the City Bank acquisition, cost basis net liabilities of $54.9 million and a cash payment received from the FDIC of $99.4 million were transferred to the Company. The goodwill represents the excess of the estimated fair value of the liabilities assumed over the estimated fair value of the assets acquired.

In the North County Bank acquisition, cost basis net assets of $11.2 million and a cash payment received from the FDIC of $46.9 million were transferred to the Company. The bargain purchase gain represents the excess of the estimated fair value of the assets acquired over the estimated fair value of the liabilities assumed.

The Bank did not immediately acquire all the real estate, banking facilities, furniture or equipment of City Bank or North County Bank as part of the purchase and assumption agreements. However, the Bank had the option to purchase or lease the real estate and furniture and equipment from the FDIC. The term of this option expired 90 days from the acquisition dates. Acquisition costs of the real estate and furniture and equipment are based on current mutually agreed upon appraisals. Prior to the expiration of option terms, the Bank exercised its option and acquired the facilities and furnishings of the eight City Bank locations for $11.1 million. For North County Bank, the Bank exercised its option to assume the leases of three North County Bank locations and acquired furnishings for $145 thousand.

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WASHINGTON BANKING COMPANY AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(3) Business Combinations (continued)

The statement of assets acquired and liabilities assumed at their estimated fair values of City Bank and North County Bank are presented below:

(dollars in thousands)	City Bank		North County Bank
	April 16, 2010		September 24, 2010
Assets
Cash and due from banks	$	277,907	$	66,770
Interest-bearing deposits		2,078		4,532
Total cash and cash equivalents		279,985		71,302

Investment securities, available for sale		9,120		21,286
Covered loans		321,581		133,136
FHLB stock		4,744		402
Goodwill		4,869		-
Core deposit intangible		3,293		50
Covered other real estate owned		5,798		12,412
FDIC indemnification asset		84,393		39,000
Other assets		4,236		2,695
Total assets acquired	$	718,019	$	280,283

Liabilities
Deposits	$	650,104	$	257,845
FHLB advances		50,152		-
Other liabilities		17,763		9,487
Total liabilities assumed		718,019		267,332
Net assets acquired/bargain purchase gain on acquisition		-		12,951
Total liabilities assumed and net assets acquired	$	718,019	$	280,283

The acquisition of assets and liabilities of City Bank and North County Bank were significant at a level to require disclosure of one year of historical financial statements and related pro forma financial disclosure. However, given the pervasive nature of the loss sharing agreement entered into with the FDIC, the historical information of City Bank and North County Bank are much less relevant for purposes of assessing the future operations of the combined entity. In addition, prior to closure, City Bank had not completed an audit of their financial statements, and the Company determined that audited financial statements are not and will not be reasonably available for the year ended December 31, 2009. Given these considerations, the Company requested, and received, relief from the Securities and Exchange Commission from submitting certain historical and proforma financial information of City Bank and North County Bank.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(4) Investment Securities

The following table presents the amortized cost, unrealized gains, unrealized losses and fair value of investment securities available for sale at March 31, 2011 and December 31, 2010. At March 31, 2011 and December 31, 2010, there were no investment securities as held to maturity or trading.

(dollars in thousands)	March 31, 2011
	Amortized cost		Unrealized gains		Unrealized losses			Fair value
U.S. government agencies	$	87,123	$	497	$	(914	)	$	86,706
U.S. Treasuries		54,151		422		(95	)		54,478
Pass-through securities		1,108		17		-			1,125
Taxable state and political subdivisions		6,085		14		(277	)		5,822
Tax exempt state and political subdivisions		22,284		775		(163	)		22,896
Corporate obligations		9,001		19		(45	)		8,975
Investments in mutual funds and other equities		4,044		-		(668	)		3,376
Total investment securities available for sale	$	183,796	$	1,744	$	(2,162	)	$	183,378

(dollars in thousands)	December 31, 2010
	Amortized cost		Unrealized gains		Unrealized losses			Fair value
U.S. government agencies	$	103,109	$	695	$	(814	)	$	102,990
U.S. Treasuries		54,175		530		(62	)		54,643
Pass-through securities		1,216		24		(1	)		1,239
Taxable state and political subdivisions		6,090		33		(356	)		5,767
Tax exempt state and political subdivisions		22,312		603		(304	)		22,611
Corporate obligations		9,001		24		(51	)		8,974
Investments in mutual funds and other equities		4,044		-		(712	)		3,332
Total investment securities available for sale	$	199,947	$	1,909	$	(2,300	)	$	199,556

(a) Other-Than-Temporary Impaired Debt Securities: At March 31, 2011 and December 31, 2010, there were 51 and 52 investment securities in unrealized loss positions, respectively. For each security in an unrealized loss position, the Company assesses whether it intends to sell the security, or it is more likely than not that it will be required to sell the security before recovery of its amortized cost basis. For debt securities that are considered other-than-temporarily impaired and that the Company does not intend to sell and will not be required to sell prior to recovery of its amortized cost basis, the Company will separate the amount of the impairment into the amount that is credit related (credit loss component) and the amount due to all other factors. The credit loss component is recognized in earnings and is calculated as the difference between the security’s amortized cost basis and the present value of its expected future cash flows. The remaining difference between the security’s fair value and the present value of future expected cash flows is deemed to be due to factors that are not credit related and is recognized in other comprehensive income.

The Company does not intend to sell the securities that are temporarily impaired, and it is more likely than not that the Company will not have to sell those securities before recovery of the cost basis. Additionally, the Company has evaluated the credit ratings of its investment securities and their issuers and/or insurers, as applicable. Based on the Company’s evaluation, management has determined that no investment security in the Company’s investment portfolio is other-than-temporarily impaired at March 31, 2011.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(4) Investment Securities (continued)

The following table shows gross unrealized losses and fair value of securities with unrealized losses that are not deemed to be other-than-temporarily impaired, aggregated by category and length of time that individual securities have been in a continuous unrealized loss position at March 31, 2011 and December 31, 2010:

(dollars in thousands)	March 31, 2011
	Less than 12 Months					12 Months or Longer				Total
	Fair value		Unrealized losses			Fair value		Unrealized losses		Fair value		Unrealized losses
U.S. government agencies	$	53,070	$	(914	)	$	-	$	-	$	53,070	$	(914	)
U.S. Treasuries		4,952		(95	)		-		-		4,952		(95	)
Taxable state and political subdivisions		4,295		(277	)		-		-		4,295		(277	)
Tax exempt state and political subdivisions		4,429		(163	)		-		-		4,429		(163	)
Corporate obligations		2,955		(45	)		-		-		2,955		(45	)
Investments in mutual funds and other equities		4,044		(668	)		-		-		4,044		(668	)
Total investment securities available for sale	$	73,745	$	(2,162	)	$	-	$	-	$	73,745	$	(2,162	)

(dollars in thousands)	December 31, 2010
	Less than 12 Months					12 Months or Longer				Total
	Fair value		Unrealized losses			Fair value		Unrealized losses		Fair value		Unrealized losses
U.S. government agencies	$	52,196	$	(814	)	$	-	$	-	$	52,196	$	(814	)
U.S. Treasuries		4,988		(62	)		-		-		4,988		(62	)
Pass-through securities		200		(1	)		-		-		200		(1	)
Taxable state and political subdivisions		4,221		(356	)		-		-		4,221		(356	)
Tax exempt state and political subdivisions		6,004		(304	)		-		-		6,004		(304	)
Corporate obligations		7,949		(51	)		-		-		7,949		(51	)
Investments in mutual funds and other equities		4,044		(712	)		-		-		4,044		(712	)
Total investment securities available for sale	$	79,602	$	(2,300	)	$	-	$	-	$	79,602	$	(2,300	)

The unrealized losses associated with U.S. government agency and treasury debt securities are primarily driven by changes in interest rates and not due to the credit quality of the securities. Further, the pass-through securities backed by GNMA, FNMA or FHLMC have the guarantee of the full faith and credit of the U.S. Federal Government. Obligations of U.S. states and political subdivisions in our portfolio are all investment grade without delinquency history.

The amortized cost and fair value of investment securities, by contractual maturity at March 31, 2011, are shown in the table below. Expected maturities may differ from contractual maturities because issuers of the securities may have the right to call or prepay obligations with or without call or prepayment penalties.

(dollars in thousands)	March 31, 2011
	Amortized		Fair
	Cost		Value
Three months or less	$	6,180	$	6,185
Over three months to one year		18,494		18,615
After one year through three years		51,212		51,936
After three years through five years		75,688		75,118
After five years through ten years		12,515		12,479
After ten years		19,707		19,045
Total	$	183,796	$	183,378

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(4) Investment Securities (continued)

The following table presents investment securities which were pledged to secure borrowings and public deposits as permitted or required by law:

(dollars in thousands)	March 31, 2011
	Amortized cost		Fair value
To state and local governments to secure public deposits	$	49,612	$	50,272
To Federal Reserve Bank to secure borrowings		27,835		27,742
To Federal Home Loan Bank to secure borrowings		7,970		7,822
Other securities pledged, principally to secure deposits		12,071		12,346
Total pledged investment securities	$	97,488	$	98,182

(5) Non-Covered Loans

The following table presents the major types of non-covered loans at March 31, 2011 and December 31, 2010. The classification of non-covered loan balances presented is reported in accordance with the regulatory reporting requirements.

(dollars in thousands)	March 31, 2011			December 31, 2010
Commercial	$	147,436		$	145,319
Real estate mortgage		397,581			395,265
Real estate construction		107,445			115,609
Consumer		172,075			175,896
		824,537			832,089
Deferred loan costs, net		2,199			2,204
Allowance for loan losses		(19,238	)		(18,812	)
Total non-covered loans, net	$	807,498		$	815,481

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(6) Allowance for Non-Covered Loan Losses and Credit Quality

Activity in the Non-Covered Allowance for Loan Losses

The following table summarizes activity related to the allowance for loan losses on non-covered loans, by portfolio segment, for the three months ended March 31, 2011 and 2010:

(dollars in thousands)	Three Months Ended March 31, 2011
	Commercial			Real estate mortgage			Real estate construction		Consumer			Total
Beginning balance	$	3,915		$	6,507		$	4,947	$	3,443		$	18,812
Provision		1,302			558			511		629			3,000
Charge-offs		(469	)		(1,285	)		-		(1,145	)		(2,899	)
Recoveries		81			88			1		155			325
Ending Balance	$	4,829		$	5,868		$	5,459	$	3,082		$	19,238

(dollars in thousands)	Three Months Ended March 31, 2010
	Commercial			Real estate mortgage			Real estate construction			Consumer			Total
Beginning balance	$	1,515		$	8,060		$	2,330		$	4,307		$	16,212
Provision		1,126			214			533			277			2,150
Charge-offs		(542	)		(470	)		(675	)		(633	)		(2,320	)
Recoveries		72			2			101			247			422
Ending Balance	$	2,171		$	7,806		$	2,289		$	4,198		$	16,464

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(6) Allowance for Non-Covered Loan Losses and Credit Quality (continued)

The following table provides a summary of the allowance for loan losses and related non-covered loans, by portfolio segment, at March 31, 2011 and December 31, 2010:

(dollars in thousands)	March 31, 2011
	Commercial		Real estate mortgage		Real estate construction		Consumer		Total
Allowance for loan losses:
Individually evaluated for impairment	$	1,182	$	113	$	2,039	$	-	$	3,334
Collectively evaluated for impairment		3,647		5,755		3,420		3,082		15,904
Total allowance for loan losses	$	4,829	$	5,868	$	5,459	$	3,082	$	19,238

Non-covered loans
Individually evaluated for impairment	$	5,059	$	14,009	$	29,866	$	240	$	49,174
Collectively evaluated for impairment		142,377		383,572		77,579		171,835		775,363
Total non-covered loans (1)	$	147,436	$	397,581	$	107,445	$	172,075	$	824,537

(1) Total non-covered loans excludes deferred loan costs of $2.2 million.

(dollars in thousands)	December 31, 2010
	Commercial		Real estate mortgage		Real estate construction		Consumer		Total
Allowance for loan losses:
Individually evaluated for impairment	$	898	$	345	$	1,100	$	-	$	2,343
Collectively evaluated for impairment		3,017		6,162		3,847		3,443		16,469
Total allowance for loan losses	$	3,915	$	6,507	$	4,947	$	3,443	$	18,812

Non-covered loans
Individually evaluated for impairment	$	3,422	$	11,625	$	30,617	$	118	$	45,782
Collectively evaluated for impairment		141,897		383,640		84,992		175,778		786,307
Total non-covered loans (1)	$	145,319	$	395,265	$	115,609	$	175,896	$	832,089

(1) Total non-covered loans excludes deferred loan costs of $2.2 million.

Credit Quality and Nonperforming Non-Covered Loans

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

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

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(6) Allowance for Non-Covered Loan Losses and Credit Quality (continued)

Loans are placed on nonaccrual status when collection of principal or interest is considered doubtful (generally, loans are 90 days or more past due). Loans placed on nonaccrual will typically remain on nonaccrual status until all principal and interest payments are brought current and the prospects for future payments, in accordance with the loan agreement, appear relatively certain.

Interest income previously accrued on nonaccrual loans, but not yet received, is reversed in the period the loan is placed on nonaccrual status. Payments received are generally applied to principal. However, based on management’s assessment of the ultimate collectability of an impaired or nonaccrual loan, interest income may be recognized on a cash basis. Nonaccrual loans are returned to an accrual status when management determines the circumstances have improved to the extent that there has been a sustained period of repayment performance and both principal and interest are deemed collectible.

Loans are reported as restructured when the Bank grants a concession(s) to a borrower experiencing financial difficulties that it would not otherwise consider. Examples of such concessions include forgiveness of principal or accrued interest, extending the maturity date(s) or providing a lower interest rate than would be normally available for a transaction of similar risk. As a result of these concessions, restructured loans are impaired as the Bank will not collect all amounts due, both principal and interest, in accordance with the terms of the original loan agreement.

Non-Covered Impaired Loans

The Company had non-covered impaired loans which consisted of nonaccrual loans and restructured loans. As of March 31, 2011, the Company had $1.5 million in commitments to extend additional credit on these non-covered impaired loans. Non-covered impaired loans and the related allowance for loan losses at March 31, 2011 and December 31, 2010 were as follows:

(dollars in thousands)	March 31, 2011				December 31, 2010
	Recorded Investment		Allowance		Recorded Investment		Allowance
With no related allowance recorded
Nonaccrual loans	$	19,482	$	-	$	11,382	$	-
Restructured loans		19,654		-		19,936		-
Total with no related allowance	$	39,136	$	-	$	31,318	$	-

With an allowance recorded
Nonaccrual loans	$	10,038	$	3,334	$	14,464	$	2,343
Total with an allowance recorded		10,038		3,334		14,464		2,343
Total	$	49,174	$	3,334	$	45,782	$	2,343

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(6) Allowance for Non-Covered Loan Losses and Credit Quality (continued)

The following table further summarizes impaired non-covered loans, by class, at March 31, 2011 and December 31, 2010:

(dollars in thousands)	March 31, 2011						December 31, 2010
	Recorded Investment		Unpaid Principal Balance		Related Allowance		Recorded Investment		Unpaid Principal Balance		Related Allowance
With no related allowance recorded
Commercial	$	2,332	$	3,047	$	-	$	1,855	$	1,858	$	-
Real estate mortgages:
One-to-four family residential		3,089		3,939		-		2,700		3,400		-
Multi-family and commercial		9,869		10,565		-		7,036		7,163		-
Total real estate mortgages		12,958		14,504		-		9,736		10,563		-
Real estate construction:
One-to-four family residential		23,219		23,909		-		19,222		19,644		-
Multi-family and commercial		387		387		-		387		387		-
Total real estate construction		23,606		24,296		-		19,609		20,031		-
Consumer:
Indirect		-		468		-		-		-		-
Direct		240		1,096		-		118		118		-
Total consumer		240		1,564		-		118		118		-
Total with no related allowance recorded	$	39,136	$	43,411	$	-	$	31,318	$	32,570	$	-

With an allowance recorded
Commercial	$	2,727	$	2,958	$	1,182	$	1,567	$	1,567	$	898
Real estate mortgages:
One-to-four family residential		189		190		31		1,180		1,188		207
Multi-family and commercial		862		876		82		709		1,036		138
Total real estate mortgages		1,051		1,066		113		1,889		2,224		345
Real estate construction:
One-to-four family residential		6,260		6,874		2,039		11,008		11,166		1,100
Multi-family and commercial		-		-		-		-		-		-
Total real estate construction		6,260		6,874		2,039		11,008		11,166		1,100
Consumer:
Indirect		-		-		-		-		-		-
Direct		-		-		-		-		-		-
Total consumer		-		-		-		-		-		-
Total with an allowance recorded		10,038		10,898		3,334		14,464		14,957		2,343
Total impaired non-coverd loans	$	49,174	$	54,309	$	3,334	$	45,782	$	47,527	$	2,343

The average recorded investment in non-covered impaired loans was approximately $47.5 million during the three months ended March 31, 2011, and $9.6 million for the year ended December 31, 2010. Interest income recognized on non-covered impaired loans was $7 thousand and $4 thousand for the three months ended March 31, 2011 and 2010, respectively. Additional interest income of $50 thousand and $79 thousand would have been recognized had the non-covered impaired loans accrued interest, in accordance with their original terms, for the three months ended March 31, 2011 and 2010, respectively.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(6) Allowance for Non-Covered Loan Losses and Credit Quality (continued)

Non-Covered Nonaccrual Loans and Loans Past Due

The following table summarizes non-covered nonaccrual loans and past due loans, by class, as of March 31, 2011 and December 31, 2010:

(dollars in thousands)	March 31, 2011
	30 - 59 Days Past Due		60 - 89 Days Past Due		Greater Than 90 Days and Accruing		Total Past Due		Nonaccrual		Current		Total Non-Covered Loans
Commercial	$	764	$	907	$	-	$	1,671	$	4,118	$	141,647	$	147,436
Real estate mortgages:
One-to-four family residential		565		74		-		639		3,278		42,847		46,764
Multi-family and commercial		1,714		461		-		2,175		2,750		345,892		350,817
Total real estate mortgages		2,279		535		-		2,814		6,028		388,739		397,581

Real estate construction:
One-to-four family residential		-		-		-		-		18,747		50,130		68,877
Multi-family and commercial		-		-		-		-		387		38,181		38,568
Total real estate construction		-		-		-		-		19,134		88,311		107,445

Consumer:
Indirect		1,185		197		-		1,382		-		87,031		88,413
Direct		421		352		-		773		240		82,649		83,662
Total consumer		1,606		549		-		2,155		240		169,680		172,075
Total	$	4,649	$	1,991	$	-	$	6,640	$	29,520	$	788,377		824,537
Deferred loan costs, net														2,199
Total non-covered loans													$	826,736

(dollars in thousands)	December 31, 2010
	30 - 59 Days Past Due		60 - 89 Days Past Due		Greater Than 90 Days and Accruing		Total Past Due		Nonaccrual		Current		Total Non-Covered Loans
Commercial	$	1,010	$	461	$	-	$	1,471	$	3,304	$	140,544	$	145,319
Real estate mortgages:
One-to-four family residential		928		32		-		960		3,880		41,877		46,717
Multi-family and commercial		-		1,799		-		1,799		3,134		343,615		348,548
Total real estate mortgages		928		1,831		-		2,759		7,014		385,492		395,265

Real estate construction:
One-to-four family residential		2,034		2,656		-		4,690		15,023		53,232		72,945
Multi-family and commercial		-		-		-		-		387		42,277		42,664
Total real estate construction		2,034		2,656		-		4,690		15,410		95,509		115,609

Consumer:
Indirect		1,159		259		34		1,452		-		88,779		90,231
Direct		1,214		271		10		1,495		118		84,052		85,665
Total consumer		2,373		530		44		2,947		118		172,831		175,896
Total	$	6,345	$	5,478	$	44	$	11,867	$	25,846	$	794,376		832,089
Deferred loan costs, net														2,204
Total non-covered loans													$	834,293

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(6) Allowance for Non-Covered Loan Losses and Credit Quality (continued)

Non-Covered Credit Quality Indicators

The Company’s internal risk rating methodology assigns risk ratings from 1 to 9, where a higher rating represents higher risk. The 9 risk ratings can be generally described by the following groups:

Pass/Watch: These loans range from minimal credit risk to lower than average, but still acceptable, credit risk.

Special Mention: Loans assigned this category present certain potential weaknesses that require management’s attention. Those weaknesses, if left uncorrected, may result in deterioration of the borrower’s repayment ability or the Company’s credit position in the future.

Substandard: Substandard loans are inadequately protected by the current worth and paying capacity of the borrower or of the collateral pledged, if any. There are well-defined weaknesses that may jeopardize the repayment of debt. Such weaknesses include deteriorated financial condition of the borrower resulting from insufficient income, excessive expenses or other factors that result in inadequate cash flows to meet all scheduled obligations.

Doubtful/Loss: Loans assigned as doubtful have all the weaknesses inherent with substandard loans, with the added characteristic that the weaknesses make collection in full, on the basis of currently existing facts, conditions and values, highly questionable. The possibility of loss is high, but because of certain important and reasonably specific pending factors that may work to the advantage of, and strengthen the credit, its classification as an estimated loss is deferred until a more exact status may be determined. The Company charges off loans that would otherwise be classified loss.

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WASHINGTON BANKING COMPANY AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(6) Allowance for Non-Covered Loan Losses and Credit Quality (continued)

The following table summarizes our internal risk rating, by class, as of March 31, 2011 and December 31, 2010:

(dollars in thousands)	March 31, 2011
	Pass/Watch		Special Mention		Substandard		Doubtful/Loss		Total
Commercial	$	113,200	$	7,101	$	27,135	$	-	$	147,436
Real estate mortgages:
One-to-four family residential		37,527		2,176		7,061		-		46,764
Multi-family and commercial		285,416		24,553		40,848		-		350,817
Total real estate mortgages		322,943		26,729		47,909		-		397,581

Real estate construction:
One-to-four family residential		23,014		5,861		40,002		-		68,877
Multi-family and commercial		28,126		9,713		729		-		38,568
Total real estate construction		51,140		15,574		40,731		-		107,445

Consumer:
Indirect		85,890		15		2,508		-		88,413
Direct		77,292		1,255		5,115		-		83,662
Total consumer		163,182		1,270		7,623		-		172,075
Total	$	650,465	$	50,674	$	123,398	$	-		824,537
Deferred loan costs, net										2,199
									$	826,736

(dollars in thousands)	December 31, 2010
	Pass/Watch		Special Mention		Substandard		Doubtful/Loss		Total
Commercial	$	112,145	$	6,265	$	26,909	$	-	$	145,319
Real estate mortgages:
One-to-four family residential		36,626		1,788		8,303		-		46,717
Multi-family and commercial		283,790		24,617		40,141		-		348,548
Total real estate mortgages		320,416		26,405		48,444		-		395,265

Real estate construction:
One-to-four family residential		27,485		3,860		41,600		-		72,945
Multi-family and commercial		32,015		9,917		732		-		42,664
Total real estate construction		59,500		13,777		42,332		-		115,609

Consumer:
Indirect		87,679		11		2,541		-		90,231
Direct		78,846		1,132		5,687		-		85,665
Total consumer		166,525		1,143		8,228		-		175,896
Total	$	658,586	$	47,590	$	125,913	$	-		832,089
Deferred loan costs, net										2,204
									$	834,293

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(7) Covered Assets and FDIC Indemnification Asset

(a) Covered Loans: Loans acquired in an FDIC assisted acquisition that are subject to a loss share agreement are referred to as “covered loans” and reported separately in the Condensed Consolidated Statements of Financial Condition. Covered loans are reported exclusive of the expected cash flow reimbursements from the FDIC.

The following table reflects the estimated fair value of the acquired loans at the acquisition dates:

(dollars in thousands)	City Bank			North County Bank
	April 16, 2010			September 24, 2010
Gross loans acquired	$	447,959		$	200,496
Fair value discount		(126,378	)		(67,360	)
Covered loans, net	$	321,581		$	133,136

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(7) Covered Assets and FDIC Indemnification Asset (continued)

The following table presents the major types of covered loans at March 31, 2011 and December 31, 2010. The classification of covered loan balances presented is reported in accordance with the regulatory reporting requirements.

(dollars in thousands)	March 31, 2011
	City Bank			North County Bank			Total
Commercial	$	21,804		$	9,944		$	31,748
Real estate mortgages:
One-to-four family residential		6,690			8,660			15,350
Multi-family residential and commercial		213,907			42,692			256,599
Total real estate mortgages		220,597			51,352			271,949

Real estate construction:
One-to-four family residential		8,659			62,867			71,526
Multi-family and commercial		39,348			27,948			67,296
Total real estate construction		48,007			90,815			138,822

Consumer - direct		3,861			17,943			21,804
Subtotal		294,269			170,054			464,323
Fair value discount		(70,403	)		(52,294	)		(122,697	)
Total covered loans		223,866			117,760			341,626
Allowance for loan losses		(1,336	)		-			(1,336	)
Total covered loans, net	$	222,530		$	117,760		$	340,290

(dollars in thousands)	December 31, 2010
	City Bank			North County Bank			Total
Commercial	$	22,524		$	10,313		$	32,837
Real estate mortgages:
One-to-four family residential		7,138			10,586			17,724
Multi-family residential and commercial		237,510			44,524			282,034
Total real estate mortgages		244,648			55,110			299,758

Real estate construction:
One-to-four family residential		8,829			62,056			70,885
Multi-family and commercial		42,281			36,398			78,679
Total real estate construction		51,110			98,454			149,564

Consumer - direct		4,050			18,576			22,626
Subtotal		322,332			182,453			504,785
Fair value discount		(82,782	)		(55,850	)		(138,632	)
Total covered loans		239,550			126,603			366,153
Allowance for loan losses		(1,336	)		-			(1,336	)
Total covered loans, net	$	238,214		$	126,603		$	364,817

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(7) Covered Assets and FDIC Indemnification Asset (continued)

In estimating the fair value of the covered loans at the acquisition date, we (a) calculated the contractual amount and timing of undiscounted principal and interest payments and (b) estimated the amount and timing of undiscounted expected principal and interest payments. The difference between these two amounts represents the nonaccretable difference.

On the acquisition date, the amount by which the undiscounted expected cash flows exceed the estimated fair value of the acquired loans is the “accretable yield.” The accretable yield is then measured at each financial reporting date and represents the difference between the remaining undiscounted expected cash flows and the current carrying value of the loans.

The following table presents a reconciliation of the undiscounted contractual cash flows, nonaccretable difference, accretable yield and fair value of covered loans for each respective acquired loan portfolio at the acquisition dates:

(dollars in thousands)	City Bank			North County Bank
	April 16, 2010			September 24, 2010
Undiscounted contractual cash flows	$	504,721		$	225,937
Undiscounted cash flows not expected to be collected
(nonaccretable difference)		(132,419	)		(61,906	)
Undiscounted cash flows expected to be collected		372,302			164,031
Accretable yield at acquisition		(50,721	)		(30,895	)
Estimated fair value of loans acquired at acquisition	$	321,581		$	133,136

The following table presents the changes in the accretable yield for the three months ended March 31, 2011, for each respective acquired loan portfolio:

(dollars in thousands)	March 31, 2011
	City Bank			North County Bank
Balance, beginning of period	$	56,079		$	27,880
Accretion to interest income		(6,064	)		(2,417	)
Disposals		(4,211	)		-
Balance, end of period	$	45,804		$	25,463

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WASHINGTON BANKING COMPANY AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(7) Covered Assets and FDIC Indemnification Asset (continued)

The following table summarizes nonperforming covered assets at March 31, 2011 and December 31, 2010:

(dollars in thousands)	March 31, 2011			December 31, 2010
Covered nonaccrual loans	$	94,438		$	96,182
Covered restructured loans		-			-
Total covered nonperforming loans		94,438			96,182
Covered other real estate owned		28,826			29,766
Total covered nonperforming assets	$	123,264		$	125,948

Total covered impaired loans	$	94,438		$	96,182
Covered accruing loans past due 90
days or more		-			-

Allowance for loan losses	$	1,336		$	1,336

Covered nonperforming loans to total covered loans		27.64	%		26.27	%
Allowance for loan losses to total covered loans		0.39	%		0.36	%
Allowance for loan losses to covered
nonperforming loans		1.41	%		1.39	%
Covered nonperforming assets to total assets		7.32	%		7.39	%

(b) Covered Other Real Estate Owned: All OREO acquired in FDIC-assisted acquisitions that are subject to an FDIC loss share agreement are referred to as “covered OREO” and reported separately in the Condensed Consolidated Statements of Financial Condition. Covered OREO is reported exclusive of expected reimbursement cash flows from the FDIC. Foreclosed covered loan collateral is transferred into covered OREO at the loan’s carrying value, inclusive of the acquisition date fair value discount.

The following table summarizes the activity related to covered OREO for the three months ended March 31, 2011:

(dollars in thousands)	Three Months Ended
	March 31, 2011
	City Bank			North County Bank			Total
Balance, beginning of period	$	17,906		$	11,860		$	29,766
Additions to covered OREO		6,008			590			6,598
Capitalized improvements		-			73			73
Dispositions of covered OREO		(6,451	)		(1,160	)		(7,611	)
Balance, end of period	$	17,463		$	11,363		$	28,826

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(7) Covered Assets and FDIC Indemnification Asset (continued)

(c) FDIC Indemnification Asset: The following table summarizes the activity related to the FDIC indemnification asset for the three months ended March 31, 2011:

(dollars in thousands)	Three Months Ended
	March 31, 2011
	City Bank			North County Bank			Total
Balance, beginning of period	$	68,389		$	39,507		$	107,896
Change in FDIC indemnification asset		(1,735	)		419			(1,316	)
Transfers to due from FDIC		(4,647	)		(5,070	)		(9,717	)
Balance, end of period	$	62,007		$	34,856		$	96,863

(8) Non-Covered Other Real Estate Owned

The following table presents the changes in non-covered other real estate owned for the three months ended March 31, 2011 and 2010:

(dollars in thousands)	Three Months Ended
	March 31,
	2011			2010
Balance, beginning of period	$	4,122		$	4,549
Additions to OREO		1,012			490
Capitalized improvements		-			118
Dispositions of OREO		(289	)		(220	)
Balance, end of period	$	4,845		$	4,937

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(9) Earnings per Common Share

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

The following table reconciles the numerators and denominators of the basic and diluted earnings per common share computations:

(dollars in thousands)	Three Months Ended
	March 31,
	2011		2010
Income available to common shareholders	$	2,992	$	1,581

Weighted average number of common shares, basic		15,329,000		15,297,000
Effect of dilutive stock awards and CPP warrants		138,000		133,000
Weighted average number of common shares, diluted		15,467,000		15,430,000

Earnings per common share
Basic	$	0.20	$	0.10
Diluted	$	0.19	$	0.10

At March 31, 2011 and 2010, antidilutive stock awards were 53,964 and 56,066, and therefore, were not included in the computation of diluted net income per share available to common shareholders.

(10) Stock-Based Compensation

(a) Stock Options: The Company measures the fair value of each stock option grant at the date of the grant, using the Black-Scholes option pricing model. There were no options granted during the three months ended March 31, 2011 and 2010.

The Company recognizes compensation expense for stock option grants on a straight-line basis over the requisite service period of the grant. For the three months ended March 31, 2011 and 2010, the Company recognized $39 thousand and $43 thousand in stock-based compensation expense, as a component of salaries and benefits, respectively. As of March 31, 2011, there was approximately $65 thousand of total unrecognized compensation cost related to nonvested stock option grants.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(10) Stock-Based Compensation (continued)

The following table summarizes information on stock option activity during 2011:

	Shares			Weighted average exercise price per share		Weighted average remaining contractual terms (in years)		Total intrinsic value (in thousands)
Outstanding, January 1, 2011		204,622		$	10.08
Granted		-			-
Exercised		(917	)		7.85			$	5
Forfeited, expired or cancelled		-			-
Outstanding, March 31, 2011		203,705			10.09		5.71	$	895

Exercisable at March 31, 2011		148,324		$	9.80		5.27	$	692

The aggregate intrinsic value in the table above represents the total pre-tax intrinsic value (i.e., the difference between the Company’s closing stock price on March 31, 2011, and the exercise price, times the number of shares) that would have been received by the option holders had all the option holders exercised their options on March 31, 2011. This amount changes based upon the fair market value of the Company’s stock.

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

The following table summarizes information RSA activity during 2011:

	Shares		Weighted average fair value per share		Weighted average remaining contractual terms (in years)
Outstanding, January 1, 2011		1,354	$	15.06
Granted		-		-
Vested		-		-
Forfeited, expired or cancelled		-		-
Outstanding, March 31, 2011		1,354	$	15.06	0.12

For the three months ended March 31, 2011 and 2010, the Company recognized $5 thousand and $11 thousand in RSA compensation expense, as a component of salaries and benefits, respectively. As of March 31, 2011, there was $3 thousand of total unrecognized compensation costs related to nonvested RSAs.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(10) Stock-Based Compensation (continued)

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

The following table summarizes information on RSU activity during 2011:

	Shares			Weighted average exercise price per share		Weighted average remaining contractual terms (in years)
Outstanding, January 1, 2011		57,533		$	12.56
Granted		500			13.92
Vested		(10,929	)		11.94
Forfeited, expired or cancelled		-			-
Outstanding, March 31, 2011		47,104		$	12.72	3.42

For the three months ended March 31, 2011 and 2010, the Company recognized $174 thousand and $23 thousand in RSU compensation expense, as a component of salaries and benefits, respectively. As of March 31, 2011, there was $467 thousand of total unrecognized compensation costs related to nonvested RSUs.

(11) Shareholders’ Equity

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

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

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

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(11) Shareholders’ Equity (continued)

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

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

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

In accordance with the relevant accounting pronouncements and a letter from the SEC’s Office of the Chief Accountant, the Company recorded the preferred stock and detachable warrants within Shareholders’ Equity on the Consolidated Balance Sheets. The preferred stock and detachable warrants were initially recognized based on their relative fair values at the date of issuance. As a result, the preferred stock’s carrying value is at a discount to the liquidation value or stated value. The discount is considered an unstated dividend cost that shall be amortized over the period preceding commencement of the perpetual dividend using the effective interest method, by charging the imputed dividend cost against retained earnings and increasing the carrying amount of the preferred stock by a corresponding amount. The discount was being amortized over five years using a 6.52% effective interest rate. The total stated dividends (whether or not declared) and unstated dividend cost combined represents a period’s total preferred stock dividend, which is deducted from net income to arrive at net income available to common shareholders on the Condensed Consolidated Statements of Income.

On January 12, 2011, the Company redeemed all 26,380 shares of Fixed Rate Cumulative Perpetual Preferred Stock, Series A, originally issued in January 2009 to the U.S. Department of the Treasury under the Troubled Asset Relief Program Capital Purchase Program. The Company paid a total of $26.6 million to the Treasury, consisting of $26.4 million in principal and $209 thousand in accrued and unpaid dividends. The Company's redemption of the shares is not subject to additional conditions. At December 31, 2010, the preferred stock had a carrying value of $25.3 million (net of a $1 million unaccreted discount) on the Company's statement of financial condition. The Company accelerated the accretion of the remaining discount in the first quarter of 2011, reducing net income available to common shareholders by $1 million.

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

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(11) Shareholders’ Equity (continued)

The preferred stock and detachable warrants were initially recognized based on their relative fair values at the date of issuance. As a result, the value allocated to the warrants was different than the estimated fair value of the warrants as of the grant date. The following assumptions were used to determine the fair value of the warrants as of the grant date:

Dividend yield		5.00	%
Expected life (years)		10
Expected volatility		49.56	%
Risk-free rate		2.80	%
Fair value per warrant at grant date	$	3.27
Relative fair value per warrant at grant date	$	3.49

On March 2, 2011, the Company completed the repurchase of the Warrant to Purchase Common Stock issued to the U.S. Department of the Treasury pursuant to the Troubled Asset Relief Program Capital Purchase Program. The Company repurchased the Warrant for $1.6 million. The Warrant repurchase, together with the Company’s earlier redemption of the entire amount of Fixed Rate Cumulative Perpetual Preferred Stock, Series A, issued to the U.S. Treasury, represents full repayment of all TARP obligations and cancellation of all equity interests in the Company held by the U.S. Treasury.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(12) Fair Value Measurements

(a) Fair Value Hierarchy and Fair Value Measurement: The Company groups its assets and liabilities that are recorded at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. These levels are:

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

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

Level 3: Significant inputs to the valuation model are unobservable.

The following table presents the Company’s assets measured at fair value on a recurring basis at March 31, 2011 and December 31, 2010:

(dollars in thousands)	Fair Value at March 31, 2011
	Level 1		Level 2		Level 3		Total
U.S. government agencies	$	-	$	86,706	$	-	$	86,706
U.S. Treasuries		-		54,478		-		54,478
Pass-through securities		-		1,125		-		1,125
Taxable state and political subdivisions		-		5,822		-		5,822
Tax exempt state and political subdivisions		-		22,896		-		22,896
Corporate obligations		-		8,975		-		8,975
Investments in mutual funds and other equities		-		3,376		-		3,376
Total	$	-	$	183,378	$	-	$	183,378

(dollars in thousands)	Fair Value at December 31, 2010
	Level 1		Level 2		Level 3		Total
U.S. government agencies	$	-	$	102,990	$	-	$	102,990
U.S. Treasuries		-		54,643		-		54,643
Pass-through securities		-		1,239		-		1,239
Taxable state and political subdivisions		-		5,767		-		5,767
Tax exempt state and political subdivisions		-		22,611		-		22,611
Corporate obligations		-		8,974		-		8,974
Investments in mutual funds and other equities		-		3,332		-		3,332
Total	$	-	$	199,556	$	-	$	199,556

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

Certain financial assets of the Company may be measured at fair value on a non-recurring basis. These assets are subject to fair value adjustments that result from application of lower-of-cost-or-market accounting or write-downs of individual assets. For example, when a loan is identified as impaired, it is reported at the lower of cost or fair value, measured based on the loan’s observable market price (Level 1), the present value of expected future cash flows discounted at the loan’s original effective interest rate (Level 2), or the current appraised value of the underlying collateral securing the loan if the loan is collateral dependent (Level 3).

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(12) Fair Value Measurements (continued)

Securities held to maturity may be written down to fair value (determined using the same techniques discussed above for securities available for sale) as a result of other-than-temporary impairment, if any.

The following table presents the carrying value of financial instruments by level within the fair value hierarchy, for which a non-recurring change in fair value has been recorded:

(dollars in thousands)	Fair Value at March 31, 2011
	Level 1		Level 2		Level 3		Total		Total losses for the period
Non-covered impaired loans (1)	$	-	$	-	$	45,840	$	45,840	$	(5,573	)
Non-covered other real estate owned (2)		-		-		4,845		4,845		-
Covered other real estate owned (2)		-		-		28,826		28,826		-
Total	$	-	$	-	$	79,511	$	79,511	$	(5,573	)

(dollars in thousands)	Fair Value at December 31, 2010
	Level 1		Level 2		Level 3		Total		Total losses for the period
Non-covered impaired loans (1)	$	-	$	-	$	43,439	$	43,439	$	(8,269	)
Non-covered other real estate owned (2)		-		-		4,122		4,122		(300	)
Covered other real estate owned (2)		-		-		29,766		29,766		(858	)
Total	$	-	$	-	$	77,327	$	77,327	$	(9,427	)

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

Following is a description of methods and assumptions used to estimate the fair value of each class of financial instrument for which a non-recurring change in fair value has been recorded:

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

Non-covered other real estate owned: Non-covered other real estate owned includes properties acquired through foreclosure. These properties are recorded at the lower of cost or estimated fair value (less estimated cost to sell), based on periodic evaluations.

The Company generally obtains appraisals for collateral dependent loans on an annual basis. Depending on the loan, the Company may obtain appraisals more frequently than 12 months, particularly if the credit is deteriorating. If the loan is performing and market conditions are stable, the Company may not obtain appraisals on an annual basis. This policy does not vary by loan type.

The Company deducts a minimum of 10% of the appraised value for selling costs. If the property has been actively listed for sale for more than six months and has had limited interest, the Company will typically reduce the fair value further based upon input from third party industry experts. This includes adjustments for outdated appraisals based on knowledgeable third party opinions.

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WASHINGTON BANKING COMPANY AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(12) Fair Value Measurements (continued)

Impaired loans that are collateral dependent are reviewed quarterly. The review involves a collateral valuation review, which also contemplates an assessment of whether the last appraisal is outdated. Recent appraisals, adjustments to outdated appraisals, knowledgeable third party opinions of value and current market conditions are combined to determine whether a specific reserve and/or a loan charge-off is required. The Company does not specifically consider the potential for outdated appraisals in its calculation of the formula portion of the allowance for loan losses.

In the rare case where an appraisal is not available, the Company consults with third party industry specific experts for estimates as well as relies upon the Company’s market knowledge and expertise.

(b) Disclosures about Fair Value of Financial Instruments: The table below is a summary of fair value estimates for financial instruments at March 31, 2011 and December 31, 2010, excluding financial instruments recorded at fair value on a recurring basis (summarized in a separate table). The carrying amounts in the following table are recorded in the statement of condition under the indicated captions. The Company has excluded non-financial assets and non-financial liabilities defined by the Codification (ASC 820-10-15-1A), such as Bank premises and equipment, deferred taxes and other liabilities. In addition, the Company has not disclosed the fair value of financial instruments specifically excluded from disclosure requirements of the Financial Instruments Topic of the Codification (ASC 825-10-50-8), such as Bank-owned life insurance policies.

(dollars in thousands)	March 31, 2011				December 31, 2010
	Carrying value		Estimated fair value		Carrying value		Estimated fair value
Financial assets:
Cash and cash equivalents	$	24,349	$	24,349	$	19,766	$	19,766
Interest-bearing deposits		102,237		102,237		61,186		61,186
Federal funds sold		1,100		1,100		735		735
Investment securities available for sale		183,378		183,378		199,556		199,556
FHLB stock		7,576		7,576		7,576		7,576
Loans held for sale		3,455		3,455		10,976		10,976
Non-covered loans, net		807,498		804,321		815,481		813,769
Covered loans, net		340,290		375,505		364,817		411,266
FDIC indemnification asset		96,863		65,622		107,896		73,078

Financial liabilities:
Deposits		1,494,513		1,503,782		1,492,220		1,496,791
Junior subordinated debentures		25,774		9,443		25,774		9,396

Following is a description of methods and assumptions used to estimate the fair value of each class of financial instrument not recorded at fair value but required for disclosure purposes:

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

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

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WASHINGTON BANKING COMPANY AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(12) Fair Value Measurements (continued)

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

Investment Securities: Fair values for investment securities are based on quoted market prices when available or through the use of alternative approaches, such as matrix or model pricing, or broker indicative bids, when market quotes are not readily accessible or available.

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

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

Covered Loans: Covered loans are measured at estimated fair value on the date of acquisition. Subsequent to acquisition, the fair value of covered loans is measured using the same methodology as that of non-covered loans.

FDIC Indemnification Asset: The FDIC indemnification asset is calculated as the expected future cash flows under the loss share agreement discounted by a rate reflective of a U.S. government agency security.

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

Trust Preferred Securities/Junior Subordinated Debentures: The fair value of trust preferred securities is estimated at their recorded value due to the cost of the instrument re-pricing on a quarterly basis.

Off-Balance Sheet Items: Commitments to extend credit represent the principal category of off-balance sheet financial instruments. The fair value of these commitments are not material since they are for relatively short periods of time and are subject to customary credit terms, which would not include terms that would expose the Company to significant gains or losses.

(13) Subsequent Events

On April 29, 2011, the Company announced that its Board of Directors declared a cash dividend of $0.05 per share to shareholders of record as of May 10, 2011, payable on May 25, 2011.

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WASHINGTON BANKING COMPANY AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(14) Commitments and Contingencies

Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements, including commercial paper, bond financing and similar transactions. Except for certain long-term guarantees, most guarantees expire within one year. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Collateral supporting those commitments, for which collateral is deemed necessary, generally amounted to one hundred percent of the commitment amount at March 31, 2011. The Company routinely charges a fee for these credit facilities. Such fees are amortized into income over the life of the agreement and unamortized amounts were not significant as of March 31, 2011. At March 31, 2011, the commitments under these agreements totaled $1.4 million.

At March 31, 2011, the Company was the guarantor of trust preferred securities. The Company issued junior subordinated debentures to a wholly owned special purpose trust, which has issued trust preferred securities. The sole assets of the special purpose trust are the junior subordinated debentures issued by the Company. Washington Banking Company has fully and unconditionally guaranteed the capital securities along with all obligations of the Trust under the trust agreements. The maximum amount of future payments the Company will be required to make under these agreements is the principal and interest of the trust preferred securities, the principal of which totaled $25.8 million at March 31, 2011.

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

Note Regarding Forward-Looking Statements: This Quarterly Report on Form 10-Q includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended and Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking statements describe Washington Banking Company’s (the “Company”) management’s expectations regarding future events and developments such as future operating results, growth in loans and deposits, credit quality and adequacy of the allowance for loan losses, and continued success of the Company’s business plan. Readers should not place undue reliance on forward-looking statements, which reflect management’s views only as of the date hereof. The words “will,” “believe,” “expect,” “should,” “anticipate” and words of similar meaning are intended in part to help identify forward-looking statements. Future events are difficult to predict, and the expectations described below are necessarily subject to risk and uncertainty that may cause actual results to differ materially. In addition to discussions about risks and uncertainties set forth from time to time in the Company’s filings with the Securities and Exchange Commission (the “SEC”), factors that may cause actual results to differ materially from those contemplated in such forward-looking statements include, among others: (1) local and national general and economic condition; (2) changes in interest rates and their impact on net interest margin; (3) competition among financial institutions; (4) legislation or regulatory requirements; and (5) the ability to realize efficiencies expected from investment in personnel and infrastructure. However, the reader should be aware that these factors are not an exhaustive list, and it should not be assumed that these are the only factors that may cause actual results to differ from expectations. In addition, the reader should note that the Company does not intend to update any of the forward-looking statements or the uncertainties that may adversely impact those statements.

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

Overview

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

The Company’s strategy is one of value-added growth. Management believes that qualitative and sustainable growth of the Company, coupled with maintaining profitability, is currently the most appropriate path to providing good value for its shareholders. The Company’s primary objectives are to improve profitability and operating efficiencies and increase market penetrations in areas currently served and expand into adjacent markets.

Executive Overview

Significant items for the first quarter of 2011 were as follows:

On March 2, 2011, the Company completed the repurchase of Warrant to Purchase Common Stock issued to the U.S. Department of the Treasury pursuant to the Troubled Asset Relief Program Capital Purchase Program. The Company repurchased the Warrant for $1.6 million. The Warrant repurchase, together with the Company’s earlier redemption of the entire amount of Fixed Rate Cumulative Perpetual Preferred Stock, Series A, issued to the U.S. Treasury, represents full repayment of all TARP obligations and cancellation of all equity interests in the Company held by the U.S. Treasury.

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Net income available to common shareholders per diluted share was $0.19 for the three months ended March 31, 2011, compared to net income available to common shareholders per diluted common share of $0.10 for the three months ended March 31, 2010. Diluted operating earnings per common share, a non-GAAP financial measure, defined as earnings available to common shareholders before the acceleration of the accretion of the remaining preferred stock discount and merger related expenses, net of tax, divided by the same diluted share total used in determining diluted earnings per common share, was $0.25 and $0.10 for the three months ended March 31, 2011 and 2010, respectively. This measurement and reconciliation to the comparable GAAP measurement is provided under the heading Results of Operations—Overview below.

·	Net interest margin, on a tax equivalent basis, was 5.42% for the three months ended March 31, 2011, compared to 4.66% for the same period a year ago.

·	Total risk-based capital decreased to 19.04% at March 31, 2011, compared to 20.96% at December 31, 2010, reflecting the first quarter 2011 redemption of the 26,380 preferred shares and the repurchase of the associated stock warrants.

·	Tangible book value per common share increased to $9.77 at March 31, 2011, up from $9.71 at December 31, 2010.

Summary of Critical Accounting Policies

The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect amounts reported in the consolidated financial statements and the accompanying notes. Changes in these estimates and assumptions are considered reasonably possible and may have a material impact on the consolidated financial statements and thus actual results could differ from the amounts reported and disclosed herein. Significant accounting policies are described in Note (1) of the Notes to Consolidated Financial Statements for the year ended December 31, 2010, as filed on Form 10-K. Not all of these accounting policies require management to make difficult, subjective or complex judgments or estimates. Management believes that the following accounting policies could be considered critical under the SEC’s definition.

Allowance for Loan Losses: The allowance for loan losses is established to absorb known and inherent losses attributable to loans outstanding. The adequacy of the allowance is monitored on a regular basis and is based on management’s evaluation of numerous quantitative and qualitative factors. Quantitative factors include our historical loss experience, delinquency and charge-off trends, estimates of, and changes in, collateral values, changes in risk ratings on loans and other factors. Qualitative factors include the general economic environment in our markets and, in particular, the state of the real estate market and specific relevant industries. Other qualitative factors that are considered in our methodology include, size and complexity of individual loans in relation to the lending officer’s background and experience levels, loan structure, extent and nature of waivers of existing loan policies, and pace of loan portfolio growth.

As the Company adds new products, increases the complexity of the loan portfolio, and expands its geographic coverage, the Company intends to enhance and adapt its methodology to keep pace with the size and complexity of the loan portfolio. Changes in any of the above factors could have a significant effect on the calculation of the allowance for credit losses in any given period. The Company believes that its systematic methodology continues to be appropriate given our size and level of complexity.

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Acquired Loans: In accordance with FASB ASC 310-30, acquired loans are aggregated into pools, based on individually evaluated common risk characteristics, and aggregate expected cash flows were estimated for each pool. A pool is accounted for as a single asset with a single interest rate, cumulative loss rate and cash flow expectation. The Bank aggregated all of the loans acquired in the FDIC-assisted acquisitions of City Bank and North County Bank into 18 and 14 pools, respectively. A loan will be removed from a pool of loans only if the loan is sold, foreclosed, assets are received in satisfaction of the loan, or the loan is written off, and will be removed from the pool at the carrying value. If an individual loan is removed from a pool of loans due to a payoff, the difference between its relative carrying amount and the cash received will be recognized in income immediately and would not affect the effective yield used to recognize the accretable difference on the remaining pool. Loans originally placed into a performing pool will not be reported individually as 30-89 days past due, non-performing (90+ days past due or nonaccrual) or accounted for as a troubled debt restructuring as the pool is the unit of accounting. Rather, these metrics related to the underlying loans within a performing pool will be considered in our ongoing assessment and estimates of future cash flows. If, at acquisition, the loans were collateral dependent and acquired primarily for the rewards of ownership of the underlying collateral, or if cash flows expected to be collected cannot be reasonably estimated, accrual of income is inappropriate. Such loans were placed into nonperforming (nonaccrual) loan pools.

The cash flows expected to be received over the life of the pool were estimated by management with the assistance of a third party valuation specialist. These cash flows were input into an ASC 310-30 compliant accounting loan system which calculates the carrying values of the pools and underlying loans, book yields, effective interest income and impairment, if any, based on actual and projected events. Default rates, loss severity and prepayment speed assumptions will be periodically reassessed and updated within the accounting model to update the expectation of future cash flows. The excess of the cash flows expected to be collected over the pool’s carrying value is considered to be the accretable yield and is recognized as interest income over the estimated life of the loan or pool using the effective yield method. The accretable yield will change due to changes in the timing and amounts of expected cash flows. For the performing loan pools, a prepayment assumption as documented by the valuation specialist was initially applied. Changes in the accretable yield will be disclosed quarterly.

The excess of the contractual balances due over the cash flows expected to be collected is considered to be the nonaccretable difference. The nonaccretable difference represents the estimate of the credit losses expected to occur and was considered in determining the fair value of the loans as of the acquisition date. Subsequent to the acquisition date, any increases in expected cash flows over those expected at purchase date in excess of fair value are adjusted through the accretable difference on a prospective basis. Any subsequent decreases in expected cash flows over those expected at purchase date are recognized by recording a provision for loan losses. Any disposals of loans, including sales of loans, payments in full or foreclosures, result in the removal of the loan from the pool at its carrying amount.

FDIC Indemnification Asset: The Company has elected to account for amounts receivable under the loss share agreement as an indemnification asset in accordance with FASB ASC 805, Business Combinations. The FDIC indemnification asset is initially recorded at fair value, based on the discounted value of expected future cash flows under the loss share agreement. The difference between the present value and the undiscounted cash flows the Company expects to collect from the FDIC will be accreted into noninterest income over the life of the FDIC indemnification asset.

The FDIC indemnification asset is reviewed quarterly and adjusted for any changes in expected cash flows based on recent performance and expectations for future performance of the covered portfolio. These adjustments are measured on the same basis as the related covered loans and covered other real estate owned. Any increases in cash flow of the covered assets over those expected will reduce the FDIC indemnification asset and any decreases in cash flow of the covered assets under those expected will increase the FDIC indemnification asset. Increases and decreases to the FDIC indemnification asset are recorded as adjustments to noninterest income.

Stock-based Compensation: Pursuant to Financial Accounting Standards 505-50-05, Share-Based Payment, the Company recognizes in the income statement the grant-date fair value of stock awards issued to employees over the employees’ requisite service period (generally the vesting period). The fair value of each stock option grant is estimated as of the grant date using the Black-Scholes option-pricing model. Significant variables used to estimate the fair value of the stock options granted include volatility, forfeiture rate and expected life. The Company’s assumptions utilized at the time of grant impact the fair value of the stock option calculated under the Black-Scholes methodology, and ultimately, the expense that will be recognized over the life of the stock award.

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Results of Operations Overview

For the three months ended March 31, 2011, net income available to common shareholders increased to $3.0 million, or $0.19 per diluted common share, as compared to net income available to common shareholders of $1.6 million, or $0.10 per diluted common share, for the same period a year ago. The increase in net income available to common shareholders was principally attributable to increased interest income on covered loans, partially offset by increased noninterest expense. Primarily due to additional expenses related to the 2010 acquisitions of City Bank and North County Bank, including hiring additional personnel, noninterest expense increased $6.3 million, or 80.8%, for the three months ended March 31, 2011, compared to the same period a year ago.

In addition to results presented in accordance with generally accepted accounting principles in the United States of America (“GAAP”), this filing presents certain non-GAAP financial measures. Management believes that certain non-GAAP financial measures provide investors with information useful in understanding the Company's financial performance; however, readers of this report are urged to review these non-GAAP measures in conjunction with the GAAP results, as reported.

Operating earnings are not a measure of performance calculated in accordance with GAAP. However, management believes that operating earnings are an important indication of the ability to generate earnings through the Company's fundamental banking business. Since operating earnings exclude the effects of certain items that are unusual and/or difficult to predict, management believes that operating earnings provide useful supplemental information to both management and investors in evaluating the Company's financial results.

Operating earnings should not be considered in isolation or as a substitute for net income, cash flows from operating activities or other income or cash flow statement data calculated in accordance with GAAP. Moreover, the manner in which the Company calculates operating earnings may differ from that of other companies reporting measures with similar names.

The following table provides the reconciliation of the Company's GAAP earnings to operating earnings (non-GAAP) for the periods presented:

Reconciliation of Net Operating Earnings to GAAP Earnings Available to Common Shareholders

(dollars in thousands)	Three Months Ended
	March 31,
	2011			2010
GAAP earnings available to common shareholders	$	2,992		$	1,581
Provision for income taxes		1,887			804
		4,879			2,385
Adjustments to GAAP earnings available to common shareholders
Merger related expenses		119			-
Accelerated accretion of remaining preferred stock discount		1,046			-
Operating earnings before taxes		6,044			2,385
Provision for income taxes		(2,115	)		(835	)
Net operating earnings	$	3,929		$	1,550

Diluted GAAP earnings per common share	$	0.19		$	0.10
Diluted operating earnings per common share	$	0.25		$	0.10

Tangible common equity, tangible assets and tangible book value per common share are not measures that are calculated in accordance with GAAP. However, management uses these non-GAAP measures in their analysis of the Company's performance. Management believes that these non-GAAP measures are an important indication of the Company's ability to grow both organically and through business combinations, and with respect to tangible common equity, the Company's ability to pay dividends and to engage in various capital management strategies.

Neither tangible common equity, tangible assets nor tangible book value per common share should be considered in isolation or as a substitute for common shareholders' equity or book value per common share or any other measure calculated in accordance with GAAP. Moreover, the manner in which the Company calculates tangible common equity, tangible assets and tangible book value per share may differ from that of other companies reporting measures with similar names.

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The following table provides the reconciliation of the Company's shareholders' equity (GAAP) to tangible common equity (non-GAAP) and total assets (GAAP) to tangible assets (non-GAAP) for the periods presented:

Tangible Common Equity and Tangible Assets

(dollars in thousands)	March 31, 2011			December 31, 2010
Total shareholders' equity	$	157,125		$	181,646
Adjustments to shareholders' equity
Preferred stock		-			(25,334	)
Other intangible assets, net		(7,383	)		(7,540	)
Tangible common equity	$	149,742		$	148,772

Total assets	$	1,683,387		$	1,704,487
Adjustments to total assets
Other intangible assets, net		(7,383	)		(7,540	)
Tangible assets	$	1,676,004		$	1,696,947

Common shares outstanding at end of period		15,333,073			15,321,277

Tangible common equity ratio		8.93	%		8.77	%
Tangible book value per common share	$	9.77		$	9.71

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

·	The volume, pricing, mix and maturity of interest-earning assets and interest-bearing liabilities;

·	The volume of free funds (consisting of noninterest-bearing deposits and other liabilities and shareholders’ equity);

·	The volume of noninterest-earning assets;

·	Market interest rate fluctuations; and

·	Asset quality.

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

(dollars in thousands)	Three Months Ended March 31,
	2011							2010
			Interest							Interest
	Average		earned/		Average			Average		earned/		Average
	balance		paid		yield			balance		paid		yield
Assets
Non-covered loans (1)(2)	$	835,122	$	12,782		6.21	%	$	820,578	$	13,212		6.53	%
Covered loans		352,663		8,310		9.56	%		-		-		-
Federal funds sold		832		-		-			-		-		-
Interest-bearing deposits		72,339		45		0.25	%		55,346		36		0.27	%
Investments
Taxable		177,583		793		1.81	%		80,861		413		2.07	%
Non-taxable (2)		22,495		319		5.76	%		16,465		239		5.88	%
Interest-earning assets		1,461,034		22,249		6.18	%		973,250		13,900		5.79	%
Noninterest-earning assets		226,636							57,947
Total assets	$	1,687,670						$	1,031,197

Liabilities and shareholders' equity
Deposits:
NOW accounts and MMA	$	559,793	$	720		0.52	%	$	339,523	$	546		0.65	%
Savings		96,176		64		0.27	%		50,594		32		0.25	%
Time deposits		653,520		1,807		1.12	%		336,121		1,925		2.32	%
Total interest-bearing deposits		1,309,489		2,591		0.80	%		726,238		2,503		1.40	%
Federal funds purchased		-		-		-			-		-		-
Junior subordinated debentures		25,774		120		1.89	%		25,774		117		1.84	%
Other interest-bearing liabilities		-		-		-			10,000		91		3.71	%
Total interest-bearing liabilities		1,335,263		2,711		0.82	%		762,012		2,711		1.44	%

Noninterest-bearing deposits		186,915							107,076
Other liabilities		6,034							2,069
Total liabilities		1,528,212							871,157
Total shareholders' equity		159,458							160,040
Total liabilities and
shareholders' equity	$	1,687,670						$	1,031,197
Net interest income/spread			$	19,538		5.36	%			$	11,189		4.35	%
Credit for interest-bearing funds						0.06	%						0.31	%
Net interest margin (2)						5.42	%						4.66	%

(1) Average balance includes nonaccrual loans.
(2) Interest income on non-taxable investments and loans is presented on a taxable-equivalent basis using the federal statutory rate of 35%. These adjustments totaled $251 thousand and $208 thousand for the three months ended March 31, 2011 and 2010,
respectively. Taxable-equivalent is a non- GAAP performance measurement that management believes provides investors with a more accurate picture of the net interest margin and efficiency ratio for comparative purposes.

Taxable-equivalent net interest income totaled $19.5 million for the first quarter of 2011, compared to $11.2 million for the first quarter of 2010. Changes in net interest income during the first quarter of 2011 reflect an $8.3 million increase in income on covered loans resulting from the FDIC-assisted acquisitions of City Bank and North County Bank.

Net interest margin (net interest income as a percentage of average interest-earning assets) on a taxable-equivalent basis was 5.42% for the first quarter of 2011, compared to 4.66% for the same period a year ago. The 76 basis point increase in net interest margin for the period was primarily attributable to the 9.56% average yield on covered loans.

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

	Three Months Ended March 31,
(dollars in thousands)	2011 compared to 2010
	Increase (decrease) due to (2):
	Volume			Rate			Total
Assets
Non-covered loans (1)(3)	$	240		$	(670	)	$	(430	)
Covered loans		8,310			-			8,310
Interest-bearing deposits		11			(2	)		9
Investments (1)
Taxable		424			(44	)		380
Non-taxable		85			(5	)		80
Interest-earning assets	$	9,070		$	(721	)	$	8,349

Liabilities
Deposits:
NOW accounts and money market	$	300		$	(126	)	$	174
Savings		30			2			32
Time deposits		1,211			(1,329	)		(118	)
Total interest-bearing deposits		1,541			(1,453	)		88
Junior subordinated debentures		-			3			3
Other interest-bearing liabilities		(45	)		(46	)		(91	)
Total interest-bearing liabilities	$	1,496		$	(1,496	)	$	-

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

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

For the three months ended March 31, 2011, the Company recorded a $3.0 million provision for non-covered loan losses, compared to $2.2 million for the same period a year ago. Net charge-offs for the first quarter of 2011 were $2.6 million, a $676 thousand increase over the first quarter of 2010. At March 31, 2011 and 2010, the allowance for non-covered loan losses, as a percent of total non-covered loans, was 2.33% and 2.00%, respectively.

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Noninterest Income: The following table presents the key components of noninterest income for the three months ended March 31, 2011 and 2010:

(dollars in thousands)	Three Months Ended March 31,					Change
	2011			2010		2011 vs. 2010
Service charges and fees	$	993		$	735	$	258
Electronic banking income		556			367		189
Investment products		222			50		172
Bank owned life insurance income		80			82		(2	)
Income from the sale of mortgage loans		338			141		197
SBA premium income		121			46		75
Change in FDIC indemnification asset		(1,316	)		-		(1,316	)
Gain on disposition of covered assets		2,218			-		2,218
Other		520			322		198
Total noninterest income	$	3,732		$	1,743	$	1,989

The changes in noninterest income for the three months ended March 31, 2011, compared to the same period a year ago were related to the following areas:

§	Service charges and fees increase was primarily attributable to the increased volume of transaction deposit accounts and an increase in NSF fees.

§	Electronic banking income increase was primarily attributable to an increase in ATM machines acquired through the acquisitions of City Bank and North County Bank.

§	Investment products increased due to increased sales of annuity products to customers seeking more stable investment options.

§	Income from the sale of mortgage loans increased due to an increase in volume of originations and refinances resulting from favorable interest rates.

§	Change in FDIC indemnification asset represents the accretion (amortization) of the FDIC indemnification asset related to the acquisitions of City Bank and North County Bank.

§	Gain on disposition of covered assets is the income the Company recognizes when a covered asset is paid off or sold and the proceeds exceed its carrying value.

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Noninterest Expense: The Company continues to focus on controlling noninterest expenses and addressing long term operating expenses. The following table presents the key elements of noninterest expense:

(dollars in thousands)	Three Months Ended March 31,				Change
	2011		2010		2011 vs. 2010
Salaries and benefits	$	6,819	$	4,329	$	2,490
Occupancy and equipment		1,667		1,027		640
Office supplies and printing		330		210		120
Data processing		470		211		259
Consulting and professional fees		444		268		176
Intangible amortization		157		-		157
Merger related expenses		119		-		119
FDIC premiums		589		252		337
Non-covered OREO and repossession expenses		300		193		107
Covered OREO and repossession expenses		770		-		770
Other		2,391		1,285		1,106
Total noninterest expense	$	14,056	$	7,775	$	6,281

The changes in noninterest expenses for the three months ended March 31, 2011, compared to the same period a year ago were related to the following areas:

§	Salaries and benefits increased primarily due to the increase in full-time equivalents due to the acquisitions of City Bank and North County Bank. Total full-time equivalents were 455 and 298 at March 31, 2011 and 2010, respectively.

§	Occupancy and equipment and office supplies and printing increased primarily due to the additional cost of operating the eight new branches acquired in the City Bank acquisition and the four branches acquired in the North County Bank acquisition.

§	Data processing increased due to the additional expenses related to the City Bank and North County Bank acquisitions. Additionally, the consolidation of North County Bank’s data systems was completed in April 2011.

§	Consulting and professional fees increased due to an increase in legal and accounting fees resulting from the acquisitions of City Bank and North County Bank.

§	Intangible amortization represents amortization related to the core deposit intangible recorded as part of the fair valuation of the City Bank and North County Bank acquisitions.

§	Merger related expenses relate to one-time expenses of the City Bank and North County Banks acquisitions. Merger related expenses include conversion expense, severance and professional and consulting services.

§	FDIC premiums increased primarily due to an increase in year-over-year deposits, as well as due to an industry wide increase in overall assessment rates.

§	Non-covered and covered OREO and repossession expense represents costs the Company incurs in reclaiming, repairing and selling real estate properties and automobiles, as well as any write-downs or losses on the sale of non-covered and covered OREO properties.

§	Other noninterest expense was primarily affected by the increase in branches due to the FDIC-assisted acquisitions.

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Income Taxes: The Company’s consolidated effective tax rates for the first quarter of 2011 and 2010 were 31.6% and 28.7%, respectively. The quarterly effective tax rates are below the federal statutory rate of 35% principally due to nontaxable income generated from investments in bank owned life insurance, tax-exempt municipal bonds and loans. Additionally, the Company’s quarterly 2011 tax rates reflect a benefit from the New Market Tax Credit Program. The tax benefits related to these credits will be recognized in the same periods that the credits are recognized on the Company’s income tax returns.

Financial Condition Overview

Total assets at March 31, 2011, were $1.68 billion, compared to $1.70 billion at December 31, 2010, a decrease of $21.1 million, or 1.2%. Deposits also remained relatively flat for the period, increasing $2.3 million. Total shareholders’ equity was $157.1 million at March 31, 2011, compared to $181.6 million at December 31, 2010, a decrease of $24.5 million, or 13.5%. The decrease in shareholders’ equity reflects the first quarter 2011 redemption of the 26,380 preferred stock shares and the repurchase of the associated stock warrants.

Investment Securities: The composition of the Company’s investment portfolio reflects management’s investment strategy of maintaining an appropriate level of liquidity while providing a relatively stable source of investment income. The investment securities portfolio mitigates interest rate risk inherent in the loan portfolio, while providing a vehicle for the investment of available funds and a source of liquidity.

Total investment securities decreased $16.2 million to $183.4 million at March 31, 2011, compared to $199.6 million December 31, 2010. The decrease in total investment securities is attributable to $19.0 million in maturities and calls, partially offset by $3.0 million in purchases.

The Company’s investment portfolio mix, based upon fair value, is outlined in the table below:

(dollars in thousands)	March 31, 2011		December 31, 2010
U.S. government agencies	$	86,706	$	102,990
U.S. Treasuries		54,478		54,643
Pass-through securities		1,125		1,239
State and political subdivisions		28,718		28,378
Corporate obligations		8,975		8,974
Investments in mutual funds and other equity securities		3,376		3,332
Total investment securities available for sale	$	183,378	$	199,556

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Non-Covered Loans: Total non-covered loans, net of allowance for loans losses, totaled $807.5 million at March 31, 2011, compared to $815.5 million at December 31, 2010, a decrease of $8.0 million, or 1.0%. The Company attempts to balance the diversity of its portfolio, believing that this provides a good means of minimizing risk due to loss and interest rate sensitivity. Active portfolio management has resulted in a diversified portfolio that is not heavily concentrated in any one industry or community.

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

(dollars in thousands)	March 31, 2011						December 31, 2010
	Balance			% of total			Balance			% of total
Commercial	$	147,436			17.9	%	$	145,319			17.5	%
Real estate mortgages:
One-to-four family residential		46,764			5.7	%		46,717			5.6	%
Multi-family and commercial		350,817			42.5	%		348,548			41.9	%
Total real estate mortgages		397,581			48.2	%		395,265			47.5	%

Real estate construction:
One-to-four family residential		68,877			8.4	%		72,945			8.8	%
Multi-family and commercial		38,568			4.7	%		42,664			5.1	%
Total real estate construction		107,445			13.0	%		115,609			13.9	%

Consumer:
Indirect		88,413			10.7	%		90,231			10.8	%
Direct		83,662			10.1	%		85,665			10.3	%
Total consumer		172,075			20.9	%		175,896			21.1	%
Subtotal		824,537			100.0	%		832,089			100.0	%
Deferred loan costs, net		2,199						2,204
Allowance for loan losses		(19,238	)					(18,812	)
Total non-covered loans	$	807,498					$	815,481

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Covered Loans: Total covered loans, net of allowance for loans losses, totaled $340.3 million at March 31, 2011, compared to $364.8 million at December 31, 2010, a decrease of $24.5 million, or 6.7%.

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

(dollars in thousands)	March 31, 2011
	City Bank			North County Bank			Total
Commercial	$	21,804		$	9,944		$	31,748
Real estate mortgages:
One-to-four family residential		6,690			8,660			15,350
Multi-family residential and commercial		213,907			42,692			256,599
Total real estate mortgages		220,597			51,352			271,949

Real estate construction:
One-to-four family residential		8,659			62,867			71,526
Multi-family and commercial		39,348			27,948			67,296
Total real estate construction		48,007			90,815			138,822

Consumer - direct		3,861			17,943			21,804
Subtotal		294,269			170,054			464,323
Fair value discount		(70,403	)		(52,294	)		(122,697	)
Total covered loans		223,866			117,760			341,626
Allowance for loan losses		(1,336	)		-			(1,336	)
Total covered loans, net	$	222,530		$	117,760		$	340,290

(dollars in thousands)	December 31, 2010
	City Bank			North County Bank			Total
Commercial	$	22,524		$	10,313		$	32,837
Real estate mortgages:
One-to-four family residential		7,138			10,586			17,724
Multi-family residential and commercial		237,510			44,524			282,034
Total real estate mortgages		244,648			55,110			299,758

Real estate construction:
One-to-four family residential		8,829			62,056			70,885
Multi-family and commercial		42,281			36,398			78,679
Total real estate construction		51,110			98,454			149,564

Consumer - direct		4,050			18,576			22,626
Subtotal		322,332			182,453			504,785
Fair value discount		(82,782	)		(55,850	)		(138,632	)
Total covered loans		239,550			126,603			366,153
Allowance for loan losses		(1,336	)		-			(1,336	)
Total covered loans, net	$	238,214		$	126,603		$	364,817

The covered loans are subject to loss sharing agreements with the FDIC. The covered loans acquired are, and will continue to be, subject to the Company’s internal and external credit review and monitoring. If credit deterioration is experienced subsequent to the initial acquisition fair value amount, such deterioration will be measured, and a provision for credit losses will be charged to earnings. These provisions will be mostly offset by an increase to the FDIC indemnification asset, and will be recognized in noninterest income.

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Credit Risks and Asset Quality

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

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

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Non-Covered Nonperforming Assets

The following table summarizes the Company’s non-covered, nonperforming assets at March 31, 2011 and December 31, 2010:

(dollars in thousands)	March 31,			December 31,
	2011			2010
Non-covered nonaccrual loans	$	29,520		$	25,846
Total non-covered nonperforming loans		29,520			25,846
Non-covered other real estate owned		4,845			4,122
Total non-covered nonperforming assets	$	34,365		$	29,968

Restructured Loans (1)	$	19,654		$	19,936

Total non-covered impaired loans	$	49,174		$	45,782
Non-covered accruing loans past due 90
days or more	$	-		$	-
Non-covered potential problem loans (2)	$	-		$	5,178

Allowance for loan losses	$	19,238		$	18,812

Non-covered nonperforming loans to total
non-covered loans		3.57	%		3.10	%
Allowance for loan losses to total non-covered loans		2.33	%		2.25	%
Allowance for loan losses to non-covered
nonperfoming loans		65.17	%		72.78	%
Non-covered nonperforming assets to total assets		2.04	%		1.76	%

(1) Represents accruing restructured loans performing according to their restructured terms.
(2) Potential problem loans represent loans where known information about possible credit problems of borrowers causes management to have serious doubts about the ability of such borrowers to comply with the present loan repayment terms but the loans do not presently meet the criteria to be classified as impaired.
Non-covered potential problem loans identified by management at December 31, 2010, have migrated to nonaccrual status at March 31, 2011. There were no loans that management deemed potential problem loans at March 31, 2011.

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The following table summarizes the Company’s non-covered, nonperforming assets, by location, at March 31, 2011:

(dollars in thousands)	Island County			King County			Skagit County			Whatcom County			Snohomish County			Total			Percent of total NPA by loan type


Commercial loans	$	737		$	-		$	3,381		$	-		$	-		$	4,118			11.98	%
Real estate mortgage loans:
One-to-four family residential		435			1,759			746			338			-			3,278			9.54	%
Multi-family and commercial		263			-			1,174			838			475			2,750			8.00	%
Real estate construction loans:
One-to-four family residential		4,035			-			9,171			5,541			-			18,747			54.55	%
Multi-family and commercial		387			-			-			-			-			387			1.13	%
Consumer loans:
Direct		240			-			-			-			-			240			0.70	%
Other Real Estate Owned		179			-			1,380			3,286			-			4,845			14.10	%
Total	$	6,276		$	1,759		$	15,852		$	10,003		$	475		$	34,365			100.00	%

Percent of total NPA by location		18.26	%		5.12	%		46.13	%		29.11	%		1.38	%		100.00	%

Covered Nonperforming Assets

The following table summarizes the Company’s covered, nonperforming assets at March 31, 2011 and December 31, 2010:

(dollars in thousands)	March 31, 2011			December 31, 2010
Covered nonaccrual loans	$	94,438		$	96,182
Covered restructured loans		-			-
Total covered nonperforming loans		94,438			96,182
Covered other real estate owned		28,826			29,766
Total covered nonperforming assets	$	123,264		$	125,948

Total covered impaired loans	$	94,438		$	96,182
Covered accruing loans past due 90
days or more		-			-

Allowance for loan losses	$	1,336		$	1,336

Covered nonperforming loans to total covered loans		27.64	%		26.27	%
Allowance for loan losses to total covered loans		0.39	%		0.36	%
Allowance for loan losses to covered
nonperforming loans		1.41	%		1.39	%
Covered nonperforming assets to total assets		7.32	%		7.39	%

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

Specific Allowances: A specific allowance is established when management has identified unique or particular risks that are related to a specific loan that demonstrate risk characteristics consistent with impairment. Specific allowances may also be established to address the unique risks associated with a group of loans or particular type of credit exposure.

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·	Formula Allowance: The calculations of expected loss rates are determined utilizing a two factor approach; loss given default (“LGD”) and probability of default (“PD”). Taken together, these two factors produce the expected loss rate.

LGD is defined as the rate of loss as determined by dividing the expected net charge-off by defaulted loans, where defaulted loans are defined as loans that have 30 days or greater payment delinquency plus non-accrual and gross loans charged off. LGD rates utilized reflect industry experience as determined by state and loan type, and are based upon banks with total assets below one billion dollars. Banks falling into these size and state groupings will better capture state/geographic differences that occur in LGD rates, as well as provide a sufficient number of observations to be statistically meaningful. LGD rates will be based upon industry experience starting in 1992 and applied at a two standard deviation level. Bank specific LGD rates will be utilized when there are sufficient observations to generate a meaningful result, and these observations should include at least three observations as observed over a minimum of at least one full economic cycle for each type/sector/subsector/geographic combination to be considered meaningful.

PD is defined as the actual payment default rate (defined as the number of times a loan has been delinquent 30 or more days divided by the number of months the loan has been outstanding from the origination date to the valuation date), or for loans which have not generated an actual payment default rate, the rate applied is based upon industry experience for such loans as applied by loan type and state in which the loan applies to (in the case of real estate loans, the state determination is based upon were the collateral resides), where the expected payment default rate is defined as the sum loans where payment delinquencies are 30 or more days delinquent, plus non-accrual and gross loans charged off divided by total loans for each group. Expected payment default rates are then scaled against the bank’s loan risk grades with the bank’s lowest pass/non-watch grade set to equal the industry PD and then scaled lower or higher against the bank’s remaining loan grades.

The Company refined its formula component of the allowance for loan losses model at March 31, 2010. Previous to March 31, 2010, the Company used a less robust model. The Company back-tested the revised model as of December 31, 2009 and ran both models as of March 31, 2010 to ensure consistency and reasonableness of results. At March 31, 2010, the Company chose to move to the revised model as we believe it is more robust, consistent with GAAP and provides additional granularity to the analysis.

Given the fact that the Company ran both models for two periods and both models produced materially similar results, it was determined there was no impact to the allowance or provision for loan losses, nor any significant changes to internal controls, as a result of the change.

The similarities of the models include:

·	Consideration of loan grade classification

·	Consideration of loan type

·	Consideration of historical loss rates

·	Consideration of the underlying business and economic and business conditions

The improvements included in the new model include:

·	Consideration of PD and LGD rates based on geographic/size peer data

·	Additional weight given to recent periods when calculating PD and LGD

·	PD and LGD based on loan type

·	Loan level consideration given to Past Due history

·	Additional detail/input for economic conditions/trends available

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The following table summarizes the Company’s allocation of allowance for non-covered loan losses:

(dollars in thousands)	March 31, 2011					December 31, 2010
	Amount		% of Loans (1)			Amount		% of Loans (1)
Commercial		4,829		17.9	%		3,915		17.5	%
Real estate mortgage		5,868		48.2	%		6,507		47.5	%
Real estate construction		5,459		13.0	%		4,947		13.9	%
Consumer		3,082		20.9	%		3,443		21.1	%
Total	$	19,238		100.0	%	$	18,812		100.0	%

(1) Represents the total of outstanding loans in each category as a percent of total loans outstanding.

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

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

(dollars in thousands)	Three Months Ended
	March 31,
	2011			2010
Balance at beginning of period	$	18,812		$	16,212
Provision for non-covered loan losses		3,000			2,150
Charge-offs:
Commercial		(469	)		(542	)
Real estate mortgage		(1,285	)		(470	)
Real estate construction		-			(675	)
Consumer
Direct		(797	)		(227	)
Indirect		(348	)		(406	)
Total charge-offs		(2,899	)		(2,320	)

Recoveries:
Commercial		81			72
Real estate mortgage		88			2
Real estate construction		1			101
Consumer
Direct		19			29
Indirect		136			218
Total recoveries		325			422
Net charge-offs		(2,574	)		(1,898	)
Balance at end of period	$	19,238		$	16,464

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Deposits: Total deposits increased $2.3 million for the period ended March 31, 2011, compared to December 31, 2010. Excluding the deposits acquired through the FDIC-assisted acquisitions of City Bank and North County Bank, organic deposit growth for the first quarter of 2011 totaled $17.6 million.

The following table further details the major components of the Company’s deposit portfolio:

(dollars in thousands)	March 31, 2011					December 31, 2010
	Balance		% of total			Balance		% of total			Change
Noninterest-bearing demand	$	188,583		12.6	%	$	184,098		12.3	%	$	4,485
NOW accounts		204,836		13.7	%		206,717		13.9	%		(1,881	)
Money market		367,940		24.6	%		341,211		22.9	%		26,729
Savings		96,389		6.5	%		94,235		6.3	%		2,154
Time deposits		636,765		42.6	%		665,959		44.6	%		(29,194	)
Total deposits	$	1,494,513		100.0	%	$	1,492,220		100.0	%	$	2,293

The following table details the major components of the Company’s deposit portfolio, the City Bank and North County Bank acquisitions deposit portfolios and an “organic” column for comparison purposes:

(dollars in thousands)	March 31, 2011
	Consolidated				North
	Balance		City Bank		County Bank		Organic
Noninterest-bearing demand	$	188,583	$	41,167	$	13,351	$	134,065
NOW accounts		204,836		31,278		18,427		155,131
Money market		367,940		76,577		27,414		263,949
Savings		96,389		29,418		3,971		63,000
Time deposits		636,765		273,670		102,669		260,426
Total deposits	$	1,494,513	$	452,110	$	165,832	$	876,571

(dollars in thousands)	December 31, 2010
	Consolidated				North
	Balance		City Bank		County Bank		Organic
Noninterest-bearing demand	$	184,098	$	43,421	$	12,800	$	127,877
NOW accounts		206,717		27,800		19,931		158,986
Money market		341,211		67,034		28,583		245,594
Savings		94,235		30,616		4,090		59,529
Time deposits		665,959		291,967		106,965		267,027
Total deposits	$	1,492,220	$	460,838	$	172,369	$	859,013

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

(dollars in thousands)	March 31, 2011						December 31, 2010
	Balance			% of total			Balance			% of total
Mutual fund money market deposits		24,704			75.2	%		24,704			72.9	%
CDARS deposits		8,141			24.8	%		9,206			27.1	%
Total wholesale deposits	$	32,845			100.0	%	$	33,910			100.0	%

Wholesale deposits to total deposits		2.2	%					2.3	%

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

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

Borrowings: At March 31, 2011 and December 31, 2010, borrowings totaled $25.8 million. The Company’s sources of funds consist of borrowings from correspondent banks, the FHLB and junior subordinated debentures.

FHLB Overnight Borrowings and Other Borrowed Funds: The Company relies upon advances from the FHLB to supplement funding needs. The FHLB provides credit for member financial institutions in the form of overnight borrowings, short term and long term advances. As a member, the Bank is required to own capital stock in the FHLB and is authorized to apply for advances on the pledge of certain of its mortgage loans and other assets (principally, securities which are obligations of, or guaranteed by, the United States) provided certain standards related to creditworthiness have been met. At March 31, 2011, the Company had no outstanding overnight borrowings or other borrowed funds. The Company had a remaining unused line of credit of $214.4 million, subject to certain collateral and stock requirements at March 31, 2011.

·	Federal Funds Purchased: The Company also uses lines of credit at correspondent banks to purchase federal funds for short-term funding. There were no outstanding borrowings at March 31, 2011. Available borrowings under these lines of credit totaled $60.0 million at March 31, 2011.

Federal Reserve Bank Overnight Borrowings: The Company can use advances from the Federal Reserve Bank (“FRB”) of San Francisco to supplement funding needs. The FRB provides credit for financial institutions in the form of overnight borrowings. The Bank is required to pledge certain of its loans and other assets (principally, securities which are obligations of, or guaranteed by, the United States) provided certain standards related to creditworthiness have been met.

Junior Subordinated Debentures: A wholly-owned subsidiary of the Company issued $25.8 million of trust preferred securities with a quarterly adjustable rate based upon the London Interbank Offered Rate (“LIBOR”) plus 1.56%. The debentures, within certain limitations, are considered Tier 1 capital for regulatory capital requirements.

Capital

Shareholders’ Equity: Shareholders’ equity decreased $24.5 million to $157.1 million at March 31, 2011, from $181.6 million at December 31, 2010. The decrease in shareholders’ equity was due principally to the $26.4 million redemption of preferred stock and the $1.6 million repurchase of stock warrants issued to the U.S. Treasury.

On April 29, 2011, the Company announced that its Board of Directors declared a cash dividend of $0.05 per share to shareholders of record as of May 10, 2011, payable on May 25, 2011.

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

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

The FDIC established the qualifications necessary to be classified as a “well-capitalized” bank, primarily for assignment of FDIC insurance premium rates. As the following table indicates, the Company and Bank qualified as “well-capitalized” at March 31, 2011 and December 31, 2010:

	Regulatory Requirements						Actual Ratios
	Adequately- capitalized			Well-capitalized			March 31, 2011			December 31, 2010
Total risk-based capital ratio
Company (consolidated)		8.00	%		N/A			19.04	%		20.96	%
Whidbey Island Bank		8.00	%		10.00	%		18.44	%		20.78	%

Tier 1 risk-based capital ratio
Company (consolidated)		4.00	%		N/A			17.78	%		19.70	%
Whidbey Island Bank		4.00	%		6.00	%		17.18	%		19.52	%

Tier 1 leverage ratio
Company (consolidated)		4.00	%		N/A			10.46	%		11.42	%
Whidbey Island Bank		4.00	%		5.00	%		10.10	%		11.30	%

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

Liquidity and Cash Flows

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

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

Consolidated Cash Flows: As disclosed in the Condensed Consolidated Statements of Cash Flows, net cash provided by operating activities was $17.4 million for the three months ended March 31, 2011. Net cash provided by investing activities was $55.1 million for the period. Decreases in net non-covered and covered loans provided $21.9 million, net investment activity provided $16.0 million and net proceeds from the FDIC indemnification asset provided $9.7 million for the period. Net cash used in financing activities was $26.5 million for the three months ended March 31, 2011, and primarily consisted of the redemption of the preferred stock and the repurchase of the stock warrants issued to the U.S. Treasury.

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Capital Resources:

Off-Balance Sheet Items: The Company is a party to financial instruments with off-balance sheet risk. Among the off-balance sheet items entered into in the ordinary course of business are commitments to extend credit and the issuance of letters of credit. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amounts recognized on the balance sheet. Certain commitments are collateralized. At March 31, 2011 and December 31, 2010, the Company’s commitments under letters of credit and financial guarantees amounted to $1.4 million and $1.8 million, respectively. Since many of the commitments are expected to expire without being drawn upon, these total commitment amounts do not necessarily represent future cash requirements.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

At March 31, 2011, based on the measures used to monitor and manage interest rate risk, there has not been a material change in the Company's interest rate risk since December 31, 2010. Should rates increase, the Company may, or may not be positively impacted due to its current slightly liability sensitive position. For additional information, refer to the Company's Form 10-K for year ended December 31, 2010 filed with the SEC.

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

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

Changes in Internal Control over Disclosure and Reporting

There was no change in the Company’s internal control over financial reporting that occurred during the period ended March 31, 2011, that has materially affected, or is reasonably likely to materially affect, the internal control over financial reporting.

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PART II – OTHER INFORMATION

Item 1. Legal Proceedings

The Company may be involved in legal proceedings in the regular course of business. At this time, based on information currently available, we believe that the eventual outcome of such pending litigation will not have a material adverse effect on the Company’s financial condition, results of operations or cash flows.

Item 1A. Risk Factors

For information regarding risk factors, please refer to Part I, Item 1A in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010.

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

(a) – (c) None

Item 3. Defaults Upon Senior Securities

None

Item 4. (Removed and Reserved)

Item 5. Other Information

(a) Not applicable

(b)

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

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Item 6. Exhibits

Exhibits

3.1

Amended and Restated Articles of Incorporation (incorporated by reference to Exhibit 3.1 to the Form 10-K filed March 12, 2010)

3.2

Bylaws of the Company (incorporated by reference to Exhibit 4.1 to the Registrant’s Form SB-2 (Registration No. 333-49925) filed April 10, 1998)

4.1

Form of Common Stock Certificate (incorporated by reference to Exhibit 4.1 to the Registrant’s Form SB-2 (Registration No. 333-49925) filed April 10, 1998)

4.2

Pursuant to Section 601(b)(4)(iii)(A) of Regulation S-K, copies of instruments defining the rights of holders of long-term debt are not filed. The Company agrees to furnish a copy thereof to the Securities and Exchange Commission upon request.

31.1

Certification of Chief Executive Officer required by Rule 13a-14(a) or Rule 15d-14(a) and Section 302 of the Sarbanes Oxley Act of 2002

31.2

Certification of Chief Financial Officer required by Rule 13a-14(a) or Rule 15d-14(a) and Section 302 of the Sarbanes Oxley Act of 2002

32.1

Certification of Chief Executive Officer required by Rule 13a-14(b) or Rule 15d-14(b) and Section 906 of the Sarbanes Oxley Act of 2002, 18 U.S.C. Section 1350

32.2

Certification of Chief Financial Officer required by Rule 13a-14(b) or Rule 15d-14(b) and Section 906 of the Sarbanes Oxley Act of 2002, 18 U.S.C. Section 1350

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

WASHINGTON BANKING COMPANY

Date: May 10, 2011	By: /s/ John L. Wagner
	President and Chief Executive Officer

Date: May 10, 2011	By: /s/ Richard A. Shields
	Executive Vice President and Chief Financial Officer

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