Washington Banking (WBCO) 10-Q 2009 Q2 Quarterly report

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 June 30, 2009
[ ]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	(I.R.S. Employer
incorporation or organization)	Identification Number)

435 E George Hopper RoadBurlington, Washington 98233(Address of principal executive offices) (Zip Code)

(360) 679-3121
(Registrant’s telephone number, including area code)

450 SW Bayshore Dr., Oak Harbor, WA  98277
(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 if the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act. (Check one):

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 August 1, 2009 was 9,546,565.

	Table of Contents
	PART I – FINANCIAL INFORMATION	Page
Item 1.	Financial Statements
	Condensed Consolidated Statements of Financial Condition -
	June 30, 2009 and December 31, 2008	1
	Condensed Consolidated Statements of Income -
	Three and Six Months Ended June 30, 2009 and 2008	2
	Condensed Consolidated Statements of Shareholders’ Equity and Comprehensive Income -
	Six Months Ended June 30, 2009 and 2008	3
	Condensed Consolidated Statements of Cash Flows -
	Six Months Ended June 30, 2009 and 2008	4
	Notes to Condensed Consolidated Financial Statements	5
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	16
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	29
Item 4.	Controls and Procedures	29
	PART II – OTHER INFORMATION
Item 1.	Legal Proceedings	30
Item 1A.	Risk Factors	30
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	30
Item 3.	Defaults Upon Senior Securities	30
Item 4.	Submission of Matters to a Vote of Security Holders	30
Item 5.	Other Information
Item 6.	Exhibits	31
	Signatures	32

i

PART I – FINANCIAL INFORMATION

Item 1. Financial Statements

WASHINGTON BANKING COMPANYAND SUBSIDIARIESCondensed Consolidated Statements of Financial Condition (unaudited)(Dollars in thousands, except per share data)

		June 30,			December 31,
Assets		2009			2008
Cash and due from banks	$	22,403		$	13,609
($2,942 and $3,496, respectively, are restricted)
Interest-bearing deposits		1,275			381
Federal funds sold		12,395			—
Total cash, restricted cash, and cash equivalents		36,073			13,990
Investment securities available for sale		31,740			17,798
Federal Home Loan Bank stock		2,430			2,430
Loans held for sale		4,385			2,896
Loans receivable		820,776			823,068
Allowance for loan losses		(14,770	)		(12,250	)
Total loans, net		806,006			810,818
Premises and equipment, net		25,527			24,971
Bank owned life insurance		17,028			16,822
Other real estate owned		2,599			2,226
Other assets		8,865			7,680
Total assets	$	934,653		$	899,631
Liabilities and Shareholders’ Equity
Liabilities:
Deposits
Noninterest-bearing	$	103,226		$	91,482
Interest-bearing		321,758			304,131
Time deposits		362,640			351,546
Total deposits		787,624			747,159
FHLB overnight borrowings		—			11,640
Other borrowed funds		10,000			30,000
Junior subordinated debentures		25,774			25,774
Other liabilities		3,329			4,498
Total liabilities		826,727			819,071
Commitments and contingencies		—			—
Shareholders’ equity:
Preferred stock, no par value. 26,380 shares authorized
Series A (Liquidation preference $1,000 per shares); and
outstanding at 6/30/09: 26,380 and none in 2008.		24,827			—
Common stock, no par value. Authorized 13,679,757 shares:
issued and outstanding 9,538,899 at 6/30/2009 and
9,510,007 at 12/31/2008		35,456			33,701
Retained earnings		47,527			46,567
Accumulated other comprehensive income		116			292
Total shareholders’ equity		107,926			80,560
Total liabilities and shareholders’ equity	$	934,653		$	899,631
See accompanying notes to condensed consolidated financial statements.

1

WASHINGTON BANKING COMPANYAND SUBSIDIARYCondensed Consolidated Statements of Income (unaudited)(Dollars in thousands, except per share data)

		Three Months Ended				Six Months Ended
		June 30,				June 30,
		2009		2008		2009		2008
Interest income:
Interest and fees on loans	$	13,244	$	14,383	$	26,245	$	29,744
Interest on taxable investment securities		141		96		277		206
Interest on tax exempt investment securities		95		51		162		102
Other		8		3		10		8
Total interest income		13,488		14,533		26,694		30,060
Interest expense:
Interest on deposits		3,386		4,542		6,905		9,837
Interest on other borrowings		114		359		247		663
Interest on junior subordinated debentures		180		284		404		689
Total interest expense		3,680		5,185		7,556		11,189
Net interest income		9,808		9,348		19,138		18,871
Provision for loan losses		3,000		1,050		5,450		2,075
Net interest income after provision for loan losses		6,808		8,298		13,688		16,796
Noninterest income:
Service charges and fees		853		711		1,711		1,437
Electronic banking income		348		347		658		661
Investment products		161		39		331		167
Bank owned life insurance income		112		121		205		222
Income from the sale of mortgage loans		301		51		570		141
Income from sale of SBA loans and servicing		16		45		33		189
Other		282		324		568		615
Total noninterest income		2,073		1,638		4,076		3,432
Noninterest expense:
Salaries and benefits		3,437		3,798		6,861		7,788
Occupancy and equipment		1,071		902		2,104		1,851
Office supplies and printing		207		120		378		240
Data processing		146		153		277		314
Consulting and professional fees		211		147		489		362
Other		2,115		1,208		3,625		2,653
Total noninterest expense		7,187		6,328		13,734		13,208
Income before provision for income taxes		1,694		3,608		4,030		7,020
Provision for income taxes		463		1,187		1,225		2,262
Net income before preferred dividends		1,231		2,421		2,805		4,758
Preferred stock dividends and discount accretion		413		—		772		—
Net income available to common shareholders	$	818	$	2,421	$	2,033	$	4,758
Net income available per common share, basic	$	0.09	$	0.25	$	0.21	$	0.50
Net income available per common share, diluted	$	0.09	$	0.25	$	0.21	$	0.50
Average number of common shares outstanding, basic		9,530,000		9,464,000		9,513,000		9,445,000
Average number of common shares outstanding, diluted		9,552,000		9,519,000		9,535,000		9,511,000

See accompanying notes to condensed consolidated financial statements.

2

WASHINGTON BANKING COMPANYAND SUBSIDIARYCondensed Consolidated Statements of Shareholders’ Equity andComprehensive Income (unaudited)(Dollars in thousands, except per share data)

												Accumulated
		Preferred										other			Total
		stock	Common stock						Retained			comprehensive			shareholders’
		amount	Shares			Amount			earnings			income (loss)			equity
Balances at December 31, 2007	$	—	9,454		$	32,812		$	40,652		$	106		$	73,570
Comprehensive income:
Net income		—	—			—			4,758			—			4,758
Net unrealized loss on securities
available for sale, net of tax of $(3)		—	—			—			—			(4	)		(4	)
Total comprehensive income		—	—			—			—			—			4,754
Cash dividend, $0.125 per share		—	—			—			(1,184	)		—			(1,184	)
Stock-based compensation expense		—	—			184			—			—			184
Exercise of common stock- stock options		—	32			172			—			—			172
Issuance of restricted stock		—	3			—			—			—			—
Cancellation of restricted stock		—	(1	)		—			—			—			—
Tax benefit associated with stock awards		—	—			40			—			—			40
Balances at June 30, 2008	$	—	9,488		$	33,208		$	44,226		$	102		$	77,536
Balances at December 31, 2008	$	—	9,510		$	33,701		$	46,567		$	292		$	80,560
Comprehensive income:
Net income		—	—			—			2,805			—			2,805
Net unrealized loss on securities
available for sale, net of tax of $(94)		—	—			—			—			(176	)		(176	)
Total comprehensive income		—	—			—			—			—			2,629
Issuance of preferred stock to U.S. Treasury		24,660	—			—			—			—			24,660
Issuance of warrants to U.S. Treasury		—	—			1,720			—			—			1,720
Preferred stock dividends and discount
accretion		167	—			(167	)		(606	)		—			(606	)
Cash dividend, $0.13 per share		—	—			—			(1,239	)		—			(1,239	)
Stock-based compensation expense		—	—			157			—			—			157
Exercise of common stock- stock options		—	30			41			—			—			41
Cancellation of restricted stock		—	(1	)		—			—			—			—
Tax benefit associated with stock awards		—	—			4			—			—			4
Balances at June 30, 2009	$	24,827	9,539		$	35,456		$	47,527		$	116		$	107,926

See accompanying notes to condensed consolidated financial statements

3

WASHINGTON BANKING COMPANYAND SUBSIDIARYCondensed Consolidated Statements of Cashflows (unaudited)(Dollars in thousands)

		Six Months Ended
		June 30,
		2009			2008
Cash flows from operating activities:
Net income from continuing operations	$	2,805		$	4,758
Adjustments to reconcile net income to net cash
provided by operating activities:
Accretion (amortization) of investment discounts, net		10			(6	)
Depreciation and amortization		884			893
Earnings on bank owned life insurance		(206	)		(222	)
Provision for loan losses		5,450			2,075
Net gain on sale of premises and equipment		(57	)		—
Net gain on sale of other real estate		(21	)		(88	)
Write-downs of other real estate		200			134
Amortization of stock-based compensation		157			184
Excess tax benefit from stock-based compensation		(4	)		(40	)
Net change in assets and liabilities:
Net (increase) decrease in loans held for sale		(1,489	)		1,785
Decrease (increase) in other assets		(983	)		353
Decrease in other liabilities		(1,168	)		(392	)
Cash provided by operating activities:		5,578			9,434
Cash flows from investing activities:
Purchases of investment securities, available-for-sale		(18,224	)		(498	)
Purchase of Federal Home Loan Bank Stock		—			(896	)
Maturities/calls/principal payments of investment and
mortgage - backed securities, available for sale		4,002			3,019
Net increase in loan originations, net of principal collections recevied		(2,517	)		(20,954	)
Purchases of premises and equipment		(1,447	)		(417	)
Proceeds from the sale of other real estate owned		1,287			796
Cash flows used by investing activities		(16,899	)		(18,950	)
Cash flows from financing activities:
Net increase (decrease) in deposits		40,464			(25,486	)
Gross payments on other borrowed funds		(20,000	)		—
New borrowings on other borrowed funds		—			30,000
Net increase (decrease) in FHLB overnight borrowings		(11,640	)		13,500
Dividends paid on common stock		(1,239	)		(1,184	)
Dividends paid on preferred stock		(606	)		—
Excess tax benefits from stock-based compensation		4			40
Proceeds from issuance of preferred stock		26,380			—
Proceeds from exercise of common stock- stock options		41			172
Cash provided by financing activities		33,404			17,042
Net change in cash and cash equivalents		22,083			7,526
Cash and cash equivalents at beginning of period		13,990			19,052
Cash and cash equivalents at end of period	$	36,073		$	26,578
Supplemental information:
Loans foreclosed and transferred to other real estate owned	$	1,879		$	600
Cash paid for interest		7,550			11,114
Cash paid for income taxes		1,400			2,352
See accompanying notes to condensed consolidated financial statements.

4

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Six months ended June 30, 2009 and 2008 (unaudited)
(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, 2009, 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 econo my 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, 2008 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, 2009 are not necessarily indicative of the results that may be expected for the year ending December 31, 2009. 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.

In preparing these financial statements, the Company has evaluated events and transactions for potential recognition or disclosure through August 6, 2009, the date the financial statements were available to be issued.  In management's opinion, all accounting adjustments necessary to accurately reflect the financial position and results of operations on the accompanying financial statements have been made.  These adjustments include normal and recurring accruals considered necessary for a fair and accurate presentation.  The results for interim periods are not necessarily indicative of results for the full year or any other interim period.  Certain reclassifications of prior period amounts have been made to conform with current classifications.

(c) Reclassifications:Certain amounts in prior year’s financial statements may have been reclassified to conform to the 2009 presentation. These reclassifications had no significant impact on the Company’s financial position or results of operations.

(2) Recent Financial Accounting Pronouncements

The FASB has issued FASB Staff Position (FSP) FAS 157-4,Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly.This FSP:

• Affirms that the objective of fair value when the market for an asset is not active is the price that would bereceived to sell the asset in an orderly transaction.

• Clarifies and includes additional factors for determining whether there has been a significant decrease in marketactivity for an asset when the market for that asset is not active.

• Eliminates the proposed presumption that all transactions are distressed (not orderly) unless proven otherwise.The FSP instead requires an entity to base its conclusion about whether a transaction was not orderly on theweight of the evidence.

• Includes an example that provides additional explanation on estimating fair value when the market activity foran asset has declined significantly.

• Requires an entity to disclose a change in valuation technique (and the related inputs) resulting from theapplication of the FSP and to quantify its effects, if practicable.

• Applies to all fair value measurements when appropriate.

5

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Six months ended June 30, 2009 and 2008 (unaudited)
(Dollars In Thousands, Except Per Share Data)

(2) Recent Financial Accounting Pronouncements-(Continued)

FSP FAS 157-4 must be applied prospectively and retrospective application is not permitted. FSP FAS 157-4 is effective for interim and annual periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009. An entity early adopting FSP FAS 157-4 must also early adopt FSP FAS 115-2 and FAS 124-2,Recognition and Presentation of Other-Than-Temporary Impairments.The Company adopted FSP FAS 157-4 commencing with the three month period ending June 30, 2009, and does not expect the standard to have any material impact on the consolidated financial statements.

The FASB has issued FSP FAS 115-2 and FAS 124-2,Recognition and Presentation of Other-Than-Temporary Impairments.This FSP:

• Changes existing guidance for determining whether an impairment is other-than-temporary to debt securities;

• Replaces the existing requirement that the entity’s management assert it has both the intent and ability to holdan impaired security until recovery with a requirement that management assert: (a) it does not have the intent tosell the security; and (b) it is more likely than not it will not have to sell the security before recovery of its costbasis;

• Incorporates examples of factors from existing literature that should be considered in determining whether adebt security is other-than-temporarily impaired;

• Requires that an entity recognize noncredit losses on held-to-maturity debt securities in other comprehensiveincome and amortize that amount over the remaining life of the security in a prospective manner by offsettingthe recorded value of the asset unless the security is subsequently sold or there are additional credit losses;

• Requires an entity to present the total other-than-temporary impairment in the statement of earnings with anoffset for the amount recognized in other comprehensive income; and

• When adopting FSP FAS 115-2 and FAS 124-2, an entity is required to record a cumulative-effect adjustmentas of the beginning of the period of adoption to reclassify the noncredit component of a previously recognizedother-than-temporary impairment from retained earnings to accumulated other comprehensive income if theentity does not intend to sell the security and it is not more likely than not that the entity will be required to sellthe security before recovery.

FSP FAS 115-2 and FAS 124-2 are effective for interim and annual periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009. An entity may early adopt this FSP only if it also elects to early adopt FSP FAS 157-4. The Company adopted FSP FAS 115-2 and FAS 124-2 commencing with the three month period ending June 30, 2009, and does not expect the standard to have any material impact on the consolidated financial statements.

The FASB has issued FSP FAS 107-1 and APB 28-1,Interim Disclosures about Fair Value of Financial Instruments.This FSP amends FASB Statement No. 107,Disclosures about Fair Value of Financial Instruments,to require an entity to provide disclosures about fair value of financial instruments in interim financial information.

This FSP also amends APB Opinion No. 28,Interim Financial Reporting,to require those disclosures in summarized financial information at interim reporting periods. Under this FSP, a publicly traded company shall include disclosures about the fair value of its financial instruments whenever it issues summarized financial information for interim reporting periods. In addition, an entity shall disclose in the body or in the accompanying notes of its summarized financial information for interim reporting periods and in its financial statements for annual reporting periods the fair value of all financial instruments for which it is practicable to estimate that value, whether recognized or not recognized in the statement of financial position, as required by Statement 107.

FSP 107-1 and APB 28-1 are effective for interim periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009. However, an entity may early adopt these interim fair value disclosure requirements only if it also elects to early adopt FSP FAS 157-4, FSP FAS 115-2 and FAS 124-2. The Company adopted the standard as required for the 2nd quarter 2009 10-Q. The Company does not expect the standard to have a significant impact on the consolidated financial statements.

6

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Six months ended June 30, 2009 and 2008 (unaudited)
(Dollars In Thousands, Except Per Share Data)

(2) Recent Financial Accounting Pronouncements-(Continued)

The FASB has issued FASB Staff Position (FSP) FAS 141(R)-1,Accounting for Assets Acquired and Liabilities Assumed in a Business Combination That Arise from Contingencies.This FSP amends the guidance in FASB Statement No. 141 (Revised December 2007),Business Combinations,to:

• Require that assets acquired and liabilities assumed in a business combination that arise from contingencies berecognized at fair value if fair value can be reasonably estimated. If fair value of such an asset or liability cannotbe reasonably estimated, the asset or liability would generally be recognized in accordance with FASBStatement No. 5,Accounting for Contingencies,and FASB Interpretation (FIN) No. 14,Reasonable Estimationof the Amount of a Loss.Further, the FASB decided to remove the subsequent accounting guidance for assetsand liabilities arising from contingencies from Statement 141R, and carry forward without significant revisionthe guidance in FASB Statement No. 141,Business Combinations.

• Eliminate the requirement to disclose an estimate of the range of outcomes of recognized contingencies at theacquisition date. For unrecognized contingencies, the FASB decided to require that entities include only thedisclosures required by Statement 5 and that those disclosures be included in the business combination footnote.

• Require that contingent consideration arrangements of an acquiree assumed by the acquirer in a businesscombination be treated as contingent consideration of the acquirer and should be initially and subsequentlymeasured at fair value in accordance with Statement 141R.

This FSP is effective for assets or liabilities arising from contingencies in business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008 (i.e., January 1, 2009 for a calendar year-end company). The Company does not expect the standard to have any material impact on the consolidated financial statements.

In May 2009, FASB issued SFAS No. 165, Subsequent Events.  SFAS No. 165 established general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued.  It should not result in significant changes in the subsequent events that an entity reports, either through recognition or disclosure in its financial statements.  The statement requires disclosure of the date through which an entity has evaluated subsequent events and the basis for that date, that is, whether that date represents the date the financial statements were issued or were available to be issued.  This disclosure should alert all users of financial statements that an entity has not evaluated subsequent events after that date in the set of financial statements being presented.  We adopted the provisions of SFAS No. 165 for the interim period ended June 30, 2009, and the impact of adoption did not have a material impact on the Company's consolidated 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 issuable upon exercise of options and non-vested restricted stock were included.

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

	Three Months Ended		Six Months Ended
	2009	2008	2009	2008
Weighted average shares-basic	9,530,000	9,464,000	9,513,000	9,445,000
Effect of dilutive securities: stock awards	22,000	55,000	22,000	66,000
Weighted average shares-diluted	9,552,000	9,519,000	9,535,000	9,511,000

At June 30, 2009 and 2008, 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
Stock awards not included in diluted earnings per share:	2009	2008	2009	2008
Antidilutive TARP CPP stock warrants	492,164	—	492,164	—
Antidilutive stock awards	204,523	95,689	212,420	83,908
Total antidilutive stock awards	696,687	95,689	704,584	83,908

7

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Six months ended June 30, 2009 and 2008 (unaudited)
(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. There were no options issued during the six months ended June 30, 2009. The weighted average fair value per share of options granted during the six months ended June 30, 2008 was $2.82 per share. The following assumptions were used in arriving at the fair value of options granted:

	Six Months Ended
	June 30,
	2009	2008
Risk-free interest rate	—	3.44%
Dividend yield rate	—	2.90%
Price volatility	—	40.50%
Expected life of stock options	—	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, 2009 and 2008 the Company recognized $90 and $64, respectively, in stock based compensation expense as a component of salaries and benefits. As of June 30, 2009, there was approximately $373 of total unrecognized compensation cost related to nonvested stock awards.

The following table summarizes information on stock option activity during 2009:

				Weighted	Weighted average		Aggregate
				average exercise	remaining contractual		intrinsic
	Shares			price per share	terms (in years)		value
Outstanding at January 1, 2009	254,214		$	9.87
Granted	—			—
Exercised	(8,213	)		5.01		$	29
Forfeited, expired or cancelled	(7,467	)		12.05
Outstanding at June 30, 2009	238,534		$	9.97	7.29	$	80
Exercisable at June 30, 2009	126,621		$	9.23	6.09	$	80

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, 2009 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, 2009. 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 2009:

				Weighted average	Weighted average remaining
	Shares			grant price per share	contractual terms (in years)
Outstanding at January 1, 2009	10,071		$	13.11
Granted	—			—
Vested	(3,437	)		12.35
Forfeited, expired or cancelled	(1,486	)		13.56
Outstanding at June 30, 2009	5,148		$	13.48	1.43

8

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Six months ended June 30, 2009 and 2008 (unaudited)
(Dollars In Thousands, Except Per Share Data)

(4) Stock-Based Compensation (Continued)

For the six months ended June 30, 2009 and 2008 the Company recognized $23 and $79, respectively, in restricted stock compensation expense as a component of salaries and benefits. As of June 30, 2009 there was $57 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, 2009:

				Weighted average	Weighted average remaining
	Shares			grant price per share	contractual terms (in years)
Outstanding at January 1, 2009	18,711		$	13.25
Granted	12,000			5.48
Vested	(11,722	)		6.18
Forfeited, expired or cancelled	(537	)		15.98
Outstanding at June 30, 2009	18,452		$	12.61	2.42

For the six months ended June 30, 2009 and 2008 the Company recognized $44 and $47, respectively, in restricted stock units compensation expense as a component of salaries and benefits. As of June 30, 2009, there was $204 of total unrecognized compensation costs related to nonvested restricted stock units.

(5) 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 Troubled Asset Relief Program Capital Purchase Program 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, with a liquidation preference of $1,000 per share ($26.4 million liquidation preference in the aggregate) and (ii) a warrant ("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. The Warrant may be exercised 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 contains 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 grants registration rights to the holders of the Series A Preferred Stock, the Warrant and the common stock to be issued under the Warrant, and subjects the Company to executive compensation limitations included in the Emergency Economic Stabilization Act of 2008. Participants in the TARP Capital Purchase Program are required to have in place limitations on the compensation of Senior Executive Officers.

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 has 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.

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

9

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Six months ended June 30, 2009 and 2008 (unaudited)
(Dollars In Thousands, Except Per Share Data)

(5) Preferred Stock- (Continued)

The Series A Preferred Stock is not subject to any contractual restrictions on transfer. The holders of the Series A Preferred Stock have no general voting rights, and have only limited class voting rights including, authorization or issuance of shares ranking senior to the Series A Preferred Stock,  any amendment to the rights of the Series A Preferred Stock, or any merger, exchange or similar transaction which would adversely affect the rights of the Series A Preferred Stock. If dividends on the Series A Preferred Stock are not paid in full for six dividend periods, whether or not consecutive, the Series A Preferred Stock holders will have the right to elect two directors. The right to elect directors will end when full dividends have been paid for four consecutive dividend periods. The Series A Preferred Stock is not subject to sinking fund requirements and has no participation rights.

On January 13, 2009, the Company’s shareholders approved an amendment to the Company’s Restated Articles of Incorporation setting and designating the specific terms and conditions of 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 Securities and Exchange Commission’s (the “SEC”) Office of the Chief Accountant, the Company recorded the Series A Preferred Stock and detachable Warrants within Shareholders’ Equity on theConsolidated Balance Sheets. The Series A Preferred Stock and detachable Warrants were initially recognized based on their relative fair values at the date of issuance. As a result, the Series A Preferred Stock’s carrying value is at a discount to the liquidation value or stated value. In accordance the SEC’s Staff Accounting Bulletin No. 68,Increasing Rate Preferred Stock, 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 is therefore 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 Series A Preferred Stock dividend, which is deducted from net income to arrive at net income available to common shareholders on theConsolidated Statements of Income.

As of June 30, 2009, no dividends on the preferred stock were in arrears.

(6) Stock Warrant

On January 16, 2009, in connection with the issuance of the Series A Preferred Stock, the Company issued a warrant ("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 Warrant is immediately exercisable, in whole or in part, and has a ten year term. The Warrantis not subject to any other contractual restrictions on transfer. The Company has granted the Warrant holder piggyback registration rights for theWarrant and the common stock underlying the Warrant and has ag reed to take such other steps as may be reasonably requested to facilitate the transfer of the Warrant and the common stock underlying the Warrant. The holder of the Warrant is not entitled to any common stockholder rights. The U.S. Treasury agrees not to exercise voting power with respect to any shares of common stock of the Company issued to it upon exercise of the Warrant.

The Series A Preferred Stock and detachable Warrant were initially recognized based on their relative fair values at the date of issuance in accordance with APB opinion No. 14,Accounting for Convertible Debt and Debt Issued with Stock Purchase Warrants. As a result, the value allocated to the Warrant is different than the estimated fair value of the Warrant as of the grant date. The following assumptions were used to determine the fair value of the Warrant as of the grant date:

Dividend yield		5.00	%
Expected life (years)		10.0
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

10

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Six months ended June 30, 2009 and 2008 (unaudited)
(Dollars In Thousands, Except Per Share Data)

(7) Fair Value Measurements

The Financial Accounting Standards Board (“FASB”) has issued several significant FASB statements on the measurement and or reporting of financial instruments at fair value. Additionally, recent FASB statements have amended previously issued FASB statements. To add further complexity to an already complex issue, entities have been permitted to determine whether or not to measure certain financial instruments at fair value and report the changes in the fair value of these financial instruments in their statements of income. Furthermore, all entities are required to measure certain financial instruments at fair value and record the changes in fair value of these financial instruments in their statements of comprehensive income.

Key Concepts:

• Fair Value:FAS No. 157 defines fair value as “the price that would be received to sell an asset or paid totransfer a liability in an orderly transaction between market participants at the measurement date.”The Company determines fair value based upon quoted prices when available or through the use ofalternative approaches, such as matrix or model pricing, when market quotes are not readily accessible oravailable.

• Financial Instrument:FAS No. 107 defines a financial instruments “as cash, evidence of an ownershipinterest in an entity, or a contract that both:

a.	Imposes on one entity a contractual obligation (1) to deliver cash or another financial instrument to a second entity or (2) to exchange other financial instruments on potentially unfavorable terms with the second entity; and
b.	Conveys to that second entity a contractual right (1) to receive cash or another financial instrument from the first entity or (2) to exchange other financial instruments on potentially favorable terms with the first entity.”

             Financial instruments for the Company represent one of two categories:

1.	Assets:Consisting primarily of cash, short investments (interest bearing deposits, federal funds sold) securities and loans.
2.	Liabilities:Consisting primarily of deposits and various forms of borrowings (overnight borrowings, junior subordinated debentures, other term borrowings)

             The Company further defines these financial instruments in the determination of fair value section of this footnote.

FAS No.157 Fair Value Hierarchy:

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 the Company’s 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 drivers are observable.
Level 3:	Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the asset or liability. Unobservable inputs are used to measure fair value to the extent that observable inputs are not available. The Company’s own data used to develop unobservable inputs shall be adjusted for market consideration when reasonably available.

11

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Six months ended June 30, 2009 and 2008 (unaudited)
(Dollars In Thousands, Except Per Share Data)

(7) Fair Value Measurements-(Continued)

Determination of Fair Value

Under FAS No. 157, the Company bases its fair values on the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. It is the Company’s policy to maximize the use of observable inputs and minimize the use of unobservable inputs when developing fair value measurements, in accordance with the fair value hierarchy in FAS No. 157.

Fair value measurements for assets and liabilities where there exists limited or no observable market data and, therefore, are based primarily upon the Company’s own estimates, are often calculated based on current pricing policy, the economic and competitive environment, the characteristics of the asset or liability and other such factors. Therefore, the results cannot be determined with precision and may not be realized in an actual sale or immediate settlement of the asset or liability. Additionally, there may be inherent weaknesses in any calculation technique, and changes in the underlying assumptions used, including discount rates and estimates of future cash flows, that could significantly affect the results of current or future values.

Following is a description of valuation methodologies used for assets and liabilities recorded at fair value and for estimating fair value for financial instruments not recorded at fair value (FAS No. 107 disclosures).

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.

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

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

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.

Bank Owned Life Insurance Assets: Fair values of insurance policies owned are based on the insurance contracts cash surrender value.

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 is included in the nonrecurring basis table below.

12

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Six months ended June 30, 2009 and 2008 (unaudited)
(Dollars In Thousands, Except Per Share Data)

(7) Fair Value Measurements-(Continued)

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.

FHLB Overnight Borrowings:The carrying value of FHLB overnight borrowings approximates fair value.

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.

Other Borrowed Funds:Other borrowed funds consist of FHLB advances. The carrying amount of FHLB advances is estimated using discounted cash flow analyses based on the Company’s current incremental borrowing rates of similar types of borrowing arrangements.

Off-Balance Sheet Items:Commitments to extend credit represent the principal category of off-balance sheet financial instruments. The fair value of these commitments is 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.

FAS No. 157,Fair Value Measurements,Assets and Liabilities Recorded at Fair Value on a Recurring Basis:

The following table presents the Company’s assets measured at fair value on a recurring basis for the year ending June 30, 2009:

				Period Ended June 30, 2009
		Level 1		Level 2		Level 3		Total
Investment securities	$	—	$	31,740	$	—	$	31,740
Total	$	—	$	31,740	$	—	$	31,740

FAS No. 157,Fair Value Measurements,Assets and Liabilities Recorded at Fair Value on a Nonrecurring Basis:The Company may be required, from time to time, to measure certain assets at fair value on a nonrecurring basis in accordance with GAAP. These adjustments to fair value usually result from application of lower-of-cost-or-market accounting or write-downs of individual assets. The valuation methodologies used to measure these fair value adjustments are described previously in this Note.

The following table presents the Company’s assets measured at fair value on a nonrecurring basis for the period ending June 30, 2009:

		Period Ended June 30, 2009
										Total losses
		Carrying value at year end								for period
		Level 1		Level 2		Level 3		Total		ended
Impaired loans (1)	$	—	$	—	$	6,875	$	6,875	$	(603	)
Other real estate owned (2)		—		—		2,599		2,599		(195	)
Total	$	—	$	—	$	9,474	$	9,474	$	(798	)

 

(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 other real estate owned.

13

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Six months ended June 30, 2009 and 2008 (unaudited)
(Dollars In Thousands, Except Per Share Data)

(7)Fair Value Measurements-(Continued)

FAS No. 107,Disclosures about Fair Value of Financial Instruments

The table below is a summary of fair value estimates as of June 30, 2009, for financial instruments, as defined by FAS No. 107. The carrying amounts in the following table are recorded in the balance sheet under the indicated captions.

In accordance with FAS No. 107, the Company has not included assets and liabilities that are not financial instruments in our disclosure, such as the value of the premises and equipment, deferred taxes and other liabilities.

		June 30				December 31
		2009					2008
		Carrying		Estimated		Carrying		Estimated
		value		fair value		value		fair value
Financial assets:
Cash and cash equivalents	$	22,403	$	22,403	$	13,609	$	13,609
Interest-earning deposits		1,275		1,275		381		381
Federal funds sold		12,395		12,395		—		—
Investment securities- available for sale		31,740		31,740		17,798		17,798
FHLB Stock		2,430		2,430		2,430		2,430
Loans held for sale		4,385		4,385		2,896		2,896
Loans		820,776		820,556		823,068		822,840
Bank owned life insurance assets		17,028		17,028		16,822		16,822
Financial liabilities:
Deposits		787,624		792,666		747,159		752,249
FHLB overnight borrowings		—		—		11,640		11,640
Junior subordinated debentures		25,774		9,531		25,774		16,000
Other borrowed funds		10,000		10,300		30,000		30,399

(8) Subsequent Events

On July 24, 2009, the Company announced that its Board of Directors declared a cash dividend of $0.025 per share to shareholders of record as of August 5, 2009, payable on August 20, 2009.

14

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Six months ended June 30, 2009 and 2008 (unaudited)
(Dollars In Thousands, Except Per Share Data)

(9) 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, 2009. 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, 2009. As of June 30, 2009 the commitments under these agreements were $1,989.

At June 30, 2009, 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, 2009.

15

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, 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. 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 and increase market penetration in areas currently served.

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, 2008 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, 2008 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, 2008 as filed in Form 10-K.

16

Results of Operations Overview

The Company’s net income available to common shareholders decreased to $818,000 or $0.09 per diluted share, in the second quarter of 2009, compared with $2.4 million or $0.25 per diluted share in the second quarter of 2008. The decrease in net income was principally attributable to a $2.0 million increase in provision for loan losses, from the same period in 2008, the accrual of $413,000 in preferred dividends on preferred stock issued to the U.S. Treasury under the TARP program, and a one time FDIC special assessment of $400,000.

The Company’s net income available to common shareholders for the first six months of 2009 decreased to $2.0 million or $0.21 per diluted share, compared with $4.8 million or $0.50 per diluted share for the same period last year. The decrease in net income was principally attributable to a $3.4 million increase in provision for loan losses, from the same period in 2008, the accrual of $772,000 in preferred dividends on preferred stock issued to the U.S. Treasury under the TARP program and a one time FDIC special assessment of $400,000.

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, 2009						June 30, 2008
		Average		Interest	Average			Average		Interest	Average
(Dollars in thousands)		balance		earned/paid	yield			balance		earned/paid	yield
Assets
Loans (1)(2)	$	830,591	$	13,351	6.45	%	$	823,052	$	14,499	7.09	%
Federal funds sold		16,161		8	0.19	%		252		1	2.05	%
Interest-bearing cash		310		—	0.00	%		378		2	2.46	%
Investments
Taxable		16,763		141	3.37	%		9,195		96	4.19	%
Non-taxable (2)		11,003		141	5.15	%		5,262		76	5.77	%
Interest-earning assets		874,828		13,641	6.26	%		838,139		14,674	7.04	%
Noninterest-earning assets		55,104						52,858
Total assets	$	929,932					$	890,997
Liabilities and shareholders’ equity
Deposits:
Interest demand and
money market	$	266,716	$	568	0.85	%	$	253,850	$	933	1.48	%
Savings		44,284		28	0.25	%		41,674		42	0.41	%
Time deposits		361,857		2,790	3.09	%		348,276		3,566	4.12	%
Total interest-bearing deposits		672,857		3,386	2.02	%		643,800		4,541	2.84	%
Federal funds purchased		—		—	—			18,334		115	2.51	%
Junior subordinated debentures		25,774		180	2.80	%		25,774		284	4.43	%
Other interest bearing liabilities		19,451		114	2.35	%		30,000		245	3.28	%
Total interest bearing liabilities		718,082		3,680	2.06	%		717,908		5,185	2.91	%
Noninterest-bearing deposits		100,179						93,191
Other liabilities		2,992						3,695
Total liabilities		821,253						814,794
Total shareholders’ equity		108,679						76,203
Total liabilities and shareholders’ equity	$	929,932					$	890,997

17

Net interest income /Spread	$	9,961	4.20	%	$	9,489	4.14	%
Credit for interest bearing funds			0.37	%			0.42	%
Net interest margin (2)			4.57	%			4.55	%

(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 $153 and $140 for the three months ended June 30, 2009 and 2008, 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, 2009						June 30, 2008
		Average		Interest	Average			Average		Interest	Average
(Dollars in thousands)		balance		earned/paid	yield			balance		earned/paid	yield
Assets
Loans (1)(2)	$	828,156	$	26,459	6.44	%	$	817,090	$	29,988	7.38	%
Federal funds sold		9,898		10	0.20	%		259		3	2.48	%
Interest-bearing cash		308		—	—			330		5	2.99	%
Investments
Taxable		15,350		277	3.64	%		9,456		206	4.39	%
Non-taxable (2)		9,317		241	5.22	%		5,264		150	5.72	%
Interest-earning assets		863,029		26,987	6.31	%		832,399		30,352	7.33	%
Non-earning assets		53,854						53,240
Total assets	$	916,883					$	885,639
Liabilities and shareholders’ equity
Deposits:
Interest demand and money market	$	263,525	$	1,134	0.87	%	$	262,559	$	2,283	1.75	%
Savings		43,106		54	0.25	%		41,801		93	0.45	%
Time deposits		358,292		5,717	3.22	%		342,615		7,460	4.38	%
Total interest-bearing deposits		664,923		6,905	2.09	%		646,975		9,837	3.06	%
Federal funds purchased		1,037		4	0.82	%		18,458		290	3.16	%
Junior subordinated debentures		25,774		404	3.16	%		25,774		689	5.37	%
Other interest-bearing liabilities		20,497		243	2.39	%		22,747		374	3.30	%
Total interest-bearing liabilities		712,231		7,556	2.14	%		713,954		11,189	3.15	%
Noninterest-bearing DDA		97,061						92,859
Other liabilities		2,168						3,592
Total liabilities		811,460						810,405
Total equity		105,423						75,234
Total liabilities and shareholder’s equity	$	916,883					$	885,639
Net interest income /Spread			$	19,431	4.17	%			$	19,163	4.18	%
Credit for interest-bearing funds					0.37	%					0.45	%
Net interest margin (2)					4.54	%					4.63	%

(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 $293 and $292 for the six months ended June 30, 2009 and 2008, 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.

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Taxable-equivalent net interest income totaled $10.0 million in the second quarter of 2009 compared with $9.5 million during the second quarter of 2008. Changes in net interest income during the second quarter of 2009 reflected a continued growth in average earning assets, average noninterest bearing deposits and deposit pricing discipline, offset by a decrease on the yield of loans.

Net interest margin (net interest income as a percentage of average interest-earning assets) on a taxable-equivalent basis was 4.57% for the second quarter of 2009, compared to 4.55% for the same period in 2008. The change in net interest margin in the second quarter of 2009 resulted from a $36.7 million increase in average interest-earning assets, with approximately $15.9 million in minimal yielding federal funds sold and $13.3 million in low yielding investment securities.

Taxable-equivalent net interest income totaled $19.4 million in the first six months of 2009 compared with $19.2 million during the same period in 2008. Changes in net interest income during the first six months of 2009 reflected a continued growth in average earning assets, average noninterest bearing deposits and deposit pricing discipline, offset by a decrease on the yield of loans.

Net interest margin on a taxable-equivalent basis was 4.54% for the second quarter of 2009, compared to 4.63% for the same period in 2008. The change in net interest margin in the second quarter of 2009 resulted from a $30.6 million increase in average interest-earning assets, with approximately $9.6 million in low yielding federal funds sold. Additionally, the margin was impacted by a decrease in the rates charged on new loans and the repricing of variable rate loans. The large majority of the Company’s variable rate loans did not have interest rate floors in place during 2008. The Company is currently implementing interest rate floors on its variable rate loans when they renew.

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

		Three Months Ended									Six Months Ended
		June 30,									June 30,
		2009 vs. 2008									2009 vs. 2008
		Increase (decrease) due to(2):									Increase (decrease) due to(2):
		Volume			Rate			Total			Volume			Rate			Total
Assets:
Loans (1)(3)	$	130		$	(1,279	)	$	(1,149	)	$	422		$	(3,952	)	$	(3,530	)
Federal funds sold		7			—			7			7			—			7
Interest-bearing cash		—			(2	)		(2	)		—			(5	)		(5	)
Investments (1)
Taxable		59			(14	)		45			98			(27	)		71
Non-taxable (2)		73			(7	)		66			104			(12	)		92
Interest- earning assets	$	269		$	(1,302	)	$	(1,033	)	$	631		$	(3,996	)	$	(3,365	)
Liabilities:
Deposits:
Interest demand and money market	$	49		$	(414	)	$	(365	)	$	8		$	(1,158	)	$	(1,150	)
Savings		3			(17	)		(14	)		3			(42	)		(39	)
Time deposits		144			(921	)		(777	)		364			(2,107	)		(1,743	)
Total interest-bearing deposits		198			(1,368	)		(1,170	)		375			(3,307	)		(2,932	)
Fed funds purchased		(57	)		(57	)		(114	)		(160	)		(126	)		(286	)
Junior subordinated debentures		—			(104	)		(104	)		—			(285	)		(285	)
Other interest-bearing liabilities		(72	)		(59	)		(131	)		(34	)		(96	)		(130	)
Total interest-bearing liabilities	$	67		$	(1,572	)	$	(1,505	)	$	181		$	(3,814	)	$	(3,633	)

(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: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 loss 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.

During the second quarter of 2009, the Company recorded a $3.0 million provision for loan losses compared to $1.1 million for the second quarter in 2008. Net charge-offs for second quarter of 2009 were $1.6 million, a $684,000 increase over the second quarter of 2008. Increases in net charge-offs were due to an increase in real estate loan charge-offs. At June 30, 2009, the allowance for loan losses as a percent of total loans was 1.80% as compared to 1.40% for the same period in 2008.

During the first six months of 2009, the Company recorded a $5.5 million provision for loan losses compared to $2.1 million in the same period in 2008. Changes in the provision were due to higher net charge-offs of $2.9 million in the first six months of 2009, compared with $1.6 million in the same period in 2008 and internal downgrades of loans within the portfolio. Increases in net charge-offs were due to an increase in real estate loan charge-offs.

Noninterest Income:Noninterest income remains a key focus of the Company. The Company has focused on diversifying the noninterest income mix. The diversification of the noninterest income mix resulted primarily from the introduction of nondeposit investment products consisting primarily of annuity sales and investment service fees. The following table presents the key components of noninterest income:

				Noninterest Income as of:
		Three months Ended June 30,				Six months Ended June 30,				Three Month			Six Month
										Change			Change
(Dollars in thousands)		2009		2008		2009		2008
Service charges and fees	$	853	$	711	$	1,711	$	1,437	$	142		$	274
Electronic banking income		348		347		658		661		1			(3	)
Investment products		161		39		331		167		122			164
Bank owned life insurance		112		121		205		222		(9	)		(17	)
Income from sale of SBA loans and servicing		16		45		33		189		(29	)		(156	)
Income from sale of mortgage loans		301		51		570		141		250			429
Other income		282		324		568		615		(42	)		(47	)
Total noninterest income	$	2,073	$	1,638	$	4,076	$	3,432	$	435		$	644

The changes in noninterest income in the second quarter of 2009 compared to 2008 were related to the following areas:

• Service charges and fees increases are principally attributable to a change in service charges instituted in October of2008. The full impact of this change is reflected in the income in the second quarter of 2009.

• Investment products increases are due to increased customer demand for alternative investment products in thesecond quarter of 2009.

• Income from the sale of loans increased due to strong refinancing activity in 2009. Additionally, income from thesame period in 2008 was negatively impacted by the proposed merger with Frontier Financial Corporation. Underthe proposed merger, the department originating real estate loans for sale on the secondary market was to be closedby April 2008.

The changes in noninterest income in the first six months of 2009 compared to 2008 were related to the following areas:

• Service charges and fees increases are principally attributable to a change in service charges instituted in October of2008. The full impact of this change is reflected in the income in the first six months of 2009.

• Investment products increases are due to increased customer demand for alternative investment products in 2009.

• Income from the sale of SBA loans decreased due to lower volumes of SBA loan originations. Additionally, theCompany did not sell SBA loans during the first six months of 2009 due to unfavorable premiums for SBA loans inthe secondary financial market.

• Income from the sale of loans increased due to strong refinancing activity in 2009. Additionally, income from thesame period in 2008 was negatively impacted by the proposed merger with Frontier Financial Corporation. Underthe proposed merger, the department originating real estate loans for sale on the secondary market was to be closedby April 2008.

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Noninterest Expense:The Company continues to focus on controlling noninterest expenses and addressing long term operating expenses. The Company continued to successfully manage noninterest expense during the first six months of 2009 as compared to the same period in 2008. The Company’s efficiency ratio was at 58.43% at June 30, 2009 as compared to 58.46% at June 30, 2008.

					Noninterest Expense as of:
		Three months Ended June 30,						Six months Ended June 30,						Three Month			Six Month
														Change			Change
(Dollars in thousands)		2009			2008			2009			2008
Salaries and benefits	$	4,086		$	4,249		$	8,105		$	8,801		$	(163	)	$	(696	)
Less: loan origination costs		(649	)		(451	)		(1,244	)		(1,012	)		(198	)		(232	)
Net salaries and benefits (as reported)		3,437			3,798			6,861			7,789			(361	)		(928	)
Occupancy expense		1,071			902			2,104			1,851			169			253
Consulting and professional fees		211			147			489			362			64			127
Data processing		146			153			277			314			(7	)		(37	)
Office supplies and printing		207			120			171			119			87			52
FDIC premiums		676			122			823			245			554			578
OREO & Repossession Expense		267			25			483			187			242			296
Other		1,172			1,061			2,526			2,341			111			185
Total noninterest expense	$	7,187		$	6,328		$	13,734		$	13,208		$	859		$	526

The changes in noninterest expense in the second quarter of 2009 compared to 2008 were related to the following areas:

• Salaries and benefits decreased due to management’s decision not to accrue a bonus for 2009 and to implement asalary freeze in 2009 for all exempt positions; in the second quarter of 2008 the bonus accrual was $400,000.During the same period the average number of full time equivalent employees (FTEs) increased to 273 at June 30,2009 from 250 at June 30, 2008. FTE’s increased between the two periods due to restaffing needs following theterminated merger with Frontier Financial Corporation.

• Occupancy expense increased during the second quarter of 2009 due to the additional occupancy expense related toa new branch opened in December of 2008 and the lease on a new administrative center which opened in Februaryof 2009.

• FDIC premiums had a significant increase during the second quarter of 2009. In the second quarter of 2009, theFDIC levied a special one time assessment totaling 5 basis points of deposits on all insured depositories; theassessment totaled $400,000. Additionally, in February 2009, the FDIC adopted final rules which increase theassessment rates paid on deposits. Assessment rates in 2008, for well capitalized banks, ranged from $0.05 to $0.07per $100 of deposits annually. Assessment rates in 2009 will range from $0.12 to $0.16 per $100 of depositsannually. This assessment increase doubles the Company’s FDIC premiums as compared to 2008.

• OREO and repossession expense represents costs the Company incurs in reclaiming, repairing and selling realestate properties and automobiles as well as any write downs or gains and losses on the sale OREO properties. Theincrease in expense during the second quarter of 2009 is primarily related to a $200,000 write down of an OREOproperty.

The changes in noninterest expense in the first six months of 2009 compared to 2008 were related to the following areas:

• Salaries and benefits decreased due to management’s decision not to accrue a bonus for 2009 and to implement asalary freeze in 2009 for all exempt positions; in the first six months of 2008 the bonus accrual was $676,000.During the same period the average number of full time equivalent employees (FTEs) increased to 268 at June 30,2009 from 258 at June 30, 2008. FTE’s increased between the two periods due to restaffing needs following theterminated merger with Frontier Financial Corporation.

• FDIC premiums had a significant increase during the first six months of 2009. As discussed above in the quarterlyanalysis, the FDIC levied a special one time assessment totaling $400,000. Additionally, the FDIC adopted newassessment rates paid on deposits, which doubled the Company’s FDIC premiums as compared to 2008.

• OREO and repossession expense represents costs the Company incurs in reclaiming, repairing and selling realestate properties and automobiles. The increase in expense during the first six months of 2009 is primarily related to$223,000 in repairs on several OREO properties in preparing them for sale.

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Income Taxes:The Company’s consolidated effective tax rates for the second quarter of 2009 and 2008 were 27.3% and 32.9%, respectively. The effective tax rate for the first six months of 2009 and 2008 were 30.4% and 32.2%, 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 2009 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

During 2009, the Company focused on maintaining its loan portfolio and increasing its deposit funding base. Loans at June 30, 2009 were flat at $820.8 million compared to $823.1 million at December 31, 2008. Deposits at June 30, 2009 increased 5.4% to $787.6 million compared to $747.2 million at December 31, 2008. Shareholders’ equity increased $27.3 million to $107.9 million at June 30, 2009, with the issuance of $26.4 million of preferred stock to the U.S. Treasury Department.

Loans:Total loans outstanding as of June 30, 2009 were $820.8 million, a decrease of $2.3 million from December 31, 2008. Loan portfolio growth during 2009 was primarily in the commercial real estate loans, which was offset by decreases in construction loans. 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 loan portfolio:
		Loan Portfolio Composition as of:
		June 30, 2009					December 31, 2008					Change
(Dollars in thousands)		Balance		% of total			Balance		% of total
Commercial	$	95,935		11.8	%	$	94,522		11.5	%	$	1,413
Real estate mortgages:
One-to-four family residential		57,414		7.0	%		58,099		7.1	%		(685	)
Multi-family residential & commercial		346,322		42.3	%		327,704		40.0	%		18,618
Total real estate mortgages		403,736		49.3	%		385,803		47.1	%		17,933
Real estate construction:
One-to-four family residential		79,493		9.7	%		101,022		12.3	%		(21,529	)
Multi-family and commercial		39,183		4.8	%		44,401		5.4	%		(5,218	)
Total real estate construction		118,676		14.5	%		145,423		17.7	%		(26,747	)
Consumer:
Indirect		104,178		12.7	%		108,266		13.2	%		(4,088	)
Direct		95,653		11.7	%		86,364		10.5	%		9,289
Total consumer		199,831		24.4	%		194,630		23.7	%		5,201
Subtotal		818,178		100.0	%		820,378		100.0	%		(2,200	)
Deferred loan costs, net		2,598					2,690					(92	)
Less: allowance for loan losses		(14,770	)				(12,250	)				(2,520	)
Total loans, net	$	806,006				$	810,818				$	(4,812	)

Credit Risks and Asset Quality

Credit Risks: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 and other real estate owned. Nonperforming assets are assessed for potential loss exposure on an individual or homogeneous group basis.

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The following table summarizes the Company’s nonperforming assets:
		Nonperforming Assets as of:
(Dollars in thousands)		June 30,			December 31,
		2009			2008
Nonaccrual loans	$	7,478		$	1,918
Restructured loans		-			-
Total nonperforming loans		7,478			1,918
Other real estate owned properties		2,599			2,226
Total nonperforming assets	$	10,077		$	4,144
Total impaired loans	$	7,478		$	1,918
Accruing loans past due 90 days or more		2			1
Potential problem loans(1)		2,986			5,168
Allowance for loan losses		14,770			12,250
Interest foregone on nonaccrual loans		276			118
Nonperforming loans to loans		0.91	%		0.23	%
Allowance for loan losses to loans		1.80	%		1.49	%
Allowance for loan losses to nonperforming loans		197.52	%		638.67	%
Nonperforming assets to total assets		1.08	%		0.46	%

1) 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.

Allowance for Loan Losses: Allowance for Loan Losses:The allowance for loan 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 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 risksthat are related to a specific loan that demonstrate risk characteristics consistent with impairment. Specificallowances may also be established to address the unique risks associated with a group of loans or particular type ofcredit exposure.

• Formula Allowance.The formula allowance is calculated by applying loss factors to individual loans based on theassignment of risk ratings, or through the assignment of loss factors to homogenous pools of loans. Changes in riskgrades of both performing and nonperforming loans affect the amount of the formula allowance. Loss factors arebased on historical loss experience and are adjusted for significant factors that, in management’s judgment, affect thecollectibility of the portfolio as of the evaluation date. The adjustments to historical loss rates are a result of ourjudgment about risks inherent in the portfolio, economic uncertainties, historical loss experience relative to currenttrends, and other subjective factors. Other considerations include: economic and business conditions that impact ourportfolio, loan growth, depth and skill level of lending staff, the interest rate environment, findings from our internalcredit review, and bank regulatory examination results.

• Unallocated Allowance.The unallocated loan loss allowance represents an amount for imprecision or uncertaintythat is inherent in estimates used to determine the allowance, which may change from period to period. EffectiveJanuary 1, 2009, the Company allocates the credit risk to each loan category and no longer maintains an unallocatedallowance for purposes of the table presentation below. In prior years, the unallocated portion of the allowance wasassociated with the portfolio as a whole, rather than with an individual loan type and was categorized as unallocated.The following table shows the allocation of the allowance for loan losses, by loan type.

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		Allocation of the Allowance for Loan Losses as of:
		June 30, 2009				December 31, 2008				June 30, 2008
			% 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	$	1,402	9.5%	11.9%	$	1,124	9.2%	11.5%	$	971	8.4%	11.9%
Real estate mortgage		7,026	47.6%	47.9%		5,426	44.3%	47.1%		4,473	38.4%	46.2%
Real estate construction		2,307	15.6%	16.7%		2,258	18.4%	17.7%		1,942	16.8%	18.2%
Consumer		4,035	27.3%	23.5%		3,313	27%	23.7%		2,802	24.2%	23.7%
Unallocated		N/A	N/A	N/A		129	1.1%	N/A		1,397	12.2%	N/A
Total	$	14,770	100.0%	100.0%	$	12,250	100%	100%	$	11,585	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.

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. Based on the assessment of loan quality, the Company believes that the current allowance for loan losses is appropriate under the current circumstances and economic conditions.

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

		Three Months Ended						Six Months Ended
		June 30,						June 30,
(Dollars in thousands)		2009			2008			2009			2008
Balance at beginning of period	$	13,323		$	11,404		$	12,250		$	11,126
Charge-offs:
Commercial		(348	)		(173	)		(556	)		(622	)
Real estate		(1,009	)		(482	)		(1,731	)		(502	)
Consumer
Direct		(151	)		(118	)		(353	)		(308	)
Indirect		(482	)		(331	)		(1,131	)		(693	)
Total charge-offs	$	(1,990	)	$	(1,104	)	$	(3,771	)	$	(2,125	)
Recoveries:
Commercial		129			92			266			147
Real estate		10			1			44			3
Consumer
Direct		44			25			73			71
Indirect		254			117			458			288
Total recoveries	$	437		$	235		$	841		$	509
Net charge-offs		(1,553	)		(869	)		(2,930	)		(1,616	)
Provision for loan losses		3,000			1,050			5,450			2,075
Balance at end of period	$	14,770		$	11,585		$	14,770		$	11,585
Indirect loans net charge-offs to average indirect loans (1)		0.86	%		0.77	%		1.27	%		0.73	%
Other net charge-offs to average other loans (1)		0.74	%		0.37	%		0.63	%		0.34	%
Net charge-offs to average loans (1)		0.75	%		0.42	%		0.72	%		0.40	%
(1)Excludes loans held for sale.

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Deposits:Total deposits in the first six months of 2009 increased $40.5 million to $787.6 million at June 30, 2009. The increase in deposits was in all deposit categories. The following table further details the major components of the deposit portfolio:

		Deposit Composition as of:
		June 30, 2009				December 31, 2008				Change
(Dollars in thousands)		Balance	% of total			Balance	% of total			2009 vs. 2008
Noninterest-bearing demand	$	103,226	13.1	%	$	91,482	12.2	%	$	11,744
NOW accounts		130,877	16.6	%		119,115	15.9	%		11,762
Money market		146,115	18.6	%		143,855	19.3	%		2,260
Savings		44,766	5.7	%		41,161	5.5	%		3,605
Time deposits		362,640	46.0	%		351,546	47.1	%		11,094
Total deposits	$	787,624	100	%	$	747,159	100	%	$	40,465

On January 27, 2009, the Company received notice from the Washington State Treasurer, that the Company would be required to pay a pro rata assessment of $114,000 to cover losses related to uninsured public deposits of a recently failed bank. The Company currently participates in a program where qualified commercial banks may accept public funds and pledge collateral representing 10.0% of the public funds accepted. Under the 1969 Washington State law, all banks participating in the program are required to cover losses related to uninsured public deposits. This is the first instance of the payment by participating banks in the law’s thirty nine year history.

The Washington State Office of the Treasurer has revised the collateral requirements for public deposits whereby all uninsured public deposits would have pledged collateral of 100.0% by June 30, 2009. The Company had $25.2 million and $49.2 million in uninsured public deposits at June 30, 2009 and December 31, 2008, respectively. Under the new collateral requirements, at June 30, 2009, the Company has pledged investment securities as collateral, to comply with the new requirement.

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

		Wholesale Deposits as of:
		June 30, 2009					December 31, 2008
(Dollars in thousands)		Balance		% of Total			Balance		% of Total
Brokered time deposits	$	7,500		17.5	%	$	10,000		20.5	%
Mutual fund money market deposits		15,004		35.0	%		26,002		53.4	%
Certificate Deposits Account Registry System deposits		20,331		47.5	%		12,727		26.1	%
Total wholesale deposits	$	42,835		100.0	%	$	48,729		100.0	%
Wholesale deposits to total deposits		5.4	%				6.5	%

Brokered time deposits are obtained through intermediary brokers that sell the certificates on the open market. All $7.5 million of the brokered time deposits mature in January 2010; the Company will evaluate alternate funding at maturity.

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.

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.

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Borrowings:Total borrowings outstanding in the first six months of 2009 decreased $31.6 million to $35.8 million at June 30, 2009. The change in borrowings is attributable to a reduction of $20.0 million in other borrowings from the FHLB and $11.6 million in overnight borrowings. 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 tosupplement funding needs. The FHLB provides credit for member financial institutions in the form of overnightborrowings, short term and long term advances. As a member, the Bank is required to own capital stock in the FHLB andis authorized to apply for advances on the pledge of certain of its mortgage loans and other assets (principally, securitieswhich are obligations of, or guaranteed by, the United States) provided certain standards related to creditworthiness havebeen met. At June 30, 2009, the Company had no outstanding overnight borrowings, and other borrowed funds totaling$10.0 million with a fixed interest rate of 3.71%, maturing in August 2010.

The Company had a remaining unused line of credit of $150.9 million, subject to certain collateral and stockrequirements.

• Federal Funds Purchased:The Company also uses lines of credit at correspondent banks to purchase federal funds forshort-term funding. There were no outstanding borrowings as of June 30, 2009. Available borrowings under these linesof credit totaled $60.0 million as of June 30, 2009.

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

Capital

Shareholders’ Equity:Shareholders’ equity increased $27.3 million to $107.9 million at June 30, 2009 from $80.6 million at December 31, 2008. The increase in shareholders’ equity was due principally to the issuance of $26.4 million of preferred stock to the U.S. Treasury Department. These increases were offset by the payment of preferred stock dividends of $606,000 and common stock dividends of $1.2 million.

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 Troubled Asset Relief Program Capital Purchase Program 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. The Warrant may be exercised 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 contains 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 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 has no maturity date and ranks senior to our common stock with respect to the payment of dividends and distributions and amounts payable upon liquidation, dissolution and winding up of the Company.

The Company intends to use the $26.4 million TARP investment to bolster its capital position and provide additional lending opportunities within its communities.

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. On July 24, 2009, the Company announced that its Board of Directors reduced is cash dividend from $0.065 per common share to $0.025 per common share. 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 June 30, 2009 and December 31, 2008:

	Regulatory Requirements		Actual Ratios
	Adequately-	Well-capitalized	June 30,	December 31,
	capitalized		2009	2008
Total risk-based capital ratio
Company (consolidated)	8%	N/A	16.24%	13.23%
Whidbey Island Bank	8%	10%	16.11%	13.10%
Tier 1 risk-based capital ratio
Company (consolidated)	4%	N/A	14.99%	11.98%
Whidbey Island Bank	4%	6%	14.86%	11.85%
Leverage ratio
Company (consolidated)	4%	N/A	14.28%	11.68%
Whidbey Island Bank	4%	5%	14.15%	11.54%

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 theCondensed Consolidated Statements of Cash Flows, net cash provided by operating activities was $5.6 million for the first six months of 2009. Approximately $2.8 million was from net income from continuing operations, offset by $1.2 million decrease in other liabilities and a $5.5 million increase in provisions for loan losses. Net cash of $16.9 million was used in investing activities during the period, primarily for the purchase of investment securities of $18.2 million. Net cash provided by financing activities was $33.4 million for the first six months of 2009. Cash from the issuance of preferred stock to the U.S. Treasury Department provided $26.4 million of additional cash during the period and increase in deposits of $40.5 million, offset by $20.0 million in other borrowing payoffs and $11.6 million in overnight borrowings payoffs.

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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. As of June 30, 2009 and December 31, 2008, the Company’s commitments under letters of credit and financial guarantees amounted to $2.0 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.

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Item 3. Quantitative and Qualitative Disclosures about Market Risk

At June 30, 2009, 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, 2008. 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, 2008 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, 2009 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, 2008. There have been no material changes in the Company’s risk factors from those disclosed in the 2008 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

The annual meeting of shareholders was held at Oak Harbor, Washington at 3:00 p.m. on April 23, 2009. The total number of shares of common stock represented in person or by proxy at the meeting was 7,668,664 shares. This represented 80.5% of the 9,529,496 shares held by shareholders as of February 27, 2009 and entitled to vote at the meeting. The following issues came before the shareholders for vote:

1) Election of directors to serve on the Board of Directors until the Annual meeting of shareholders in the year 2012, or until their successors are duly elected and qualified – three director position terms had expired and were open for election. Two of the directors whose terms expired, Mr. Krieg and Mr. Olson, both having reached the retirement age as determined by a resolution of the Board of Directors, did not stand for reelection. The nominees for the open positions were Gregg A. Davidson, Gragg E. Miller, and Anthony B. Pickering, who were each elected with the following vote totals:

	For	Withheld
Gregg A. Davidson	7,568,461	100,203
Gragg E. Miller	7,532,994	135,670
Anthony B. Pickering	7,595,943	72,721

The other directors who continue in office are: Jay T. Lien; John L. Wagner; Edward J. Wallgren; and Dennis A. Wintch.

2) A non-binding advisory vote on executive compensation as required by the American Recovery and Reinvestment Act of 2009. Shareholders approved the compensation of executive officers with the following vote totals:

	For	Against	Abstain
Executive Compensation	7,063,165	349,570	255,929

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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. ExhibitsExhibits

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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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 7, 2009

By/s/ John L. WagnerJohn L. WagnerPresident andChief Executive Officer

Date: August 7, 2009

By/s/ Richard A. ShieldsRichard A. ShieldsExecutive Vice President andChief Financial Officer

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