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Washington Banking Company 10-Q 2008

Documents found in this filing:

  1. 10-Q
  2. Ex-31.1
  3. Ex-31.2
  4. Ex-32.1
  5. Ex-32.2
  6. Ex-32.2
e10vq
Table of Contents

 
 
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
     
þ   Quarterly report pursuant to Section 13 or l5(d) of the Securities Exchange Act of 1934
For the quarterly period ended June 30, 2008
     
o   Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the transition period from                      to                     
Commission File Number 000-24503
WASHINGTON BANKING COMPANY
(Exact name of registrant as specified in its charter)
     
Washington   91-1725825
(State or other jurisdiction of
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 þ No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
             
Large accelerated filer o    Accelerated filer þ    Non-accelerated filer   o
(Do not check if a smaller reporting company)
  Smaller reporting company o 
Indicate by check mark if the registrant is a shell company as defined in Rule 12b-2 under the Securities Exchange Act of 1934, as amended. Yes o No þ
The number of shares of the issuer’s Common Stock outstanding at August 1, 2008 was 9,487,560.
 
 

 


 

Table of Contents
         
    Page
PART I — FINANCIAL INFORMATION
 
       
 
    1  
 
    2  
 
    3  
 
    4  
 
    5  
 
    11  
 
    21  
 
    21  
 
PART II — OTHER INFORMATION
 
    22  
 
    22  
 
    22  
 
    22  
 
    22  
 
    22  
 
    22  
 
    23  
 
 EXHIBIT 31.1
 EXHIBIT 31.2
 EXHIBIT 32.1
 EXHIBIT 32.2

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PART I — FINANCIAL INFORMATION
Item 1. Financial Statements
WASHINGTON BANKING COMPANY
AND SUBSIDIARIES
Condensed Consolidated Statements of Financial Condition (unaudited)
(Dollars in thousands, except per share data)
                 
    June 30,     December 31,  
    2008     2007  
Assets
               
Cash and due from banks
($3,481 and $3,496, respectively, are restricted)
  $ 22,783     $ 18,795  
Interest-bearing deposits
    515       257  
Federal funds sold
    3,280        
 
           
Total cash, restricted cash, and cash equivalents
    26,578       19,052  
Investment securities available for sale
    11,310       13,832  
 
               
Federal Home Loan Bank stock
    2,880       1,984  
 
               
Loans held for sale
    562       2,347  
 
               
Loans receivable
    824,600       805,862  
Allowance for loan losses
    (11,585 )     (11,126 )
 
           
Total loans, net
    813,015       794,736  
 
               
Premises and equipment, net
    24,662       25,138  
Bank owned life insurance
    16,739       16,517  
Other assets
    8,131       8,683  
 
           
Total assets
  $ 903,877     $ 882,289  
 
           
 
               
Liabilities and Shareholders’ Equity
               
Liabilities:
               
Deposits
               
Noninterest-bearing
  $ 91,764     $ 101,539  
Interest-bearing
    290,437       315,298  
Time deposits
    350,667       341,517  
 
           
Total deposits
    732,868       758,354  
 
               
FHLB overnight borrowings
    34,000       20,500  
Other borrowed funds
    30,000        
Junior subordinated debentures
    25,774       25,774  
Other liabilities
    3,699       4,091  
 
           
Total liabilities
    826,341       808,719  
 
               
Commitments and contingencies
           
 
               
Shareholders’ equity:
               
Preferred stock, no par value. Authorized 20,000 shares: no shares issued or outstanding
           
Common stock, no par value. Authorized 13,679,757 shares:
issued and outstanding 9,487,560 at 6/30/2008 and 9,453,767 at 12/31/2007
    33,208       32,812  
Retained earnings
    44,226       40,652  
Accumulated other comprehensive income
    102       106  
 
           
Total shareholders’ equity
    77,536       73,570  
 
           
Total liabilities and shareholders’ equity
  $ 903,877     $ 882,289  
 
           
See accompanying notes to condensed consolidated financial statements.

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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     Six Months Ended  
    June 30,     June 30,  
    2008     2007     2008     2007  
Interest income:
                               
Interest and fees on loans
  $ 14,383     $ 15,185     $ 29,744     $ 29,614  
Interest on taxable investment securities
    96       136       206       269  
Interest on tax exempt investment securities
    51       68       102       138  
Other
    3       67       8       99  
 
                       
Total interest income
    14,533       15,456       30,060       30,120  
Interest expense:
                               
Interest on deposits
    4,542       5,480       9,837       10,803  
Interest on other borrowings
    359       137       663       170  
Interest on junior subordinated debentures
    284       484       689       822  
 
                       
Total interest expense
    5,185       6,100       11,189       11,795  
Net interest income
    9,348       9,356       18,871       18,325  
Provision for loan losses
    1,050       850       2,075       1,400  
 
                       
Net interest income after provision for loan losses
    8,298       8,506       16,796       16,925  
 
                       
Noninterest income:
                               
Service charges and fees
    711       797       1,437       1,614  
Income from the sale of loans
    51       211       141       366  
SBA premium income
    45       123       189       261  
Other
    831       822       1,665       1,517  
 
                       
Total noninterest income
    1,638       1,953       3,432       3,758  
Noninterest expense:
                               
Salaries and benefits
    3,798       4,132       7,788       8,543  
Occupancy and equipment
    902       980       1,851       1,936  
Office supplies and printing
    120       179       240       309  
Data processing
    153       167       314       308  
Consulting and professional fees
    147       99       362       270  
Other
    1,208       1,313       2,653       2,428  
 
                       
Total noninterest expense
    6,328       6,870       13,208       13,794  
 
                       
Income before provision for income taxes
    3,608       3,589       7,020       6,889  
Provision for income taxes
    1,187       1,129       2,262       2,161  
 
                       
Net income
  $ 2,421     $ 2,460     $ 4,758     $ 4,728  
 
                       
 
                               
Net income per share, basic
  $ 0.25     $ 0.26     $ 0.50     $ 0.50  
 
                       
 
                               
Net income per share, diluted
  $ 0.25     $ 0.26     $ 0.50     $ 0.50  
 
                       
 
                               
Average number of shares outstanding, basic
    9,464,000       9,363,000       9,445,000       9,403,000  
Average number of shares outstanding, diluted
    9,519,000       9,486,000       9,511,000       9,548,000  
See accompanying notes to condensed consolidated financial statements.

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WASHINGTON BANKING COMPANY
AND SUBSIDIARY
Condensed Consolidated Statements of Shareholders’ Equity and
Comprehensive Income (unaudited)
(Dollars in thousands, except per share data)
                                         
                            Accumulated        
                            other     Total  
    Common stock     Retained     comprehensive     Shareholders’  
    Shares     Amount     earnings     Income (loss)     equity  
Balances at December 31, 2006
    9,389     $ 33,016     $ 33,422     $ (45 )   $ 66,393  
 
Comprehensive income:
                                       
Net income
    ¾       ¾       4,728       ¾       4,728  
Net change in unrealized loss on securities available for sale, net of tax of ($32)
    ¾       ¾       ¾       (59 )     (59 )
 
                                     
Total comprehensive income
    ¾       ¾       ¾       ¾       4,669  
 
                                     
Cash dividend, $0.11 per share
    ¾       ¾       (1,042 )     ¾       (1,042 )
Stock-based compensation
    ¾       155       ¾       ¾       155  
Common stock repurchased and retired
    (116 )     (1,851 )     ¾       ¾       (1,851 )
Stock options exercised
    109       675       ¾       ¾       675  
Forfeited and cancelled restricted stock
    (2 )     ¾       ¾       ¾       ¾  
Tax benefit associated with stock awards
    ¾       122       ¾       ¾       122  
 
                             
Balances at June 30, 2007
    9,380     $ 32,117     $ 37,108     $ (104 )   $ 69,121  
 
                             
 
                                       
Balances at December 31, 2007
    9,454     $ 32,812     $ 40,652     $ 106     $ 73,570  
 
Comprehensive income:
                                       
Net income
    ¾       ¾       4,758       ¾       4,758  
Net change in unrealized loss on securities available for sale, net of tax of ($3)
    ¾       ¾       ¾       (4 )     (4 )
 
                                     
Total comprehensive income
    ¾       ¾       ¾       ¾       4,754  
 
                                     
Cash dividend, $0.125 per share
    ¾       ¾       (1,184 )     ¾       (1,184 )
Tax benefit associated with stock awards
    ¾       40       ¾       ¾       40  
Stock based compensation expense
    ¾       184       ¾       ¾       184  
Exercise of common stock- stock options
    32       172       ¾       ¾       172  
Issuance of restricted stock
    3       ¾       ¾       ¾       ¾  
Cancellation of restricted stock
    (1 )     ¾       ¾       ¾       ¾  
Tax benefit associated with stock awards
    ¾       40       ¾       ¾       40  
 
                             
Balances at June 30, 2008
    9,488     $ 33,208     $ 44,226     $ 102     $ 77,536  
 
                             

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WASHINGTON BANKING COMPANY
AND SUBSIDIARY
Condensed Consolidated Statements of Cashflows (unaudited)
(Dollars in thousands)
                 
    Six Months Ended  
    June 30,  
    2008     2007  
Cash flows from operating activities:
               
Net income from continuing operations
  $ 4,758     $ 4,728  
Adjustments to reconcile net income to net cash provided by operating activities:
               
Accretion of investment discounts, net
    (6 )     (3 )
Deferred income tax expense (benefit)
    (116 )     223  
Depreciation and amortization
    893       886  
Earnings on bank owned life insurance
    (222 )     (247 )
Provision for loan losses
    2,075       1,400  
Net gain on sale of other real estate
    (88 )     (71 )
Write-downs of other real estate
    134       ¾  
Amortization of stock-based compensation
    184       155  
Excess tax benefit from stock-based compensation
    (40 )     (122 )
Net change in assets and liabilities:
               
Net (increase) decrease in loans held for sale
    1,785       (2,377 )
Decrease (increase) in other assets
    469       (778 )
Increase (decrease) in other liabilities
    (392 )     272  
 
           
Cash provided by operating activities:
    9,434       4,066  
 
           
Cash flows from investing activities:
               
Purchases of investment securities, available-for-sale
    (498 )     (2,635 )
Purchase of Federal Home Loan Bank Stock
    (896 )     ¾  
Maturities/calls/principal payments of investment and
    ¾       ¾  
mortgage — backed securities, available for sale
    3,019       2,318  
Net (increase) loans
    (20,954 )     (46,286 )
Purchases of premises and equipment
    (417 )     (681 )
Purchases of bank owned life insurance
    ¾       (5,000 )
Proceeds from the sale of other real estate owned
    796       940  
 
           
Cash flows used by investing activities
    (18,950 )     (51,344 )
 
           
 
               
Cash flows from financing activities:
               
Net increase (decrease) in deposits
    (25,486 )     25,819  
Gross payments on other borrowed funds
    ¾       (10,000 )
New borrowings on other borrowed funds
    30,000       20,000  
Net increase (decrease) in FHLB overnight borrowings
    13,500       7,925  
Gross payments on junior subordinated debentures
    ¾       (15,007 )
New borrowings on junior subordinated debentures
    ¾       25,774  
Dividends paid on common stock
    (1,184 )     (1,042 )
Common stock repurchased
    ¾       (1,851 )
Excess tax benefits from stock-based compensation
    40       122  
Proceeds from exercise of common stock- stock options
    172       675  
 
           
Cash provided by financing activities
    17,042       52,415  
 
           
Net change in cash and cash equivalents
    7,526       5,137  
 
           
Cash and cash equivalents at beginning of period
    19,052       19,745  
 
           
Cash and cash equivalents at end of period
  $ 26,578     $ 24,882  
 
           
Supplemental information:
               
Loans foreclosed and transferred to other real estate owned
  $ 600     $ 548  
Cash paid for interest
    11,114       12,054  
Cash paid for income taxes
    2,352       1,360  
See accompanying notes to condensed consolidated financial statements.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
     (Dollars In Thousands, Except Per Share Data)
(1) Description of Business and Summary of Significant Accounting Policies
(a) Description of Business: Washington Banking Company (the “Company” or “WBCO”) is a registered bank holding company formed on April 30, 1996. At June 30, 2008 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, 2007 audited consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K filed with the SEC. In management’s opinion, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the six months ended June 30, 2008 are not necessarily indicative of the results that may be expected for the year ending December 31, 2008. 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 2008 presentation. These reclassifications had no significant impact on the Company’s financial position or results of operations.
(2) Recent Financial Accounting Pronouncements
In March 2008, the Financial Accounting Standards Board (“FASB”) issued FASB Statement No. 161, Disclosures about Derivative Instruments and Hedging Activities — an Amendment of FASB Statement 133. Statement No. 161 enhances required disclosures regarding derivatives and hedging activities, including enhanced disclosures regarding how: (a) an entity uses derivative instruments; (b) derivative instruments and related hedged items are accounted for under FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities; and (c) derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows. Specifically, Statement 161 requires:
    Disclosure of the objectives for using derivative instruments be disclosed in terms of underlying risk and accounting designation;
 
    Disclosure of the fair values of derivative instruments and their gains and losses in a tabular format;
 
    Disclosure of information about credit-risk-related contingent features; and
 
    Cross-reference from the derivative footnote to other footnotes in which derivative-related information is disclosed.
Statement No. 161 is effective for fiscal years and interim periods beginning after November 15, 2008. The Company does not expect the standard to have a material impact on its financial statements.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Dollars In Thousands, Except Per Share Data)
(2) Recent Financial Accounting Pronouncements- (Continued)
In May 2008, the Financial Accounting Standards Board (“FASB”) issued FASB Statement No. 162, The Hierarchy of Generally Accepted Accounting Principles. Statement No. 162 identifies the sources of accounting principles and the framework for selecting the principles to be used in the preparation of financial statements of nongovernmental entities that are presented in conformity with generally accepted accounting principles (GAAP) in the United States (the GAAP hierarchy).
Statement No. 162 is effective 60 days following the SEC’s approval of the Public Company Accounting Oversight Board amendments to AU Section 411, The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles. The Company does not expect the standard to have any impact on its financial statements.
In May 2008, FASB issued Statement No. 163, Accounting for Financial Guarantee Insurance Contracts: An interpretation of FASB Statement No. 60. Statement No. 163 requires that an insurance enterprise to recognize a claim liability prior to an event of default when there is evidence that credit deterioration has occurred in an insured financial obligation.
Statement No. 163 is effective for financial statements issued for fiscal years beginning after December 15, 2008, and all interim periods within those fiscal years. The Company does not expect the standard to have any impact on its financial statements.
(3) Earnings Per Share
Basic earnings per share is computed by dividing net income available to common shareholders by the weighted average number 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 issueable upon exercise of options and non-vested restricted stock were included.
The following table reconciles the denominator of the basic and diluted earnings per share computation:
                                 
    Three Months Ended   Six Months Ended
    June 30,   June 30,
    2008   2007   2008   2007
Weighted average shares-basic
    9,464,000       9,363,000       9,445,000       9,403,000  
Effect of dilutive securities: stock awards
    55,000       123,000       66,000       145,000  
 
                               
Weighted average shares-diluted
    9,519,000       9,486,000       9,511,000       9,548,000  
 
                               
At June 30, 2008 and 2007, the following stock awards were antidilutive and therefore not included in the computation of diluted net income per share.
                                 
    Three Months Ended   Six Months Ended
    June 30,   June 30,
    2008   2007   2008   2007
Antidilutive awards not included in diluted earnings per share
    95,689       43,595       83,908       23,675  

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Dollars In Thousands, Except Per Share Data)
(4) Stock-Based Compensation
(a) Stock Options: The Company measures the fair value of each stock option grant at the date of the grant, using the Black Scholes option pricing model. The weighted average fair value per share of options granted during the six months ended June 30, 2008 and 2007 was $2.82 and $5.11 per share, respectively. The following assumptions were used in arriving at the fair value of options granted:
                 
    Six Months Ended
    June 30,
    2008   2007
Risk-free interest rate
    3.44 %     4.59 %
Dividend yield rate
    2.90 %     1.50 %
Price volatility
    40.50 %     33.00 %
Expected life of stock options
  5 years   5 years
The Company recognizes compensation expense for stock option awards on a straight-line basis over the requisite service period of the award. For the six months ended June 30, 2008 and 2007 the Company recognized $64 and $45, respectively, in stock based compensation expense as a component of salaries and benefits. As of June 30, 2008 there was approximately $625 of total unrecognized compensation cost related to nonvested stock awards.
The following table summarizes information on stock option activity during 2008:
                                 
            Weighted   Weighted average   Aggregate
            average exercise   remaining contractual   intrinsic
    Shares   price per share   terms (in years)   value
Outstanding at January 1, 2008
    192,618     $ 9.63                  
Granted
    131,500       9.11                  
Exercised
    (31,629 )     5.48             $ 274  
Forfeited, expired or cancelled
    (5,202 )     15.85                  
 
                               
Outstanding at June 30, 2008
    287,287     $ 9.74       7.77     $ 209  
 
                               
 
                               
 
                               
Exercisable at June 30, 2008
    103,141     $ 7.48       4.50     $ 209  
 
                               
The aggregate intrinsic value in the table above represents the total pretax intrinsic value (i.e., the difference between the Company’s closing stock price on June 30, 2008 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 June 30, 2008. 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”) and restricted stock units (“RSU”) periodically for the benefit of employees and directors. Recipients of RSA awards 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. Recipients of RSU awards do not pay any cash consideration to the Company for the shares. Restrictions for both awards are based on continuous service requirements with the Company.
The following table summarizes information on restricted stock activity during 2008:
                         
            Weighted average   Weighted average remaining
    Shares   grant price per share   contractual terms (in years)
Outstanding at January 1, 2008
    29,561     $ 13.08          
Granted
    ¾       ¾          
Vested
    (13,341 )     12.24          
Forfeited, expired or cancelled
    (1,290 )     13.41          
 
                       
Outstanding at June 30, 2008
    14,930     $ 13.80       2.00  
 
                       

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Dollars In Thousands, Except Per Share Data)
For the six months ended June 30, 2008 and 2007 the Company recognized $79 and $110, respectively, in restricted stock compensation expense as a component of salaries and benefits. As of June 30, 2008 there was $205 of total unrecognized compensation costs related to nonvested restricted stock.
(c) Restricted Stock Units: The Company grants restricted stock units periodically for the benefit of employees and directors. Recipients of restricted stock units receive shares of the Company’s stock upon the lapse of their related restrictions and do not pay any cash consideration to the Company for the shares. Restrictions are based on continuous service.
The following table summarizes information on restricted stock unit activity during the six months ended June 30, 2008:
                         
            Weighted average   Weighted average remaining
    Shares   grant price per share   contractual terms (in years)
Outstanding at January 1, 2008
    17,815     $ 15.98          
Granted
    17,925       11.86          
Vested
    (3,866 )     ¾          
Forfeited, expired or cancelled
    (1,036 )     15.98          
 
                       
Outstanding at June 30, 2008
    30,838     $ 13.58       3.14  
 
                       
For the six months ended June 30, 2008 the Company recognized $47 in restricted stock units compensation expense as a component of salaries and benefits; there was no compensation expense in the prior year. As of June 30, 2008, there was $391 of total unrecognized compensation costs related to nonvested restricted stock units.
(5) Fair Value Measurements
Effective January 1, 2008, the Company adopted FASB Statement No.157, Fair Value Measurements, for all financial instruments and non-financial instruments accounted for at fair value on a recurring basis. Statement No. 157 establishes a new framework for measuring fair value and expands related disclosures. Broadly, Statement No. 157 framework requires fair value to be determined based on the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants. Statement No. 157 establishes market or observable inputs as the preferred source of values, followed by assumptions based on hypothetical transactions in the absence of market inputs.
The valuation techniques required by Statement No. 157 are based upon observable and unobservable inputs. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect our market assumptions. These two types of inputs create the following fair value hierarchy:
     
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 section describes the valuation methodologies the Company uses to measure different financial instruments at fair value.
Investments in debt and equity securities: 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, municipal bonds and one mortgage-backed security.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Dollars In Thousands, Except Per Share Data)
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. 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. Impaired loans, which are collateral dependent, are included in the nonrecurring basis table below.
Other real estate owned: Other real estate owned (“OREO”) 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. Other real estate owned, which has been recorded at estimated fair value are included in the nonrecurring basis table below
The following table presents the Company’s assets measured at fair value on a recurring basis at June 30, 2008:
                                 
    Level 1     Level 2     Level 3     Total  
Assets
                               
Investment securities
  $ ¾     $ 11,310     $ ¾     $ 11,310  
 
                       
Total
  $ ¾     $ 11,310     $ ¾     $ 11,310  
 
                       
The following table presents the Company’s assets measured at fair value on a nonrecurring basis at June 30, 2008:
                                 
    Level 1     Level 2     Level 3     Total  
Assets
                               
Impaired loans
  $ ¾     $ ¾     $ 2,515     $ 2,515  
Other real estate owned
    ¾       ¾       932       932  
 
                       
Total
  $ ¾     $ ¾     $ 3,447     $ 3,447  
 
                       
In accordance with FASB Statement No. 114, Accounting by Creditors for Impairment of a Loan, impaired loans, with carrying amounts of $2,500 had specific valuation allowances totaling $292, which were included in the allowance for loan losses.
In accordance with FASB Statement No.144, Accounting for the Impairment or Disposal of Long-Lived Assets, OREO properties with a total carrying amount of $1,066 were written down to their fair value of $932. The write down of OREO properties totaling $134, was included in other noninterest expense.
(6) Subsequent Events
On July 24, 2008, the Company announced that its Board of Directors declared a cash dividend of $0.065 per share to shareholders of record as of August 5, 2008, payable on August 20, 2008.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Dollars In Thousands, Except Per Share Data)
(7) Commitments and Guarantees
Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements, including commercial paper, bond financing and similar transactions. Except for certain long-term guarantees, most guarantees expire in one year. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Collateral supporting those commitments, for which collateral is deemed necessary, generally amounted to one hundred percent of the commitment amount at June 30, 2008. 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 June 30, 2008. As of June 30, 2008 the commitments under these agreements were $2,201.
At June 30, 2008, the Company was the guarantor of trust preferred securities. The Company has issued junior subordinated debentures to a wholly owned special purpose trust, which has issued trust preferred securities. The sole assets of the special purpose trust are the junior subordinated debentures issued by the Company. Washington Banking Company has fully and unconditionally guaranteed the capital securities along with all obligations of the Trust under the trust agreements. The maximum amount of future payments the Company will be required to make under these agreements is the principal and interest of the trust preferred securities, the principal of which totaled $25,774 at June 30, 2008.

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

Note Regarding Forward-Looking Statements: This Quarterly Report on Form 10-Q includes forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). These forward-looking statements describe Washington Banking Company’s (the “Company”) management’s expectations regarding future events and developments such as future operating results, growth in loans and deposits, continued success of the Company’s business plan and the strength of the local economy. The words “will,” “believe,” “expect,” “should,” “anticipate” and words of similar construction are intended in part to help identify forward-looking statements. Future events are difficult to predict, and the expectations described below are necessarily subject to risk and uncertainty that may cause actual results to differ materially and adversely. In addition to discussions about risks and uncertainties set forth from time to time in the Company’s filings with the SEC, factors that may cause actual results to differ materially from those contemplated in such forward-looking statements include, among others, the following possibilities: (1) local and national general and economic conditions, (2) changes in interest rates and their impact on net interest margins; (3) projected business increases following strategic expansion or opening or acquiring new branches are lower than expected; (4) greater than expected costs or difficulties related to the integration of acquisitions; (5) increased competitive pressure among financial institutions; (6) legislation or regulatory requirements or changes that adversely affect the banking and financial services sector; and (7) the Company’s ability to realize efficiencies from investment in personnel and infrastructure. However, the reader should be aware that these factors are not an exhaustive list, and should not assume that these are the only factors that may cause actual results to differ from expectations. In addition, it should be noted 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. To date, the Company’s growth has been achieved organically and it attributes its reputation for focusing on customer service and satisfaction as one of the cornerstones to the Company’s success. The Company’s primary objectives are to improve profitability and operating efficiencies, increase market penetration in areas currently served, and to continue an expansion strategy in appropriate market areas.
Summary of Critical Accounting Policies
Significant accounting policies are described in Note (1) of the Notes to Consolidated Financial Statements for the year ended December 31, 2007 as filed in Form 10-K. Not all of these accounting policies require management to make difficult, subjective or complex judgments or estimates. Management believes that the following accounting policies could be considered critical under the SEC’s definition.
Allowance for Loan Losses: There have been no material changes in the accounting policy relating to allowance for loan losses as compared to that contained in Note (1) of the Notes to Consolidated Financial Statements for the year ended December 31, 2007 as filed in Form 10-K.
Stock-based Compensation: There have been no material changes in the accounting policy relating to stock-based compensation as compared to that contained in Note (1) of the Notes to Consolidated Financial Statements for the year ended December 31, 2007 as filed in Form 10-K.

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Results of Operations Overview
The Company’s net income was stable at $2.4 million, or $0.25 per diluted share, in the second quarter of 2008, compared with $2.5 million or $0.26 per diluted share in the second quarter of 2007. Return on average equity decreased to 12.74% in the second quarter of 2008, compared with 14.43% in the corresponding quarter of 2007. Return on average assets decreased to 1.09% in the second quarter of 2008, compared with 1.19% in second quarter of 2007.
For the first six months of 2008, net income was $4.8 million and diluted earnings per share was $0.50, compared to $4.7 million or $0.50 per diluted share for the same period last year. Return on average equity decreased to 12.68% for the first six months of 2008, compared with 14.07% last year.
Net Interest Income: One of the Company’s key sources of earnings is net interest income. To make it easier to compare results among several periods and the yields on various types of earning assets (some of which are taxable and others which are not), net interest income is presented in this discussion on a “taxable-equivalent basis” (i.e., as if it were all taxable at the same rate). There are several factors that affect net interest income including:
      §      The volume, pricing, mix and maturity of interest-earning assets and interest-bearing liabilities;
 
      §      The volume of free funds (consisting of noninterest-bearing deposits and other liabilities and shareholders’ equity);
 
      §      The volume of noninterest-earning assets;
 
      §      Market interest rate fluctuations; and
 
      §      Asset quality.
The following tables set forth various components of the balance sheet that affect interest income and expense, and their respective yields or rates:
                                                 
    Average Balance Sheet and Analysis of Net Interest Income and Yields/Rates  
    Three Months Ended     Three Months Ended  
    June 30, 2008     June 30, 2007  
    Average     Interest     Average     Average     Interest     Average  
(Dollars in thousands)   balance     earned/paid     yield     balance     earned/paid     yield  
Assets
                                               
Loans (1) (2)
  $ 823,052     $ 14,499       7.07 %   $ 747,645     $ 15,317       8.22 %
Federal funds sold
    252       1       2.05 %     2,600       35       5.41 %
Interest-bearing cash
    378       2       2.45 %     2,437       32       5.26 %
Investments
                                               
Taxable
    9,195       96       4.18 %     12,300       136       4.44 %
Non-taxable (2)
    5,262       76       5.76 %     6,817       99       5.84 %
 
                                   
Interest-earning assets
    838,139       14,674       7.02 %     771,799       15,619       8.12 %
Noninterest-earning assets
    52,858                       55,838                  
 
                                           
Total assets
  $ 890,997                     $ 827,636                  
 
                                           
 
                                               
Liabilities and shareholders’ equity
                                               
Deposits:
                                               
Interest demand and money market
  $ 253,850     $ 933       1.47 %   $ 262,008     $ 1,690       2.59 %
Savings
    41,674       42       0.41 %     47,185       84       0.71 %
CDs
    348,276       3,567       4.11 %     306,774       3,706       4.85 %
 
                                   
Total interest-bearing deposits
    643,800       4,542       2.83 %     615,967       5,480       3.57 %
 
                                   
Federal funds purchased
    18,334       115       2.51 %     6,815       94       5.53 %
Junior subordinated debentures
    25,774       284       4.42 %     25,540       484       7.60 %
Other interest bearing liabilities
    30,000       245       3.27 %     3,516       43       4.91 %
 
                                   
Total interest bearing liabilities
    717,908       5,185       2.90 %     651,838       6,100       3.75 %
 
                                               
Noninterest-bearing DDA
    93,191                       101,433                  
Other liabilities
    3,695                       5,988                  
Total liabilities
    814,794                       759,259                  
 
                                           
Total shareholders’ equity
    76,203                       68,377                  
 
                                           
Total liabilities and shareholders’ equity
  $ 890,997                     $ 827,636                  
 
                                           
 
                                               
Net interest income /Spread
          $ 9,489       4.12 %           $ 9,520       4.36 %
 
                                           
Credit for interest bearing funds
                    0.43 %                     0.58 %
 
                                           
Net interest margin (2)
                    4.54 %                     4.95 %
 
                                           

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(1)   Average balance includes nonaccrual loans.
 
(2)   Interest income on non-taxable investments and loans is presented on a taxable-equivalent basis using the federal statutory rate of 35%. These adjustments were $140 and $164 for the three months ended June 30, 2008 and 2007, 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.
                                                 
    Average Balance Sheet and Analysis of Net Interest Income and Yields/Rates  
    Six Months Ended     Six Months Ended  
    June 30, 2008     June 30, 2007  
    Average     Interest     Average     Average     Interest     Average  
(Dollars in thousands)   balance     earned/paid     yield     balance     earned/paid     yield  
Assets
                                               
Loans (1) (2)
  $ 817,090     $ 29,988       7.36 %   $ 735,756     $ 29,879       8.19 %
Federal funds sold
    259       3       2.48 %     2,188       57       5.23 %
Interest-bearing cash
    330       5       2.98 %     1,608       42       5.27 %
Investments
                                               
Taxable
    9,456       206       4.37 %     12,349       269       4.39 %
Non-taxable (2)
    5,264       150       5.70 %     6,808       203       6.00 %
 
                                   
Interest-earning assets
    832,399       30,352       7.31 %     758,709       30,450       8.09 %
Non-earning assets
    53,240                       53,739                  
 
                                           
Total assets
  $ 885,639                     $ 812,447                  
 
                                           
 
                                               
Liabilities and shareholders’ equity
                                               
Deposits:
                                               
Interest demand and money market
  $ 262,559     $ 2,283       1.74 %   $ 257,497     $ 3,274       2.56 %
Savings
    41,801       93       0.45 %     48,175       175       0.73 %
Time deposits
    342,615       7,460       4.37 %     307,678       7,355       4.82 %
 
                                   
Total interest-bearing deposits
    646,976       9,837       3.05 %     613,350       10,804       3.55 %
 
                                   
Federal funds purchased
    18,458       290       3.15 %     4,565       127       5.59 %
Junior subordinated debentures
    25,774       689       5.36 %     20,302       822       8.17 %
Other interest-bearing liabilities
    22,747       374       3.29 %     1,768       43       4.96 %
 
                                   
 
Total interest-bearing liabilities
    713,955       11,189       3.14 %     639,986       11,796       3.72 %
 
                                               
Noninterest-bearing DDA
    92,859                       98,780                  
Other liabilities
    3,593                       5,908                  
Total liabilities
    810,406                       744,673                  
 
                                           
Total equity
    75,234                       67,774                  
 
                                           
Total liabilities and shareholder’s equity
  $ 885,639                     $ 812,447                  
 
                                           
Net interest income /Spread
          $ 19,163       4.17 %           $ 18,655       4.37 %
 
                                           
Credit for interest-bearing funds
                    0.45 %                     0.59 %
 
                                           
Net interest margin (2)
                    4.62 %                     4.96 %
 
                                           
 
(1)   Average balance includes nonaccrual loans.
 
(2)   Interest income on non-taxable investments and loans is presented on a taxable-equivalent basis using the federal statutory rate of 35%. These adjustments were $292 and $330 for the six months ended June 30, 2008 and 2007, respectively. Taxable-equivalent is a Non-GAAP performance measurement that management believes provides investors with a more accurate picture of the net interest margin and efficiency ratio for comparative purposes.
Taxable-equivalent net interest income was $9.5 million in the second quarter of 2008 and 2007. There were significant changes in the mix of interest-earning assets and interest-bearing liabilities and their related volumes and rates during the second quarter. Average interest-earning assets increased $66.3 million to $838.1 million, due to strong loan growth, as compared to $771.8 million for the second quarter of 2007. However, the yields on interest-earning assets decreased 110 basis points to 7.02% in the second quarter of 2008 from 8.12% in the same period in 2007. This decrease was primarily attributed to a 325 basis point decrease in the prime rate charged on variable rate loans, which occurred between August 2007 and April 2008. Average interest-bearing liabilities increased $66.1 million to $717.9 million as compared to $651.8 million in the second quarter of 2007, with interest-bearing deposits increasing $27.8 million and the remaining $38.3 million increase in the second quarter of 2007 made up of various other borrowing sources. The average cost of interest-bearing

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liabilities decreased 85 basis points to 2.90% in the second quarter of 2008 from 3.75% in the same period in 2007. These changes in loan and deposit volumes and rates caused the net interest margin to decrease 41 basis points in the second quarter of 2008 to 4.54% from 4.95% in the same period last year.
Taxable-equivalent net interest income was $19.1 million in the first six months of 2008 compared to $18.7 million in the same period in 2007. There were significant changes in the mix of interest-earning assets and interest-bearing liabilities and their related volumes and rates in the first six months of 2008. Average interest-earning assets increased $73.7 million to $832.4 million, due to strong loan growth, compared to $758.7 million for the same period last year. However, the yields on interest-earning assets decreased 78 basis points to 7.31% in the first six months of 2008 from 8.09% in the same period in 2007. This decrease was primarily attributed to a 325 basis point decrease in the prime rate charged on variable rate loans, which occurred between August 2007 and April 2008. Average interest-bearing liabilities increased $74.0 million to $714.0 million compared to $640.0 million in the first six months of 2007, with interest-bearing deposits increasing $33.6 million and the remaining $40.4 million increase in the first six months of 2008 made up of various other borrowing sources. The average cost of interest-bearing liabilities decreased 58 basis points to 3.14% in the first six months of 2008 from 3.72% in the same period in 2007. These changes in loan and deposit volumes and rates caused the net interest margin to decrease 34 basis points in the first six months of 2008 to 4.62% from 4.96% in the same period last year.
The following table shows how changes in yields or rates and average balances affected net interest income for the second quarters of 2008 and 2007:
                                                 
    Three Months Ended     Six Months Ended  
    June 30,     June 30,  
    2008 vs. 2007     2008 vs. 2007  
    Increase (decrease) due to(2):     Increase (decrease) due to(2):  
    Volume     Rate     Total     Volume     Rate     Total  
Assets:
                                               
 
                                               
Loans (1) (3)
  $ 2,101     $ (2,919 )   $ (818 )   $ 1,284     $ (1,175 )   $ 109  
Federal funds sold
    (20 )     (14 )     (34 )     (34 )     (20 )     (54 )
Interest-bearing cash
    (18 )     (11 )     (29 )     (24 )     (13 )     (37 )
Investments (1)
                                               
Taxable
    (32 )     (8 )     (40 )     (62 )     (1 )     (63 )
Non-taxable (2)
    (23 )     (1 )     (24 )     (43 )     (10 )     (53 )
 
                                   
Interest- earning assets
  $ 2,008     $ (2,953 )   $ (945 )   $ 1,121     $ (1,219 )   $ (98 )
 
                                   
 
                                               
Liabilities:
                                               
Deposits:
                                               
Interest demand and money market
  $ (51 )   $ (706 )   $ (757 )   $ 65     $ (1,056 )   $ (991 )
Savings
    (9 )     (33 )     (42 )     (21 )     (61 )     (82 )
Time deposits
    1,107       (1,246 )     (139 )     616       (511 )     105  
 
                                   
Total interest-bearing deposits
    1,047       (1,985 )     (938 )     660       (1,628 )     (968 )
 
                                   
 
                                               
Fed funds purchased
    31       (10 )     21       191       (28 )     163  
Junior subordinated debentures
    4       (204 )     (200 )     484       (617 )     (133 )
Other interest-bearing liabilities
    211       (9 )     202       340       (9 )     331  
 
                                   
Total interest-bearing liabilities
  $ 1,293     $ (2,208 )   $ (915 )   $ 1,675     $ (2,282 )   $ (607 )
 
                                   
 
(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.

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Provision for Loan Losses: During the second quarter of 2008, the Company recorded a $1.1 million provision for loan losses compared to $850,000 for the second quarter in 2007. Net charge-offs for second quarter of 2008 were $869,000, a $333,000 increase over the second quarter of 2007. Increases in net charge-offs were due to an increase in real estate and indirect consumer loan charge-offs.
During the first six months of 2008, the Company recorded a $2.1 million provision for loan losses compared to $1.4 million in the same period in 2007. The increase in the provision for loan and lease losses is primarily due to loan portfolio growth and the level of net charge-offs. Net charge-offs for the first six months of 2008 were $1.6 million, compared with $922,000 in the same period last year.
The provision for loan losses is based on management’s evaluation of inherent risk in the loan portfolio and a corresponding analysis of the allowance for loan and lease losses. Additional discussion on loan quality and the allowance for loan and lease losses is provided under the Allowance for Loan Losses and Nonperforming Assets section of this report.
Noninterest Income: Noninterest income in the second quarter of 2008 decreased 16% to $1.6 million compared to $2.0 million in the corresponding quarter of 2007. Service charges and fees decreased $86,000 due to a decline in the number of deposit accounts. Additional changes in noninterest income were primarily due to decreases: in income from the sale of loans of $160,000; SBA premiums of $78,000; and a $62,000 decline in sales of investment products.
Noninterest income of $3.4 million for the first six months of 2008 decreased 9%, compared with $3.8 million in the same period last year. Service charges and fees decreased $177,000 due to a decline in the number of deposit accounts Additional changes in noninterest income in the first six months of 2008 were primarily due to decreases in income from the sale of loans of $225,000. The decrease in income from sale of loans, SBA premiums and investment product income are principally related to the decreased volume and operations associated with the proposed merger with Frontier Financial Corporation that was terminated in May 2008. The Company anticipates that noninterest income in these areas will increase through the remainder of 2008.
Noninterest Expense: Noninterest expense in the second quarter of 2008 decreased 8% to $6.3 million compared to $6.9 million for the second quarter of 2007. Salaries and benefits decreased $334,000, due to reduction in full time equivalent employees (“FTE’s”). Advertising for the second quarter of 2008 decreased $114,000.
Noninterest expense for the first six months of 2008 was $13.2 million, a 4% decrease over last year. The decrease was principally due to a decrease in salaries and benefits of $755,000 due to a reduction in FTEs. The number of FTEs decreased to 251 at June 30, 2008 from 305 at June 30, 2007. This decrease in the number of FTE’s was offset by an $134,000 increase in write-downs of several other real estate owned properties, and a $138,000 increase in merger related expenses associated with the terminated merger with Frontier Financial Corporation. Additionally, FDIC premiums in the first six months of 2008 increased $221,000 as compared to the same period in 2007. In 2007, the Bank received a credit from the FDIC which reduced the expense by $100,000.
Income Taxes: The Company’s consolidated effective tax rates for the second quarters of 2008 and 2007 were 32.9% and 31.5%, respectively. The effective tax rates for the first six months of 2008 and 2007 were 32.2% and 31.4%, respectively. The quarterly and year to date 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 year to date and quarterly 2008 tax rates reflect a benefit from the New Market Tax Credit Program, whereby a subsidiary of Whidbey Island Bank has been awarded approximately $3.1 million in future federal tax credits. 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 over the next seven years.
Financial Condition Overview
Total assets were $903.9 million at June 30, 2008, an increase of $21.6 million from December 31, 2007. Loans at June 30, 2008 grew 2% to $824.6 million compared to $805.9 million at December 31, 2007. Deposits at June 30, 2008 decreased 3% to $732.9 million, compared to $758.4 million at December 31, 2007. Shareholders’ equity increased $4.0 million to $77.5 million, with a book value of $8.17 per share at June 30, 2008.

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Loans: Total loans outstanding as of June 30, 2008 were $824.6 million, an increase of $18.7 million from December 31, 2007. Loan portfolio growth during 2008 was primarily in the commercial real estate loans, which was offset by decreases in commercial loans and consumer loans. The Company has attempted 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 loan portfolio:
                                         
    Loan Portfolio Composition as of:  
    June 30, 2008     December 31, 2007     Change  
(Dollars in thousands)   Balance     % of total     Balance     % of total        
Commercial
  $ 97,572       11.9 %   $ 102,284       12.7 %   $ (4,712 )
 
                                       
Real estate mortgages:
                                       
One-to-four family residential
    56,796       6.9 %     56,636       7.0 %     160  
Multi-family residential & commercial
    322,943       39.3 %     296,902       37.0 %     26,041  
 
                             
Total real estate mortgages
    379,738       46.2 %     353,538       44.0 %     26,200  
Real estate construction:
                                       
One-to-four family residential
    104,597       12.7 %     101,912       12.7 %     2,685  
Multi-family and commercial
    45,359       5.5 %     44,735       5.6 %     624  
 
                             
Total real estate construction
    149,955       18.2 %     146,647       18.3 %     3,308  
Consumer:
                                       
Indirect
    109,167       13.3 %     114,271       14.2 %     (5,104 )
Direct
    85,603       10.4 %     86,716       10.8 %     (1,113 )
 
                             
Total consumer
    194,770       23.7 %     200,987       25.0 %     (6,217 )
 
                             
Subtotal
    822,036       100.0 %     803,456       100.0 %     18,580  
 
                                 
Deferred loan costs, net
    2,563               2,406               157  
 
                                 
Total loans, net
  $ 824,600             $ 805,862             $ 18,738  
 
                                 
Allowance for Loan Losses: The allowance for loan losses at June 30, 2008 was $11.6 million or 1.40% of total loans and 460.64% of total nonperforming loans. This compares with an allowance of $11.1 million or 1.38% of total loans and 395.41% of total non-performing loans at December 31, 2007.
The allowance for loan and losses is maintained at a level considered adequate by management to provide for loan losses inherent in the portfolio. The Company assesses the allowance on a quarterly basis. The evaluation of the allowance is based on an assessment of
non-performing loans, recent and historical loss experience, and other factors, including regulatory guidance and economic factors. While the Company believes that it uses the best information available to determine the allowance for loan losses, unforeseen market conditions could result in adjustments to the allowance for loan losses, and net income could be significantly affected if circumstances differ substantially from the assumptions used in making the final determination. The Company anticipates that normal growth of the loan portfolio will require continued increases in the allowance for loan losses. The following table details the activity of the allowance for loan losses:
                                 
    Three Months Ended     Six Months Ended  
    June 30,     June 30,  
(Dollars in thousands)   2008     2007     2008     2007  
Balance at beginning of period
  $ 11,404     $ 10,212     $ 11,126     $ 10,048  
Charge-offs:
                               
Commercial
    (173 )     (246 )     (622 )     (616 )
Real estate
    (482 )     ¾       (502 )     ¾  
Consumer
                               
Direct
    (118 )     (196 )     (308 )     (285 )
Indirect
    (331 )     (263 )     (693 )     (398 )
 
                       
Total charge-offs
  $ (1,104 )   $ (705 )   $ (2,125 )   $ (1,299 )
 
                       

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    Three Months Ended     Six Months Ended  
    June 30,     June 30,  
(Dollars in thousands)   2008     2007     2008     2007  
Recoveries:
                               
Commercial
    92       56       147       105  
Real estate
    1       3       3       73  
Consumer
                               
Direct
    25       48       71       82  
Indirect
    117       63       288       117  
 
                       
Total recoveries
  $ 235     $ 170     $ 509     $ 377  
 
                       
Net charge-offs
    (869 )     (536 )     (1,616 )     (922 )
Provision for loan losses
    1,050       850       2,075       1,400  
 
                       
Balance at end of period
  $ 11,585     $ 10,526     $ 11,585     $ 10,526  
 
                       
 
                               
Indirect loans net charge-offs to average indirect loans
    0.77 %     0.77 %     0.73 %     0.54 %
Other net charge-offs to average other loans
    0.37 %     0.21 %     0.34 %     0.20 %
Net charge-offs to average loans (1)
    0.42 %     0.28 %     0.40 %     0.25 %
 
(1) Excludes loans held for sale.
The changes in the allocation of the allowance for loan losses in the first six months of 2008 were due primarily to changes in the loan portfolio and its mix, changes in the risk grading of loans, and charge-off and recovery activity.
The table below details the Company’s allocation of the allowance for loan losses by loan type and remaining unallocated allowances:
                                                                         
    Allocation of the Allowance for Loan Losses as of:  
    June 30, 2008     December 31, 2007     June 30, 2007  
            % of     % of             % of     % of             % of     % of  
(Dollars in thousands)   Amount     Allowance(2)     Loans(1)     Amount     Allowance(2)     Loans(1)     Amount     Allowance(2)     Loans(1)  
Balance applicable to:
                                                                       
Commercial
  $ 971       8.4 %     11.9 %   $ 976       8.8 %     12.8 %   $ 937       8.9 %     13.0 %
Real estate mortgage
    4,473       38.6 %     46.2 %     3,928       35.3 %     44.0 %     3,486       33.1 %     41.6 %
Real estate construction
    1,942       16.8 %     18.2 %     1,812       16.3 %     18.3 %     1,862       17.7 %     19.6 %
Consumer
    2,802       24.2 %     23.7 %     2,773       24.9 %     24.9 %     2,754       26.2 %     25.8 %
Unallocated
    1,397       12.2 %     N/A       1,637       14.7 %     N/A       1,487       14.1 %     N/A  
             
Total
  $ 11,585       100.0 %     100.0 %   $ 11,126       100.0 %     100.0 %   $ 10,526       100.0 %     100.0 %
             
 
(1) Represents the total of all outstanding loans in each category as a percent of total loans outstanding.
 
(2) Represents the total allowance allocated to each loan category as a percent of total allowance for loan losses.

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Nonperforming Assets and Other Real Estate Owned Properties (“OREO”): Nonperforming assets include nonaccrual loans, restructured loans and OREO. At June 30, 2008 nonperforming assets were $3.7 million, or 0.41% of total assets, compared to $4.3 million or 0.49% at December 31, 2007.
Loans are classified as non-accrual when collection of principal or interest is doubtful. Additionally, loans that are “impaired” in accordance with SFAS No. 114 Accounting by Creditors for the Impairment of a Loan, are considered for non-accrual status. These loans 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.
Foreclosed properties held as OREO are recorded at the lower of the recorded investment in the loan or market value of the property less estimated selling costs.
The table below shows the composition of the Company’s nonperforming assets:
                 
    Nonperforming Assets as of:  
    June 30,     December 31,  
(Dollars in thousands)   2008     2007  
Nonaccrual loans
  $ 2,515     $ 2,839  
Restructured loans
           
 
           
Total nonperforming loans
    2,515       2,839  
Other real estate owned properties
    1,198       1,440  
 
           
Total nonperforming assets
  $ 3,713     $ 4,279  
 
           
Total impaired loans
  $ 2,515     $ 2,839  
Accruing loans past due ³ 90 days
           
Potential problem loans
           
Allowance for loan losses
  $ 11,585     $ 11,126  
Nonperforming loans to loans
    0.30 %     0.35 %
Nonperforming assets to total assets
    0.41 %     0.49 %
Allowance for loan losses to loans
    1.40 %     1.38 %
Allowance for loan losses to nonperforming loans
    460.64 %     395.41 %
Allowance for loan losses to nonperforming assets
    312.01 %     262.34 %
Changes in the nonaccrual loans for the first six months of 2008 consisted primarily of one relationship totaling $600,000, which was transferred to OREO and subsequently sold during the second quarter of 2008. At June 30, 2008 OREO consisted of four properties. Changes in OREO for the first six months of 2008 consisted of the sale of two properties totaling $708,000 for a gain of $88,000. Additionally, the fair value of three OREO properties fair values were written down a total of $134,000.

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Deposits: Total deposits in the first six months of 2008 decreased $25.5 million to $732.9 million at June 30, 2008. The Decrease in deposits was primarily associated with the proposed merger with Frontier Financial Corporation. The Company anticipates deposit balances to increase through the remainder of 2008. Information on average deposit balances and average rates paid is included under the Net Interest Income section of this report.
The following table further details the major components of the deposit portfolio:
                                         
    Deposit Composition as of:  
    June 30, 2008     December 31, 2007     Change  
(Dollars in thousands)   Balance     % of total     Balance     % of total        
Noninterest-bearing demand
  $ 91,764       12.5 %   $ 101,539       13.4 %   $ (9,775 )
NOW accounts
    126,307       17.2 %     140,145       18.5 %     (13,838 )
Money market
    122,724       16.8 %     133,265       17.6 %     (10,541 )
Savings
    41,406       5.7 %     41,888       5.5 %     (482 )
Time deposits
    350,667       47.8 %     341,517       45.0 %     9,150  
 
                             
Total deposits
  $ 732,868       100 %   $ 758,354       100 %   $ (25,486 )
 
                             
The Company has $10.0 million in brokered time deposits outstanding as of June 30, 2008 and December 31, 2007. All $10.0 million mature in August 2008; the Company does not intend to renew these deposits.
Borrowings: Total borrowings outstanding in the first six months of 2008 increased $43.5 million to $89.8 million at June 30, 2008. The change in borrowings is attributable to increases in short-term and overnight borrowings with the Federal Home Loan Bank (“FHLB”).
FHLB Overnight Borrowings and Other Borrowed Funds: The Company utilizes advances from the FHLB to supplement funding needs. The FHLB provides credit for member financial institutions in the form of overnight borrowings, short-term and long-term advances. As a member, the Bank is required to own capital stock in the FHLB and is authorized to apply for advances on the pledge of certain of its mortgage loans and other assets.
During the first quarter the Company entered into a short term borrowing agreement with the FHLB for a total of $30.0 million. The advances are as follows:
      §     $10.0 million advance with a fixed interest rate of 3.64% maturing in January 2009.
 
      §     $20.0 million advance with a fixed interest rate of 3.02% maturing in August 2008.
Capital
Shareholders’ Equity: Total shareholders’ equity increased $4.0 million to $77.5 million at June 30, 2008 from $73.6 million at December 31, 2007. Increases in shareholders’ equity were principally due to $4.8 million of net income for the first six months of 2008, and proceeds from the exercise of stock awards of $172,000. These increases were offset by the payment of cash dividends of $1.2 million during the first and second Quarters of 2008.
Regulatory Capital Requirements: Banking regulations require bank holding companies and banks to maintain a minimum leverage ratio of core capital to adjusted average total assets of at least 4%. In addition, banking regulators have adopted risk-based capital guidelines, under which risk percentages are assigned to various categories of assets and off-balance sheet items to calculate a risk-adjusted capital ratio. Tier I capital generally consists of common shareholders’ equity (which does not include unrealized gains and losses on securities), less goodwill and certain identifiable intangible assets, while Tier II capital includes the allowance for loan losses and subordinated debt, both subject to certain limitations.

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The FDIC established the qualifications necessary to be classified as a “well-capitalized” bank, primarily for assignment of FDIC insurance premium rates. As the following table indicates, the Company and Bank qualified as “well-capitalized” at June 30, 2008 and December 31, 2007:
                                 
    Regulatory Requirements   Actual Ratios
    Adequately-   Well-   June 30,   December 31,
    capitalized   capitalized   2008   2007
Total risk-based capital ratio
                               
Company (consolidated)
    8 %     N/A       12.79 %     12.45 %
Whidbey Island Bank
    8 %     10%       12.58 %     12.03 %
Tier 1 risk-based capital ratio
                               
Company (consolidated)
    4 %     N/A       11.50 %     11.14 %
Whidbey Island Bank
    4 %     6%       11.28       10.78 %
Leverage ratio
                               
Company (consolidated)
    4 %     N/A       11.54 %     11.29 %
Whidbey Island Bank
    4 %     5%       11.33 %     10.92 %
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
Liquidity: The principal objective of the liquidity management program is to maintain the Bank’s ability to meet the day to day cash flow requirements of its customers who either wish to withdraw funds or draw upon credit facilities to meet their needs.
Management monitors the sources and uses of funds on a daily basis to maintain an acceptable liquidity position. The Company’s sources of funds are customer deposits, loan repayments, current earnings, cash and demand balances due from other banks, federal funds, short-term investments, investment securities available for sale and trust preferred securities. The Company’s strategy includes maintaining a “well-capitalized” status for regulatory purposes, while maintaining a favorable liquidity position and proper asset/liability mix. With this strategy in mind, management anticipates that the Bank will rely primarily upon customer deposits to provide liquidity in 2008. These funds will be used for loan originations and deposit withdrawals, to satisfy other financial commitments and to support continuing operations. Additional funds are available through established FHLB and correspondent bank lines of credit, which the Bank may use to supplement funding sources.
Consolidated Cash Flows: As disclosed in the Condensed Consolidated Statements of Cash Flows, net cash provided by operating activities was $9.4 million for the first six months of 2008. The principal source of cash provided by operating activities was net income from continuing operations. Net investing activities used $19.0 million in the first six months of 2008. $21.0 million was used to fund net loan growth. Net cash provided by financing activities was $17.0 million for the first six months of 2008. The principal sources of cash were a $30.0 million net increase in other borrowings, and $13.5 million in overnight borrowings. Principal uses of cash were the payment of a $1.2 million cash dividend and the net decrease of $25.5 million in deposits.
Capital Resources:
Off-Balance Sheet Items: The Company is a party to financial instruments with off-balance sheet risk. Among the off-balance sheet items entered into in the ordinary course of business are commitments to extend credit and the issuance of letters of credit. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amounts recognized on the balance sheet. Certain commitments are collateralized. As of June 30, 2008 and December 31, 2007, the Company’s commitments under letters of credit and financial guarantees amounted to $2.2 million and $1.2 million, respectively. Since many of the commitments are expected to expire without being drawn upon, these total commitment amounts do not necessarily represent future cash requirements.

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Item 3. Quantitative and Qualitative Disclosures about Market Risk
At June 30, 2008, based on the measures used to monitor and manage interest rate risk, there had not been a material change in the Company’s interest rate risk since December 31, 2007. Should rates increase, the Company may, or may not be positively impacted due to its current slightly asset sensitive position. For additional information, refer to the Company’s Form 10-K for year ended December 31, 2007 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 quarterly period ended June 30, 2008 that has materially affected, or is reasonably likely to materially affect, the internal control over financial reporting.

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PART II — OTHER INFORMATION
Item 1. Legal Proceedings
The Company may be involved in legal proceedings in the regular course of business. At this time, management does not believe that there is pending litigation resulting in an unfavorable outcome of which would result in a material adverse change to the Company’s financial condition, results of operations or cash flows.
Item 1A. Risk Factors
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, 2007. There have been no material changes in the Company’s risk factors from those disclosed in the 2007 Annual Report on Form 10-K.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
     (a) - (c) None
Item 3. Defaults Upon Senior Securities
     None
Item 4. Submission of Matters to a Vote of Security Holders
     None
Item 5. Other Information
  (a)   Not applicable
 
  (b)   There have been no material changes in the procedures for shareholders to nominate directors to the Company’s board.
Item 6. Exhibits
Exhibits
  31.1   Certification of Chief Executive Officer required by Rule 13a-14(b) or Rule 15d-14(a) and Section 302 of the Sarbanes Oxley Act of 2002
 
  31.2   Certification of Chief Financial Officer required by Rule 13a-14(b) or Rule 15d-14(a) and Section 302 of the Sarbanes Oxley Act of 2002
 
  32.1   Certification of Chief Executive Officer required by Rule 13a-14(b) or Rule 15d-14(b) and Section 906 of the Sarbanes Oxley Act of 2002, 18 U.S.C. Section 1350
 
  32.2   Certification of Chief Financial Officer required by Rule 13a-14(b) or Rule 15d-14(b) and Section 906 of the Sarbanes Oxley Act of 2002, 18 U.S.C. Section 1350

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Table of Contents

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: August 8, 2008
  By   /s/ Michal D. Cann
 
Michal D. Cann
   
 
      President and    
 
      Chief Executive Officer    
 
           
Date: August 8, 2008
  By   /s/ Richard A. Shields
 
Richard A. Shields
   
 
      Executive Vice President and    
 
      Chief Financial Officer    

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