Washington Banking (WBCO) 10-Q 2006 Q1 Quarterly report

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended March 31, 2006

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

For the transition period from _________ to _________

Commission File Number 000-24503

WASHINGTON BANKING COMPANY

(Exact name of registrant as specified in its charter)

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

450 SW Bayshore Drive
Oak Harbor, Washington 98277
(Address of principal executive offices)     (Zip Code)

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

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

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

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 filero Accelerated filerþ Non-Accelerated filero

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. Yeso Noþ

The number of shares of the issuer’s Common Stock outstanding at April 30, 2006 was 7,414,018.

Table of Contents
	Page
PART I — FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Consolidated Statements of Financial Condition — March 31, 2006 and December 31, 2005		1
Condensed Consolidated Statements of Income — Three Months Ended March 31, 2006 and 2005		2
Condensed Consolidated Statements of Shareholders’ Equity and Comprehensive Income — Three Months Ended March 31, 2006 and 2005		3
Condensed Consolidated Statements of Cash Flows — Three Months Ended March 31, 2006 and 2005		4
Notes to Condensed Consolidated Financial Statements		5
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		9
Item 3. Quantitative and Qualitative Disclosures about Market Risk		16
Item 4. Controls and Procedures		16
PART II – OTHER INFORMATION
Item 1. Legal Proceedings		17
Item 1A. Risk Factors		17
Item 2. Unregistered Sale of Equity Securities and Use of Proceeds		17
Item 3. Defaults Upon Senior Securities		17
Item 4. Submission of Matters to a Vote of Security Holders		17
Item 5. Other Information		17
Item 6. Exhibits		17
Signatures		17
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1
EXHIBIT 32.2

i

PART I — FINANCIAL INFORMATION

Item 1. Financial Statements

WASHINGTON BANKING COMPANY

AND SUBSIDIARY

Condensed Consolidated Statements of Financial Condition

March 31, 2006 and December 31, 2005 (unaudited)

(Dollars in thousands)

	March 31,			December 31,
	2006			2005
Assets
Cash and due from banks ($618 and $3,313, respectively, are restricted)	$	22,433		$	19,949
Interest-bearing deposits		692			983
Federal funds sold		8,530			21,095
Total cash, restricted cash, and cash equivalents		31,655			42,027
Investment securities available for sale		19,013			19,077
Federal Home Loan Bank stock		1,984			1,984
Loans held for sale		1,356			2,829
Loans receivable		651,134			630,258
Allowance for loan losses		(9,130	)		(8,810	)
Total loans, net		642,004			621,448
Premises and equipment, net		20,591			20,514
Bank owned life insurance		10,646			10,558
Other assets		8,372			7,539
Total assets	$	735,621		$	725,976
Liabilities and Shareholders’ Equity
Liabilities:
Deposits
Noninterest-bearing	$	100,537		$	105,365
Interest-bearing		300,096			287,214
Time deposits		245,373			244,910
Total deposits		646,006			637,489
Other borrowed funds		10,000			10,000
Junior subordinated debentures		15,007			15,007
Other liabilities		4,560			5,631
Total liabilities		675,573			668,127
Commitments and contingencies		—			—
Shareholders’ equity:
Preferred stock, no par value. Authorized 20,000 shares:
no shares issued or outstanding		—			—
Common stock, no par value. Authorized 11,822,706 shares: issued and outstanding 7,409,115 and 7,382,210 shares at March 31, 2006 and December 31, 2005, respectively		32,251			32,106
Retained earnings		27,878			25,789
Accumulated other comprehensive income		(81	)		(46	)
Total shareholders’ equity		60,048			57,849
Total liabilities and shareholders’ equity	$	735,621		$	725,976

See accompanying notes to condensed consolidated financial statements.

1

WASHINGTON BANKING COMPANY
AND SUBSIDIARY

Condensed Consolidated Statements of Income

Three months ended March 31, 2006 and 2005 (unaudited)

(Dollars in thousands, except per share data)

	Three Months Ended
	March 31,
	2006		2005
Interest income:
Interest and fees on loans	$	12,407	$	10,094
Interest on taxable investment securities		103		88
Interest on tax exempt investment securities		80		80
Other		59		31
Total interest income		12,649		10,293
Interest expense:
Interest on deposits		3,095		2,107
Interest on other borrowings		150		169
Interest on junior subordinated debentures		309		237
Total interest expense		3,554		2,513
Net interest income		9,095		7,780
Provision for loan losses		500		425
Net interest income after provision for loan losses		8,595		7,355
Noninterest income:
Service charges and fees		817		699
Income from the sale of loans		182		172
SBA premium income		135		112
Other		749		668
Total noninterest income		1,883		1,651
Noninterest expense:
Salaries and benefits		4,276		3,431
Occupancy and equipment		859		789
Office supplies and printing		181		185
Data processing		82		118
Consulting and professional fees		119		266
Other		1,165		1,198
Total noninterest expense		6,682		5,987
Income before income taxes and discontinued operations		3,796		3,019
Provision for income taxes		1,244		976
Net income	$	2,552	$	2,043
Net income per share, basic	$	0.35	$	0.28
Net income per share, diluted	$	0.34	$	0.27
Average number of shares outstanding, basic		7,362,843		7,249,213
Average number of shares outstanding, diluted		7,578,177		7,521,261

See accompanying notes to condensed consolidated financial statements.

2

WASHINGTON BANKING COMPANY
AND SUBSIDIARY

Condensed Consolidated Statements of Shareholders’ Equity

and Comprehensive Income

Three months ended March 31, 2006 and 2005 (unaudited)

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

											Accumulated
											other			Total
	Common stock				Retained			Deferred			comprehensive			shareholders’
	Shares		Amount		earnings			compensation			income			equity
Balances at December 31, 2004		5,429	$	31,516	$	17,928					$	147		$	49,591
Comprehensive income:
Net income		¾		¾		2,043						¾			2,043
Net unrealized loss on securities available for sale, net of tax of ($79)		¾		¾		¾						(134	)		(134	)
Total comprehensive income															1,909
Cash dividend, $0.054 per share		¾		¾		(395	)					¾			(395	)
Stock option compensation		¾		6		¾						¾			6
Four-for-three stock split		1,810		¾		¾						¾			¾
Stock options exercised		16		64		¾						¾			64
Restricted Stock		35		637		¾			(637	)		¾			¾
Balances at March 31, 2005		7,290	$	32,223	$	19,576		$	(637	)	$	13		$	51,175
Balances at December 31, 2005		7,382	$	32,492	$	25,789		$	(386	)	$	(46	)	$	57,849
Comprehensive income:
Net income		¾		¾		2,552						¾			2,552
Net unrealized loss on securities available for sale, net of tax of ($18)		¾		¾		¾						(35	)		(35	)
Total comprehensive income															2,517
Cash dividend, $0.625 per share		¾		¾		(463	)					¾			(463	)
Stock option compensation		¾		17		¾						¾			17
Stock options exercised		24		91		¾						¾			91
Issuance of restricted stock		3		62		¾			(62	)		¾			¾
Amortization of stock compensation		¾				¾			37			¾			37
Balances at March 31, 2006		7,409	$	32,662	$	27,878		$	(411	)	$	(81	)	$	60,048

See accompanying notes to condensed consolidated financial statements.

3

WASHINGTON BANKING COMPANY
AND SUBSIDIARY

Condensed Consolidated Statements of Cash Flows

Three months ended March 31, 2006 and 2005 (unaudited)

(Dollars in thousands)

	Three Months Ended March 31,
	2006			2005
Cash flows from operating activities:
Net income from continuing operations	$	2,552		$	2,043
Adjustments to reconcile net income to net cash provided by operating activities:
Federal Home Loan Bank stock dividends		—			(8	)
Amortization of investment premiums, net		3			7
Amortization of stock compensation		54			—
Net decrease (increase) in subsidiary investment		12			19
Earnings on bank owned life insurance		(88	)		(85	)
Provision for loan losses		500			425
Net decrease in loans held for sale		1,404			2,627
Depreciation and amortization of premises and equipment		408			399
Net loss (gain) on sale of premises and equipment		127			(95	)
Net loss on sale of other real estate		(6	)		(7	)
Write-downs of other real estate		10			85
Increase in other assets		(827	)		(1,236	)
(Decrease) increase in other liabilities		(1,071	)		680
Cash provided by operating activities		3,078			4,854
Cash flows from investing activities:
Maturities/calls/principal payments of investment and mortgage-backed securities available for sale		8			25
Net increase in loans		(21,056	)		(10,780	)
Purchases of premises and equipment		(612	)		(1,357	)
Proceeds from the sale of other real estate owned and premises and equipment		65			714
Cash flows used by investing activities		(21,595	)		(11,398	)
Cash flows from financing activities:
Net increase in deposits		8,517			24,538
Net decrease in FHLB overnight borrowings		—			(13,000	)
Dividends paid on common stock		(463	)		(395	)
Proceeds from stock options exercised		91			64
Cash flows provided by financing activities		8,145			11,207
Net change in cash and cash equivalents		(10,372	)		4,663
Cash and cash equivalents at beginning of period		42,027			17,933
Cash and cash equivalents at end of period	$	31,655		$	22,596
Supplemental information:
Loans foreclosed and transferred to other real estate owned	$	69		$	53
Cash paid for interest		3,572			2,510
Cash paid for income taxes		—			220

See accompanying notes to condensed consolidated financial statements.

4

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Three months ended March 31, 2006 and 2005 (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 March 31, 2006, WBCO had two wholly owned subsidiaries – Whidbey Island Bank (“WIB” or the “Bank”), the Company’s principal subsidiary, and Washington Banking Capital Trust I (the “Trust”). The business of the Bank, which is focused in the northern area of Western Washington, consists primarily of attracting deposits from the general public and originating loans. The region’s economy has evolved from one that was once heavily dependent upon forestry, fishing and farming to an economy with a much more diverse blend of industries including retail trade, services, manufacturing, tourism and a large military base presence. Although the Bank has a diversified loan portfolio, a substantial portion of its borrowers’ ability to repay their loans is dependent upon the economic conditions affecting this area.

(b) Basis of Presentation

The accompanying interim condensed consolidated financial statements include the accounts of WBCO and its subsidiaries described above. The accompanying interim condensed consolidated financial statements have been prepared, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. These condensed consolidated financial statements should be read in conjunction with the December 31, 2005 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 three months ended March 31, 2006 are not necessarily indicative of the results that may be expected for the year ending December 31, 2006. In preparing the condensed consolidated financial statements, estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses are required. Actual results could differ from those estimates.

(c) Reclassifications

Certain amounts in prior year’s financial statements may have been reclassified to conform to the 2006 presentation. These reclassifications had no significant impact on the Company’s financial position or results of operations.

(2) Recent Financial Accounting Pronouncements

In December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123R,Shared Based Payment,which is a revision of SFAS No. 123,Accounting for Stock-Based Compensation.Statement No. 123R supersedes Accounting Principles Board Opinion No. 25 (“APB 25”),Accounting for Stock Issued to Employees, and amends SFAS No. 95,Statement of Cash Flows. SFAS NO. 123R requires that the costs resulting from all stock-based compensation be measured at fair value and recognized in the Company’s financial statements. Application of the Statement is effective for reporting periods after December 15, 2005. The Company has adopted SFAS No. 123R effective January 1, 2006. For further details on the impact to the Company’s financial statements please refer to footnote 4-Stock-Based Compensation.

In February 2006, FASB issued SFAS No. 155,Accounting for Certain Hybrid Financial Instruments. SFAS NO. 155 resolves issues addressed in Statement 133 Implementation Issue No. D1, “Application of Statement 133 to Beneficial Interests in Securitized Financial Assets.” This Statement is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006. The Company does not expect the adoption of SFAS No. 155 to have a material impact on its financial statements.

5

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Three months ended March 31, 2006 and 2005 (unaudited)
(Dollars in thousands, except per share data)

In March 2006, FASB issued SFAS No. 156,Accounting for Servicing of Financial Assets, which amended FASB Statement No. 140,Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities,with respect to the accounting for separately recognized servicing assets and servicing liabilities. SFAS NO. 156 permits an entity to reclassify certain available-for-sale securities to trading securities, regardless of the restriction in paragraph 15 of Statement No. 115, provided that those available-for-sale securities are identified in some manner as offsetting the entity’s exposure to changes in fair value of servicing assets or servicing liabilities that a servicer elects to subsequently measure at fair value. Statement No. 156 is effective at the date an entity adopts the requirements of this Statement. The adoption of SFAS No. 156 had no material impact on the Company’s financial statements.

(3) Earnings Per Share

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

	Three Months Ended March 31,
	2006		2005
Weighted average shares-basic		7,362,843		7,249,213
Effect of dilutive securities: stock options		215,334		272,048
Weighted average shares-diluted		7,578,177		7,521,261

Adjusted for the 4-for -3 stock split declared March 24, 2005.

At March 31, 2006 and 2005, there were options to purchase 313,088 and 436,118 shares of common stock outstanding, respectively. For the three months ended March 31, 2006 and 2005 no options were antidilutive and therefore all were included in the computation of diluted net income per share.

(4) Stock-Based Compensation

On January 1, 2006, the Company adopted the provisions of SFAS 123R,Share Based Payment, requiring the Company to recognize expense related to the fair value of stock option awards. The Company elected to use the modified prospective transition method as permitted by SFAS 123R and therefore has not restated the financial results for prior periods. Under this transition method, stock option compensation expense for the three months ended March 31, 2006 includes compensation expense for all stock option compensation awards granted prior to, but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS 123. Stock option compensation expense for all stock option compensation awards granted subsequent to January 1, 2006 was based on the grant date fair value estimated in accordance with the provisions of SFAS 123R. The Company recognizes compensation expense for stock option awards on a straight-line basis over the requisite service period of the award.

For the three months ended March 31, 2006 the Company recognized $17 thousand in stock option compensation expense as a component of salaries and benefits. As of March 31, 2006 there was $59 thousand of total unrecognized compensation cost related to nonvested options.

Prior to the adoption of SFAS 123R, the Company applied SFAS No. 123, amended by SFAS No. 148, “Accounting for Stock-Based Compensation –Transition and Disclosure” (“SFAS 148”), which allowed companies to apply the existing accounting rules under APB 25 and related Interpretations. In general, as the exercise price of options granted under these plans was equal to the market price of the underlying common stock on the grant date, no stock-option employee compensation cost was recognized in the Company’s net income. As required by SFAS 148 prior to the adoption of SFAS 123R, the Company provided pro forma net income and pro forma net income per common share disclosures for stock-option awards, as if the fair-value-based method defined in SFAS 123 had been applied. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS 123 to stock-based compensation during the three-month period ended March 31, 2005 (in thousands, except per share amounts):

6

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Three months ended March 31, 2006 and 2005 (unaudited)
(Dollars in thousands, except per share data)

	March 31,
	2005
Net income, as reported	$	2,043
Stock compensation recognized, net of tax		4
Additional compensation for fair value of stock options, net of tax		(15	)
Pro forma net income	$	2,032
Basic earnings per share:
Net Income, as reported	$	0.28
Net Income, pro forma	$	0.28
Diluted earnings per share:
Net Income, as reported	$	0.27
Net Income, pro forma	$	0.27

The Company measures the fair value of each stock option grant at the date of the grant, using the Black Scholes option pricing model. The weighted average grant date fair value of options granted during the three months ended March 31, 2006, was $7.24 per share. There were no stock options issued during fiscal year 2005. The following assumptions were used in arriving at the fair value of options granted during the three months ended March 31, 2006:

	2006
Risk-free interest rate		4.32	%
Dividend yield rate		1.40	%
Price volatility		38.13	%
Expected life of options	7 years

						Weighted Average
				Weighted		Remaining		Aggregate
				Average		Contractual		Intrinsic Value
	Shares			Exercise Price		Terms (in years)		(in thousands)
Outstanding at January 1, 2006		336,493		$	5.93
Granted		500			17.76		9.76
Exercised		(23,905	)		3.99			$	337
Forfeited, expired or cancelled		(35	)
Outstanding at March 31, 2006		313,053		$	6.10		3.84	$	3,740
Exercisable at March 31, 2006		268,547		$	5.94		3.37	$	3,247

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 March 31, 2006 and the exercised price, times the number of shares) that would have been received by the option holders had all the option holders exercised their options on March 31, 2006. This amount changes based upon the fair market value of the Company’s stock.

7

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Three months ended March 31, 2006 and 2005 (unaudited)
(Dollars in thousands, except per share data)

(5) Subsequent Event

On April 27, 2006, the Board of Directors declared a cash dividend of $0.0625 per share to shareholders of record as of May 8, 2006, payable on May 23, 2006.

(6) 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 amounts to one hundred percent of the commitment amount at March 31, 2006. 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 are not significant as of March 31, 2006. As of March 31, 2006 the commitments under these agreements were as follows:

                     Standby letters of credit and financial guarantees $1,540

At March 31, 2006, 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 $15 million at March 31, 2006.

8

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

Note Regarding Forward-Looking Statements: This Quarterly Report on Form 10-Q includes forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). These forward-looking statements describe Washington Banking Company’s (the “Company”) management’s expectations regarding future events and developments such as future operating results, growth in loans and deposits, continued success of the Company’s business plan and the strength of the local economy. The words “will,” “believe,” “expect,” “should,” “anticipate” and words of similar construction are intended in part to help identify forward-looking statements. Future events are difficult to predict, and the expectations described below are necessarily subject to risk and uncertainty that may cause actual results to differ materially and adversely. In addition to discussions about risks and uncertainties set forth from time to time in the Company’s filings with the 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, the following possibilities: (1) local and national general and economic conditions, including the possible impact of international conflict or further terrorist events, are less favorable than expected or have a more direct and pronounced effect than expected on the Company and adversely affect the Company’s ability to continue its internal growth at historical rates and maintain the quality of its earning assets; (2) changes in interest rates reduce interest margins more than expected or negatively affect liquidity; (3) projected business increases following strategic expansion or the opening or acquisition of new branches are lower than expected; (4) there are greater than expected costs or difficulties related to the integration of acquisitions; (5) there is increased competitive pressure among financial institutions; (6) legislation or regulatory requirements or changes that adversely affect the banking and financial services sector; and (7) the Company is unable to realize the efficiencies it expects to derive from its investment in personnel and infrastructure. However, you should be aware that these factors are not an exhaustive list, and you should not assume that these are the only factors that may cause actual results to differ from expectations. In addition, you should note that we do 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 (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 Capital Trust I (the “Trust”). Headquartered in Oak Harbor, the Company’s market area is primarily northwestern Washington. The market area encompasses distinct economies, and none are particularly dependent upon a single industrial or occupational source. The economies within the market areas have evolved from being heavily dependent upon forestry, fishing and farming to a more diverse blend of industries including retail trade, services, manufacturing, tourism and a large military presence.

The Company’s strategy is one of value-added growth. Management believes that qualitative and sustainable growth of the Company, coupled with maintaining profitability, is currently the most appropriate path to providing good value for its shareholders. To date, the Company’s growth has been achieved organically and it attributes its reputation for focusing on customer service and satisfaction as one of the cornerstones to the Company’s success. The Company’s primary objectives are to improve profitability and operating efficiencies, increase market penetration in areas currently served, and to continue an expansion strategy in appropriate market areas.

Results of Operations Overview

The Company earned $2.6 million for the first quarter of 2006 compared with $2.0 million for the first quarter of 2005. Earnings per diluted share increased 26% to $0.34, compared to $0.27 per diluted share in the first quarter of 2005. Return on average equity increased to 17.68% in the first quarter of 2006, compared to 16.38% a year ago. Return on average assets for the first quarter of 2006 increased to 1.45%, from 1.24% in the first quarter of 2005. The Company’s efficiency ratio improved to 60.49% for the first quarter 2006.

9

Net Interest Income:Net interest income, on a fully tax-equivalent basis, for the first quarter of 2006 increased 17% to $9.2 million from $7.8 million for the first quarter of 2005. This increase in net interest income was primarily due to a $55.2 million increase in average interest-earning assets and an increase in the net interest spread. Loans, the largest component of interest-earning assets, increased an average of $53.8 million from a year ago. The yield on interest earning assets increased 0.87% to 7.75% for the first quarter of 2006; this increase was primarily a result of higher yields on loans. The higher yields on loans was due to repricing of variable rate loans, higher rates on new loan originations as well as recoveries of non accrual interest totaling $130,000.

Average interest-bearing liabilities increased $28.9 million for the quarter ended March 31, 2006, or 5.5% from the same quarter a year ago. The average cost of interest-bearing liabilities increased 0.66% in the first quarter of 2006 compared with the first quarter of 2005. This increase was primarily the result of an increase in the cost of time deposits and to a lesser extent interest-bearing demand and money market accounts. Additionally, the Company’s junior subordinated debentures continued to contribute to the overall increase in interest expense in the first quarter of 2006. The rate on junior subordinated debentures is tied to the Three-Month LIBOR index plus 3.65% and is adjusted on a quarterly basis.

As a result of the above changes in the components of net interest income, the net interest spread widened to 5.13% for the quarter ended March 31, 2006 from 4.92% in the first quarter of 2005. The net interest margin increased to 5.59% in the first quarter of 2006 from 5.20% in the first quarter of 2005. The net interest margin widened by more than the net interest spread due to a $26.3 million increase in net noninterest-bearing funding (consisting of average noninterest-bearing deposits, other liabilities and equity offset by noninterest-earning assets) as compared with 2005.

Consolidated Average Balance Sheet and Analysis of Net Interest Income and Expense

The following table sets forth the Company’s consolidated average balance sheet and analysis of net interest income and expense:

	Three Months Ended March 31, 2006						Three Months Ended March 31, 2005
	Average		Interest		Average		Average		Interest		Average
(Dollars in thousands)	balance		earned/paid		yield		balance		earned/paid		yield
Assets
Loans(1) (2)	$	639,742	$	12,433		7.88%	$	585,952	$	10,112		7.00%
Federal funds sold		3,457		39		4.58%		1,680		10		2.41%
Interest-earning cash		867		11		5.15%		1,049		6		2.32%
Investments:
Taxable		13,696		112		3.32%		14,404		103		2.90%
Non-taxable(2)		7,589		124		6.63%		7,085		119		6.81%
Interest-earning assets		665,351		12,719		7.75%		610,170		10,350		6.88%
Noninterest-earning assets		46,702						49,477
Total assets	$	712,053					$	659,647
Liabilities and Shareholders’ equity
Deposits:
Interest demand and money market	$	216,038	$	814		1.53%	$	217,329	$	492		0.92%
Savings		57,690		112		0.79%		56,283		110		0.79%
CDs		247,336		2,169		3.56%		210,471		1,515		2.92%
Interest-bearing deposits		521,064		3,095		2.41%		484,083		2,117		1.77%

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CONTINUED

	Three Months Ended March 31, 2006						Three Months Ended March 31, 2005
	Average		Interest		Average		Average		Interest		Average
(Dollars in thousands)	balance		earned/paid		yield		balance		earned/paid		yield
Federal funds purchased		4,519		54		4.85%		14,450		90		2.53%
Junior subordinated debentures		15,007		309		8.35%		15,007		237		6.40%
Other borrowed funds		10,046		96		3.88%		8,185		79		3.91%
Interest-bearing liabilities		550,636		3,554		2.62%		521,725		2,523		1.96%
Noninterest-bearing deposits		98,780						85,022
Other noninterest-bearing liabilities		4,094						3,009
Total liabilities		653,510						609,756
Shareholders’ equity		58,543						49,891
Total liabilities and shareholders’ equity	$	712,053					$	659,647
Net interest income			$	9,165					$	7,827
Net interest spread						5.13%						4.92%
Net interest margin						5.59%						5.20%

(1)

Average balance includes nonaccrual loans.

(2)

Interest income on non-taxable investments and loans is presented on a fully tax-equivalent basis using the federal statutory rate of 34%. These adjustments were $70 and $57 for the three months ended March 31, 2006 and 2005, respectively. Fully tax-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.

The following table sets forth the amounts of the changes in consolidated net interest income attributable to changes in volume and to changes in interest rates:

	Three months ended March 31
	2006 vs. 2005
	Increase (decrease) due to(2)
	Volume			Rate			Total
Assets:
Loans(1) (3)	$	978		$	1,343		$	2,321
Federal funds sold		16			13			29
Interest-earning cash		(1	)		6			5
Investments(1)		3			11			14
Total interest-earning assets	$	996		$	1,373		$	2,369
Liabilities:
Deposits
Interest demand and money market	$	(3	)	$	325		$	322
Savings		3			(1	)		2
Time deposits		291			363			654
Interest on other borrowed funds		107			(143	)		(36	)
Junior subordinated debentures		—			72			72
Other interest-bearing liabilities		18			(1	)		17
Total interest-bearing liabilities	$	416		$	615		$	1,031

(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. The Company recorded a $500,000 provision for loan losses for the first quarter of 2006, compared to $425,000 for the same period in 2005. Net loan charge-offs were $180,000 for the first quarter of 2006, compared with $276,000 for the first quarter of 2005. Recoveries of $375,000 in the first quarter of 2006 contributed to the historically low level of net charge-offs. This level of recoveries is not anticipated to continue through the remaining quarters of 2006.

Noninterest Income:Noninterest income remains a key focus of the Company. In the first quarter of 2006, noninterest income increased $232,000 to $1.9 million from a year ago. Changes in noninterest income were primarily due to increases in service charges on deposits, ATM income and income from the sale of SBA loans. Additionally, in the first quarter of 2005 the Company recorded a $95,000 gain on the sale of its former operations building.

Noninterest Expense:Noninterest expense increased $695,000 to $6.7 million in the first quarter of 2006 or 12% from a year ago. Salaries and benefits increased $845,000 to $4.3 million due to higher salaries, commissions, bonus accrual, stock based compensation, and healthcare costs. The Company’s full time equivalent employees increased to 315 from 290 at March 31, 2006 and 2005, respectively. Consulting and professional fees decreased $147,000 to $119,000 due to lower technology and accounting consulting costs.

Income Taxes:The Company’s consolidated effective tax rate was 32.7% and 32.3% for the three months ended March 31, 2006 and 2005, respectively. The effective tax rate is lower than the federal statutory rate due to nontaxable income generated from investments in bank owned life insurance, tax-exempt municipal bonds and loans.

Financial Condition Overview

The Company’s total assets grew $9.6 million to $735.6 million in the first quarter of 2006. During the first quarter of 2006 the Company continued to focus on growing its loan portfolio. Total loans grew $20.8 million to $651.1 million at March 31, 2006 from $630.3 million at December 31, 2005, a 3.3% increase.

Federal Funds Sold:Federal funds sold decreased by $12.6 million to $8.5 million in the first quarter of 2006. The decrease in federal funds has been used to fund the Company’s growth in the loan portfolio, which increased $20.8 million in the first quarter of 2006.

Loans:The Company’s loan portfolio represented 88.5% of total assets as of March 31, 2006. Growth in the portfolio since December 31, 2005 has been primarily in real estate related loans due to continued market demand for such products. 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 Company’s loan portfolio composition:

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	Loan Portfolio Composition as of:
	March 31, 2006					December 31, 2005					Change
(Dollars in thousands)	Balance			% of total		Balance			% of total		2006 vs. 2005
Commercial	$	80,667			12.4%	$	79,341			12.6%	$	1,326
Real estate mortgages:
One-to-four family residential		50,095			7.7%		45,278			7.2%		4,817
Commercial		223,979			34.4%		218,260			34.6%		5,719
Total real estate mortgages		274,074			42.1%		263,538			41.8%		10,536
Real estate construction:
One-to-four family residential		86,437			13.3%		79,016			12.5%		7,421
Multi-family and commercial		34,163			5.2%		34,645			5.5%		(482	)
Total real estate construction		120,600			18.5%		113,661			18.0%		6,939
Consumer:
Indirect		93,900			14.4%		91,251			14.5%		2,649
Direct		81,712			12.6%		82,425			13.1%		(713	)
Total consumer		175,612			27.0%		173,676			27.6%		1,936
Subtotal		650,953			100.0%		630,216			100.0%		20,737
Less: allowance for loan losses		(9,130	)				(8,810	)				(320	)
Deferred loan fees, net		181					42					139
Total loans, net	$	642,004				$	621,448				$	20,556

Allowance for Loan Losses:The Company increased its allowance for loan losses to $9.1 million, at March 31, 2006, representing 1.40% of total loans. 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 evaluation of the allowance is based on a continuing assessment of nonperforming assets, recent and historical loss experience, and other factors, including regulatory guidance and economic factors. While the Company believes that it uses the best information available to determine the allowance for loan losses unforeseen market conditions could result in adjustments to the allowance for loan losses, and net income could be significantly affected if circumstances differ substantially from the assumptions used in making the final determination. The Company anticipates that normal growth of the loan portfolio will require continued increases in the allowance for loan losses. The following table details the activity of the allowance for loan losses:

Activity of Allowance for Loan Losses as of:

	March 31,			March 31,
(Dollars in thousands)	2006			2005
Balance at beginning of period	$	8,810		$	7,903
Charge-offs:
Commercial		(163	)		(108	)
Real estate		(60	)		(27	)
Consumer
Direct		(101	)		(131	)
Indirect		(231	)		(318	)
Total charge-offs		(555	)		(584	)

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CONTINUED

	March 31,			March 31,
(Dollars in thousands)	2006			2005
Recoveries:
Commercial	$	191		$	82
Real estate		0			123
Consumer
Direct		53			21
Indirect		131			82
Total recoveries		375			308
Net charge-offs		(180	)		(276	)
Provision for loan losses		500			425
Balance at end of period	$	9,130		$	8,052
Indirect net charge-offs to average indirect loans(1)		0.43%			0.96%
Other net charge-offs to average other loans(1)		0.06%			0.03%
Net charge-offs to average loans(1)		0.11%			0.19%
Allowance for loan losses to loans		1.40%			1.36%

⁽¹⁾   Net charge-offs are annualized.

Nonperforming Assets:The Company’s asset quality for the first quarter of 2006 improved over the first quarter of 2005. Total impaired loans decreased by $1,056,000 from March 31, 2005 versus $560,000 from December 31, 2005 to $1.6 million as of March 31, 2006. The following table sets forth an analysis of the composition of the Company’s nonperforming assets:

	Nonperforming Assets as of:
	March 31,		March 31,
(Dollars in thousands)	2006		2005
Nonaccrual loans	$	1,599	$	2,159
Restructured loans		—		—
Total nonperforming loans		1,599		2,159
Other real estate owned		—		—
Total nonperforming assets	$	1,599	$	2,159
Total impaired loans	$	1,599	$	2,159
Accruing loans past due³ 90 days		24		—
Potential problem loans		—		—
Allowance for loan losses		9,130		8,810
Nonperforming loans to loans		0.25%		0.34%
Allowance for loan losses to nonperforming loans		570.98%		408.06%
Allowance for loan losses to nonperforming assets		570.98%		408.06%
Nonperforming assets to total assets		0.22%		0.30%

Deposits:In the first quarter of 2006 the Company made a concerted effort to attract deposits, through competitive pricing and delivery of quality service. The Company’s total deposits for the first quarter of 2006 grew $8.5 million, to $646.0 million at quarter end. As outlined in the table below, time deposit growth was less than 1%, while noninterest-bearing demand and savings deposits decreased 4.6% during the quarter. Conversely, NOW and money market deposits grew during the first quarter by 7.8% and 5.4%, respectively.

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\

	Deposit Composition as of:
	March 31, 2006				December 31, 2005				Change
(Dollars in thousands)	Balance		% of total		Balance		% of total		2006 vs. 2005
Noninterest-bearing demand	$	100,537		15.6%	$	105,365		16.5%	$	(4,828	)
NOW accounts		154,170		23.9%		143,042		22.4%		11,128
Money market		89,086		13.8%		84,537		13.3%		4,549
Savings		56,840		8.8%		59,635		9.4%		(2,795	)
Time deposits		245,373		38.0%		244,910		38.4%		463
Total deposits	$	646,006		100.0%	$	637,489		100.0%	$	8,517

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 March 31, 2006 and December 31, 2005, the Company’s commitments under letters of credit and financial guarantees amounted to $1.5 million and $1.6 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.

Shareholders’ Equity:The Company’s shareholders’ equity increased to $60.0 million at March 31, 2006 from $57.9 million at December 31, 2005. This increase is due to net income of $2.5 million, proceeds from stock options exercised in the amount of $91,000, stock based compensation of $37,000, offset by the payment of cash dividends of $463,000.

Liquidity and Sources of Funds

Sources of Funds:The Company’s sources of funds are customer deposits, loan repayments, current earnings, cash and demand balances due from other banks, federal funds, short-term investments, investment securities available for sale and trust preferred securities. The Company’s strategy includes maintaining a “well-capitalized” status for regulatory purposes, while maintaining a favorable liquidity position and proper asset/liability mix. With this strategy in mind, management anticipates that the Bank will rely primarily upon customer deposits and investments to provide liquidity in 2006. These funds will be used for loan originations and deposit withdrawals, to satisfy other financial commitments and to support continuing operations. Additional funds are available through established FHLB and correspondent bank lines of credit, which the Company may use to supplement funding sources.

Capital and Capital Ratios

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 Bank qualified as “well-capitalized” at March 31, 2006 and December 31, 2005:

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	Regulatory Requirements				Actual Ratios
	Adequately-		Well-		March 31,		December 31,
	capitalized		capitalized		2006		2005
Total risk-based capital ratio
Consolidated		8%		N/A		11.48%		11.52%
Whidbey Island Bank		8%		10%		11.23%		11.21%
Tier 1 risk-based capital ratio
Consolidated		4%		N/A		10.23%		10.28%
Whidbey Island Bank		4%		6%		9.98%		9.96%
Leverage ratio
Consolidated		4%		N/A		10.55%		10.26%
Whidbey Island Bank		4%		5%		10.28%		9.93%

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

Capital Expenditures and Commitments

The Company entered into an option to purchase agreement for a 70,000 square-foot property located in the Smokey Point / Arlington, WA area for the purpose of relocating the Smokey Point branch, which is currently in leased space. Management anticipates the closing of the sale and the branch construction to begin during the third quarter of 2006.

Significant Accounting Policies

See “Notes to Condensed Consolidated Financial Statements.”

Item 3. Quantitative and Qualitative Disclosures about Market Risk

At March 31, 2006, 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, 2005. Should rates increase, the Company may, or may not be positively impacted due to its current slightly asset sensitive position. For additional information, refer to the Company’s Form 10-K for year ended December 31, 2005 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. In addition, there have been no significant changes in the internal controls or in other factors known to management that could significantly affect the internal controls subsequent to the most recent evaluation. 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 March 31, 2006 that has materially effected, or is reasonably likely to materially effect, 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, 2005. There have been no material changes in the Company’s risk factors from those disclosed in the 2005 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

No matters were submitted to a vote of the Company’s security holders in the quarter ended March 31, 2006.

Item 5. Other Information

(a)	Not applicable
(b)	There have been no material changes in the procedures for shareholders to nominate directors to the Company’s board.

Item 6. Exhibits

Exhibits

31.1	Certification of Chief Executive Officer required by Rule 13a-14(b) or Rule 15d-14(a) and Section 302 of the Sarbanes Oxley Act of 2002
31.2	Certification of Chief Financial Officer required by Rule 13a-14(b) or Rule 15d-14(a) and Section 302 of the Sarbanes Oxley Act of 2002
32.1	Certification of Chief Executive Officer required by Rule 13a-14(b) or Rule 15d-14(b) and Section 906 of the Sarbanes Oxley Act of 2002, 18 U.S.C. Section 1350
32.2	Certification of Chief Financial Officer required by Rule 13a-14(b) or Rule 15d-14(b) and Section 906 of the Sarbanes Oxley Act of 2002, 18 U.S.C. Section 1350

17

SIGNATURES

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

WASHINGTON BANKING COMPANY

Date: May 9, 2006	By	/s/ Michal D. Cann
		Michal D. Cann
		President and
		Chief Executive Officer
Date: May 9, 2006	By	/s/ Richard A. Shields
		Richard A. Shields
		Senior Vice President and
		Chief Financial Officer

18