Washington Banking (WBCO) 10-Q 2013 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, 2013

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

For the transition period from ________ to ________

Commission File Number 000-24503

WASHINGTON BANKING COMPANY

(Exact name of registrant as specified in its charter)

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

450 SW Bayshore Drive

Oak Harbor, Washington    98277

(Address of principal executive offices)   (Zip Code)

(360) 679-3121

(Registrant’s telephone number, including area code)

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

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

Yes [X]   No [   ]

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 229.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes [X]    No [  ]

Indicate by check mark if the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer [   ] Accelerated filer [X]      Non-Accelerated filer [   ]        Smaller reporting company [   ]

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

The number of shares of the issuer’s Common Stock outstanding at August 5, 2013 was 15,532,199

TABLE OF CONTENTS

PART I - FINANCIAL INFORMATION
		Page
Item 1.	Financial Statements
	Condensed Consolidated Statements of Financial Condition (unaudited)
	June 30, 2013 and December 31, 2012	1
	Condensed Consolidated Statements of Income (unaudited)
	Three and Six Months Ended June 30, 2013 and 2012	2
	Condensed Consolidated Statements of Comprehensive Income (unaudited)
	Three and Six Months Ended June 30, 2013 and 2012	3
	Condensed Consolidated Statements of Shareholders' Equity (unaudited)
	Six Months Ended June 30, 2013 and 2012	4
	Condensed Consolidated Statements of Cash Flows (unaudited)
	Six Months Ended June 30, 2013 and 2012	5
	Notes to Condensed Consolidated Financial Statements	7
Item 2.	Management's Discussion and Analysis of Financial Condition and Results of Operations	35
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	54
Item 4.	Controls and Procedures	54
PART II - OTHER INFORMATION
Item 1.	Legal Proceedings	55
Item 1A.	Risk Factors	55
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	55
Item 3.	Defaults Upon Senior Securities	55
Item 4.	Mine Safety Disclosures	55
Item 5.	Other Information	55
Item 6.	Exhibits	56
	Signatures	57

WASHINGTON BANKING COMPANY AND SUBSIDIARIES

Condensed Consolidated Statements of Financial Condition (unaudited)

 (Dollars in thousands, except per share data)

	June 30, 2013			December 31, 2012
Assets
Cash and due from banks ($3,864 and $3,801, respectively, are restricted)	$	25,183		$	32,145
Interest-bearing deposits	46,059			75,428
Total cash and cash equivalents	71,242			107,573
Investment securities available for sale, at fair value	386,111			372,968
Federal Home Loan Bank stock	7,307			7,441
Loans held for sale	9,749			18,043
Non-covered loans, net of allowance for loan losses	836,323			835,987
Covered loans, net of allowance for loan losses	176,737			214,087
Total loans	1,013,060			1,050,074
Premises and equipment, net	35,898			36,751
Bank owned life insurance	17,779			17,704
Goodwill and other intangible assets, net	5,809			6,027
Non-covered other real estate owned	4,726			3,023
Covered other real estate owned	12,927			13,460
FDIC indemnification asset	32,832			34,571
Other assets	20,053			20,042
Total assets	$	1,617,493		$	1,687,677
Liabilities and Shareholders' Equity
Liabilities:
Deposits
Noninterest-bearing demand	$	245,505		$	261,310
Interest-bearing	1,158,867			1,201,663
Total deposits	1,404,372			1,462,973
Junior subordinated debentures	25,774			25,774
Other liabilities	10,097			16,306
Total liabilities	1,440,243			1,505,053
Commitments and contingencies
Shareholders' Equity:
Common stock, no par value; 35,000,000 shares authorized; 15,527,037 and 15,483,598 shares issued and outstanding at June 30, 2013 and December 31, 2012, respectively	86,197			85,707
Retained earnings	95,078			92,234
Accumulated other comprehensive (loss) income, net of tax	(4,025		)	4,683
Total shareholders' equity	177,250			182,624
Total liabilities and shareholders' equity	$	1,617,493		$	1,687,677

See notes to condensed consolidated financial statements

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WASHINGTON BANKING COMPANY AND SUBSIDIARIES

Condensed Consolidated Statements of Income (unaudited)

(Dollars in thousands, except per share data)

	Three Months Ended June 30,						Six Months Ended June 30,
	2013			2012			2013				2012
Interest income:
Interest and fees on non-covered loans	$	10,978		$	11,613		$	22,131			$	23,366
Interest and fees on covered loans	5,972			9,382			12,685				19,250
Interest on taxable investment securities	1,344			1,387			2,657				2,743
Interest on tax-exempt investment securities	393			276			765				531
Other	39			68			98				119
Total interest income	18,726			22,726			38,336				46,009
Interest expense:
Interest on deposits	1,248			1,704			2,558				3,549
Interest on junior subordinated debentures	121			133			239				269
Total interest expense	1,369			1,837			2,797			��	3,818
Net interest income	17,357			20,889			35,539				42,191
Provision for loan losses, non-covered loans	850			2,350			1,300				4,350
Provision for loan losses, covered loans	10,914			398			12,414				398
Net interest income after provision for loan losses	5,593			18,141			21,825				37,443
Noninterest income:
Service charges and fees	845			921			1,661				1,814
Electronic banking income	969			1,012			2,112				1,908
Investment products	248			367			472				729
Gain on sale of investment securities, net	291			—			556				342
Bank owned life insurance income	37			55			75				115
Income from the sale of mortgage loans	1,061			776			2,072				1,481
SBA premium income	215			105			493				192
Change in FDIC indemnification asset	7,502			(3,145		)	7,328				(6,136		)
Gain on disposition of covered assets	213			556			593				1,185
Other	316			341			681				655
Total noninterest income	11,697			988			16,043				2,285
Noninterest expense:
Salaries and benefits	7,181			7,242			14,857				14,576
Occupancy and equipment	1,836			1,659			3,637				3,388
Office supplies and printing	390			425			790				838
Data processing	569			536			1,104				1,064
Consulting and professional fees	141			273			474				516
Intangible amortization	110			128			218				254
FDIC premiums	281			317			570				653
FDIC clawback liability adjustment	(463		)	1,098			(263		)		1,138
Non-covered OREO and repossession expenses, net	379			739			904				1,113
Covered OREO and repossession expenses, net	437			578			573				1,152
Other	2,065			2,114			3,929				4,072
Total noninterest expense	12,926			15,109			26,793				28,764
Income before provision for income tax	4,364			4,020			11,075				10,964
Provision for income tax	1,456			1,173			3,583				3,344
Net income available to common shareholders	$	2,908		$	2,847		$	7,492			$	7,620
Net income available per common share, basic	0.19			0.18			0.48				0.49
Net income available per common share, diluted	0.19			0.18			0.48				0.49
Average number of common shares outstanding, basic	15,506,000			15,411,000			15,487,000				15,414,000
Average number of common shares outstanding, diluted	15,552,000			15,446,000			15,529,000				15,449,000

See notes to condensed consolidated financial statements

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WASHINGTON BANKING COMPANY AND SUBSIDIARIES

Condensed Consolidated Statements of Comprehensive (Loss) Income (unaudited)

(Dollars in thousands)

	Three Months Ended June 30,					Six Months Ended June 30,
	2013			2012		2013			2012
Net income available to common shareholders	$	2,908		$	2,847	$	7,492		$	7,620
Investment securities available for sale:
Unrealized (losses) gains arising in period	(11,869		)	1,696		(12,842		)	1,550
Reclassification adjustment for net gains realized in earnings (net of tax expense of $102 for the three months ended June 30, 2013, and net of tax expense of $195 and $120 for the six months ended June 30, 2013 and 2012, respectively.)	(189		)	—		(361		)	(222		)
Income tax (benefit) provision related to unrealized (losses) gains	(4,155		)	593		(4,495		)	543
Other comprehensive (loss) income, net of tax	(7,903		)	1,103		(8,708		)	785
Total comprehensive (loss) income	$	(4,995	)	$	3,950	$	(1,216	)	$	8,405

See notes to condensed consolidated financial statements

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WASHINGTON BANKING COMPANY AND SUBSIDIARIES

Condensed Consolidated Statements of Shareholders’ Equity (unaudited)

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

	Common stock						Accumulated other comprehensive income (loss)			Total shareholders' equity
	Shares	Amount		Retained earnings
Balance at December 31, 2011	15,398	$	84,564	$	83,107		$	3,149		$	170,820
Comprehensive income:
Net income	—	—		7,620			—			7,620
Other comprehensive income, net	—	—		—			785			785
Cash dividends on common stock,
$0.26 per share	—	—		(4,009		)	—			(4,009		)
Stock-based compensation expense	—	335		—			—			335
Issuance of common stock under stock plans	48	182		—			—			182
Tax benefit associated with stock awards	—	20		—			—			20
Balance at June 30, 2012	15,446	$	85,101	$	86,718		$	3,934		$	175,753
Balance at December 31, 2012	15,484	$	85,707	$	92,234		$	4,683		$	182,624
Comprehensive income:
Net income	—	—		7,492			—			7,492
Other comprehensive loss, net	—	—		—			(8,708		)	(8,708		)
Cash dividends on common stock,
$0.30 per share	—	—		(4,648		)	—			(4,648		)
Stock-based compensation expense	—	478		—			—			478
Issuance of common stock under stock plans	43	1		—			—			1
Tax benefit associated with stock awards	—	11		—			—			11
Balance at June 30, 2013	15,527	$	86,197	$	95,078		$	(4,025	)	$	177,250

See notes to condensed consolidated financial statements

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WASHINGTON BANKING COMPANY AND SUBSIDIARIES

Condensed Consolidated Statements of Cash Flows (unaudited)

(Dollars in thousands)

	Six Months Ended June 30,
	2013			2012
Cash flows from operating activities:
Net income	$	7,492		$	7,620
Adjustments to reconcile net income to net cash provided by
operating activities:
Amortization of investment security premiums, net	1,514			1,036
Depreciation	1,288			1,176
Intangible amortization	218			254
Provision for loan losses, non-covered loans	1,300			4,350
Provision for loan losses, covered loans	12,414			398
Earnings on bank owned life insurance	(75		)	(115		)
Net gain on sale of investment securities	(556		)	(342		)
Net loss on sale of premises and equipment	—			10
Net (gain) loss on sale of non-covered other real estate owned	(53		)	50
Net gain on sale of covered other real estate owned	(1,129		)	(2,300		)
Net gain on sale of loans held for sale	(2,072		)	(1,481		)
Origination of loans held for sale	(86,392		)	(85,357		)
Proceeds from sales of loans held for sale	96,758			96,738
Valuation adjustment on non-covered other real estate owned	356			549
Valuation adjustment on covered other real estate owned	1,195			2,799
Deferred taxes	(7,896		)	2,177
Change in FDIC indemnification asset	(7,328		)	6,136
Stock-based compensation	478			335
Excess tax benefit from stock awards	(11		)	(20		)
Net change in assets and liabilities:
Net decrease (increase) in other assets	19,051			(2,387		)
Net (decrease) increase in other liabilities	(6,209		)	4,699
Net cash provided by operating activities	30,343			36,325
Cash flows from investing activities:
Purchases of investment securities available for sale	(72,792		)	(74,936		)
Proceeds from investment securities available for sale	45,294			48,728
Redemption of Federal Home Loan Bank stock	134			—
Net decrease in non-covered loans and covered loans	14,958			11,992
Purchases of premises and equipment	(435		)	(808		)
Proceeds from the sale of premises and equipment	—			8
Proceeds from sale of non-covered other real estate owned	1,836			705
Proceeds from sale of covered other real estate owned	7,770			10,296
Capitalization of non-covered other real estate owned improvements	(202		)	—
Net cash used in investing activities	$	(3,437	)	$	(4,015	)

See notes to condensed consolidated financial statements

-5-

WASHINGTON BANKING COMPANY AND SUBSIDIARIES

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

(Dollars in thousands)

	Six Months Ended June 30,
	2013			2012
Cash flows from financing activities:
Net decrease in deposits	$	(58,601	)	$	(16,434	)
Proceeds from exercise of stock options	1			182
Excess tax benefits from stock awards	11			20
Dividends paid on common stock	(4,648		)	(4,009		)
Net cash used in financing activities	(63,237		)	(20,241		)
Net change in cash and cash equivalents	(36,331		)	12,069
Cash and cash equivalents at beginning of period	107,573			105,913
Cash and cash equivalents at end of period	$	71,242		$	117,982
Supplemental disclosures of cash flow information:
Cash paid during the period for:
Interest	$	2,875		$	3,977
Income taxes	$	7,500		$	1,000
Supplemental disclosures about noncash investing and financing activities:
Change in fair value of investment securities available for sale, net of tax	$	(8,708	)	$	785
Transfer of non-covered loans to non-covered other real estate owned	$	3,640		$	3,742
Transfer of covered loans to covered other real estate owned	$	7,303		$	7,173

See notes to condensed consolidated financial statements

-6-

WASHINGTON BANKING COMPANY AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

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

(a) Description of Business:Washington Banking Company (the “Company”) was formed on April 30, 1996 and is a registered bank holding company whose primary business is conducted by its wholly-owned subsidiary, Whidbey Island Bank (the “Bank”). 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 Company and the Bank have formed several subsidiaries for various purposes as follows:

▪ Washington Banking Master Trust (the “Master Trust”) is a wholly-owned subsidiary of the Company. The Master Trust was formed in April 2007 for the exclusive purpose of issuing trust preferred securities.

▪ Rural One, LLC (“Rural One”) is a majority-owned subsidiary of the Bank and is certified as a Community Development Entity by the Community Development Financial Institutions Fund of the United States Department of Treasury. Rural One was formed in September 2006 for the purpose of investing in Federal tax credits related to the New Markets Tax Credit program through a real estate development loan to a community development organization.

(b) Basis of Presentation: The accompanying interim condensed consolidated financial statements include the accounts of the Company 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, 2012 audited consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K filed with the SEC.

In preparing these financial statements, the Company has evaluated events and transactions subsequent to June 30, 2013 for potential recognition or disclosure.  In management’s opinion, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included.  Operating results for the three and six months ended June 30, 2013, are not necessarily indicative of the results that may be expected for the year ending December 31, 2013.  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.  Management considers the estimates used in developing the allowance for loan losses, the valuation of covered loans and the FDIC indemnification asset and determining the fair value of financial assets and liabilities to be particularly sensitive estimates that may be subject to revision in the near term.

(c) Reclassifications: Certain amounts in prior year’s financial statements may have been reclassified to conform to the 2013 presentation. These reclassifications had no significant impact on previously reported net income, net income available per common share or equity.

(d) Significant Accounting Policies: The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect amounts reported in the consolidated financial statements and the accompanying notes.  Changes in these estimates and assumptions are considered reasonably possible and may have a material impact on the consolidated financial statements and thus actual results could differ from the amounts reported and disclosed herein.  A more detailed description of the Company’s significant accounting policies are described in Note (1) of the Notes to Consolidated Financial Statements for the year ended December 31, 2012, as filed on Form 10-K.

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WASHINGTON BANKING COMPANY AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(2)  Recent Financial Accounting Pronouncements

In December 2011, the FASB issued ASU No. 2011-11, Disclosures about Offsetting Assets and Liabilities. The ASU requires an entity to offset, and present as a single net amount, a recognized eligible asset and a recognized eligible liability when it has an unconditional and legally enforceable right of setoff and intends either to settle the asset and liability on a net basis or to realize the asset and settle the liability simultaneously. The ASU requires an entity to disclose information about offsetting and related arrangements to enable users of its financial statements to understand the effect of those arrangements on its financial position. The Company adopted the provisions of this ASU effective January 1, 2013. The adoption of this ASU did not have a material impact on the Company’s consolidated financial statements.

In July 2012, the FASB issued ASU No. 2012-2, Testing Indefinite-Lived Intangible Assets for Impairment.  This ASU states that an entity has the option to first assess qualitative factors to determine whether the existence of events and circumstances indicates that it is more likely than not that the indefinite-lived intangible asset is impaired. If, after assessing the totality of events and circumstances, an entity concludes that it is not more likely than not that the indefinite-lived intangible asset is impaired, then the entity is not required to take further action. However, if an entity concludes otherwise, it is required to determine the fair value of the indefinite-lived intangible asset and perform the quantitative impairment test by comparing the fair value with the carrying amount, in accordance with Codification Subtopic 350-30, Intangibles—Goodwill and Other, General Intangibles Other than Goodwill. Under guidance in this ASU, an entity also has the option to bypass the qualitative assessment for any indefinite-lived intangible asset in any period and proceed directly to performing the quantitative impairment test. An entity will be able to resume performing the qualitative assessment in any subsequent period. The amendments in this ASU are effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012. Early adoption is permitted, including for annual and interim impairment tests performed as of a date before July 27, 2012, if a public entity’s financial statements for the most recent annual or interim period have not yet been issued. The adoption of this ASU did not have a material impact on the Company’s consolidated financial statements.

In October 2012, the FASB issued ASU No. 2012-06, Subsequent Accounting for an Indemnification Asset Recognized at the Acquisition Date as a Result of a Government-Assisted Acquisition of a Financial Institution.  The ASU clarifies that when an entity recognizes an indemnification asset as a result of a government-assisted acquisition of a financial institution and subsequently, a change in the cash flows expected to be collected on the indemnification asset occurs, as a result of a change in cash flows expected to be collected on the assets subject to indemnification, the reporting entity should subsequently account for the change in the measurement of the indemnification asset on the same basis as the change in the assets subject to indemnification. Any amortization of changes in value should be limited to the contractual term of the indemnification agreement. The amendments are effective for annual and interim reporting periods beginning on or after December 15, 2012. The adoption of this ASU did not have a material impact on the Company’s consolidated financial statements.

In January 2013, the FASB issued ASU No. 2013-01, Clarifying the Scope of Disclosures about Offsetting Assets and Liabilities. ASU No. 2013-01 clarifies that ASU No. 2011-11 applies only to derivatives, including bifurcated embedded derivatives, repurchase agreements and reverse repurchase agreements, and securities borrowing and securities lending transactions that are either offset or subject to an enforceable master netting arrangement or similar agreement. Entities with other types of financial assets and financial liabilities subject to a master netting arrangement or similar agreement are no longer subject to the disclosure requirements in ASU No. 2011-11. The amendments are effective for annual and interim reporting periods beginning on or after January 1, 2013. The adoption of this ASU did not have a material impact on the Company's consolidated financial statements.

In February 2013, the FASB issued ASU No. 2013-02, Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income, to improve the transparency of reporting these reclassifications. The ASU does not amend any existing requirements for reporting net income or other comprehensive income in the financial statements but requires an entity to disaggregate the total change of each component of other comprehensive income and separately present reclassification adjustments and current period other comprehensive income. The provisions of this ASU also requires that entities present either in a single note or parenthetically on the face of the financial statements, the effect of significant amounts reclassified from each component of accumulated other comprehensive income based on its source and the income statement line item affected by the reclassification. If a component is not required to be reclassified to net income in its entirety, entities would instead cross reference to the related note to the financial statements for additional information. The Company adopted the provisions of this ASU effective January 1, 2013. The adoption of this ASU did not have a material impact on the Company’s consolidated financial statements.

-8-

WASHINGTON BANKING COMPANY AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(2)  Recent Financial Accounting Pronouncements (continued)

In July 2013, the FASB issued ASU No. 2013-11, Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists. The ASU requires an entity to present an unrecognized tax benefit, or a portion of an unrecognized tax benefit, as a reduction to a deferred tax asset for a net operating loss carryforward, a similar tax loss, or a tax credit carryforward, except to the extent a net operating loss carryforward, a similar tax loss, or a tax credit carryforward is not available at the reporting date under the tax law of the applicable jurisdiction to settle any additional income taxes that would result from the disallowance of a tax position or the tax law of the applicable jurisdiction does not require the entity to use, and the entity does not intend to use, the deferred tax asset for such purpose, the unrecognized tax benefit should be presented in the financial statements as a liability and should not be combined with deferred tax assets. No new recurring disclosures are required. The amendments are effective for annual and interim reporting periods beginning on or after December 15, 2013, and are to be applied prospectively to all unrecognized tax benefits that exist at the effective date. Retrospective application is permitted. The adoption of this ASU is not expected to have a material impact on the Company's consolidated financial statements.

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WASHINGTON BANKING COMPANY AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(3)  Investment Securities

The following table presents the amortized cost, unrealized gains, unrealized losses and fair value of investment securities available for sale at June 30, 2013 and December 31, 2012.  At June 30, 2013 and December 31, 2012, there were no investment securities classified as held to maturity or trading.

(dollars in thousands)	June 30, 2013
	Amortized cost		Unrealized gains		Unrealized losses				Fair value
U.S. government agencies	$	87,952	$	718	$	(847	)		$	87,823
Residential pass-through securities	164,712		724		(3,852		)		161,584
Taxable state and political subdivisions	2,297		212		—				2,509
Tax exempt state and political subdivisions	72,418		1,136		(2,057		)		71,497
Corporate obligations	11,000		—		(288		)		10,712
Agency-issued collateralized mortgage obligations	27,516		—		(662		)	��	26,854
Asset-backed securities	24,383		—		(1,170		)		23,213
Investments in mutual funds and other equities	2,018		—		(99		)		1,919
Total investment securities available for sale	$	392,296	$	2,790	$	(8,975	)		$	386,111

(dollars in thousands)	December 31, 2012
	Amortized cost		Unrealized gains		Unrealized losses			Fair value
U.S. government agencies	$	87,297	$	1,321	$	(32	)	$	88,586
Residential pass-through securities	165,175		3,430		(182		)	168,423
Taxable state and political subdivisions	4,759		553		—			5,312
Tax exempt state and political subdivisions	56,431		2,703		(149		)	58,985
Corporate obligations	11,000		—		(565		)	10,435
Agency-issued collateralized mortgage obligations	13,967		79		—			14,046
Asset-backed securities	25,108		150		(70		)	25,188
Investments in mutual funds and other equities	2,018		—		(25		)	1,993
Total investment securities available for sale	$	365,755	$	8,236	$	(1,023	)	$	372,968

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WASHINGTON BANKING COMPANY AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(3)  Investment Securities (continued)

Investment securities that were in an unrealized loss position at June 30, 2013 and December 31, 2012, are presented in the following tables, based on the length of time individual securities have been in an unrealized loss position. In the opinion of management, these securities are considered only temporarily impaired due to changes in market interest rates or the widening of market spreads subsequent to the initial purchase of the securities, and not due to concerns regarding the underlying credit of the issuers or the underlying collateral.

(dollars in thousands)	June 30, 2013
	Less than 12 Months					12 Months or Longer					Total
	Fair value		Unrealized losses			Fair value		Unrealized losses			Fair value		Unrealized losses
U.S. government agencies	$	45,530	$	(847	)	$	—	$	—		$	45,530	$	(847	)
Residential pass-through securities	$	117,850	$	(3,852	)	$	—	$	—		$	117,850	$	(3,852	)
Tax exempt state and political subdivisions	44,462		(2,057		)	—		—			44,462		(2,057		)
Corporate obligations	7,952		(48		)	2,760		(240		)	10,712		(288		)
Agency-issued collateralized mortgage obligations	26,854		(662		)	—		—			26,854		(662		)
Asset-backed securities	23,214		(1,170		)	—		—			23,214		(1,170		)
Investments in mutual funds and other equities	—		—			1,919		(99		)	1,919		(99		)
Total investment securities available for sale	$	265,862	$	(8,636	)	$	4,679	$	(339	)	$	270,541	$	(8,975	)

(dollars in thousands)	December 31, 2012
	Less than 12 Months					12 Months or Longer					Total
	Fair value		Unrealized losses			Fair value		Unrealized losses			Fair value		Unrealized losses
U.S. government agencies	$	12,056	$	(32	)	$	—	$	—		$	12,056	$	(32	)
Residential pass-through securities	27,680		(182		)	—		—			27,680		(182		)
Tax exempt state and political subdivisions	10,113		(149		)	—		—			10,113		(149		)
Corporate obligations	—		—			10,435		(565		)	10,435		(565		)
Asset-backed securities	9,856		(70		)	—		—			9,856		(70		)
Investments in mutual funds and other equities	—		—			1,993		(25		)	1,993		(25		)
Total investment securities available for sale	$	59,705	$	(433	)	$	12,428	$	(590	)	$	72,133	$	(1,023	)

At June 30, 2013 and December 31, 2012, there were 95 and 25 investment securities in unrealized loss positions, respectively.  For each security in an unrealized loss position, the Company assesses whether it intends to sell the security, or it is more likely than not that it will be required to sell the security before recovery of its amortized cost basis. For debt securities that are considered other-than-temporarily impaired and that the Company does not intend to sell and will not be required to sell prior to recovery of its amortized cost basis, the Company will separate the amount of the impairment into the amount that is credit related (credit loss component) and the amount due to all other factors. The credit loss component is recognized in earnings and is calculated as the difference between the security’s amortized cost basis and the present value of its expected future cash flows. The remaining difference between the security’s fair value and the present value of future expected cash flows is deemed to be due to factors that are not credit related and is recognized in other comprehensive income.

-11-

WASHINGTON BANKING COMPANY AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(3)  Investment Securities (continued)

The Company does not intend to sell the securities that are temporarily impaired, and it is more likely than not that the Company will not have to sell those securities before recovery of the cost basis. Additionally, the Company has evaluated the credit ratings of its investment securities and their issuers and/or insurers, as applicable. Based on the Company’s evaluation, management has determined that no investment security in the Company’s investment portfolio was other-than-temporarily impaired at June 30, 2013 or December 31, 2012.

The amortized cost and fair value of investment securities, by maturity, are shown in the table below.  The amortized cost and fair value of residential pass-through securities, agency-issued collateralized mortgage obligations and asset-backed securities are presented by expected average life, rather than contractual maturity.  Expected maturities may differ from contractual maturities because issuers of the securities may have the right to call or prepay obligations with or without call or prepayment penalties.

(dollars in thousands)	June 30, 2013
	Amortized cost		Fair value
Three months or less	$	2,010	$	2,013
Over three months to one year	3,935		3,990
After one year through three years	29,455		29,982
After three years through five years	241,327		237,481
After five years through ten years	80,535		78,981
After ten years	35,034		33,664
Total	$	392,296	$	386,111

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

(dollars in thousands)	June 30, 2013
	Amortized cost		Fair value
To state and local governments to secure public deposits	$	56,356	$	57,359
To Federal Reserve Bank to secure borrowings	18,265		18,091
To Federal Home Loan Bank to secure borrowings	533		553
Other securities pledged, principally to secure deposits	12,601		12,886
Total pledged investment securities	$	87,755	$	88,889

The following table presents the gross realized gains and gross realized losses on the sale of investment securities available for sale for the three and six months ended June 30, 2013 and 2012:

(dollars in thousands)	Three Months Ended				Six Months Ended
	June 30,				June 30,
	2013		2012		2013		2012
Gross realized gains	291		—		556		344
Gross realized losses	—		—		—		(2		)
Gain on sale of investment securities, net	$	291	$	—	$	556	$	342

-12-

WASHINGTON BANKING COMPANY AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(4)  Non-Covered Loans

The following table presents the major types of non-covered loans at June 30, 2013 and December 31, 2012.  The classification of non-covered loan balances presented is reported in accordance with regulatory reporting requirements.

(dollars in thousands)	June 30, 2013			December 31, 2012
Commercial	$	167,124		$	162,481
Real estate mortgage	462,316			452,627
Real estate construction	65,395			81,398
Consumer	156,638			154,890
	851,473			851,396
Deferred loan costs, net	1,817			1,738
Allowance for loan losses	(16,967		)	(17,147		)
Total non-covered loans, net	$	836,323		$	835,987

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

Activity in the Allowance for Non-Covered Loan Losses

The following table summarizes activity related to the allowance for loan losses on non-covered loans, by portfolio segment, for the three and six months ended June 30, 2013 and 2012:

(dollars in thousands)	Three Months Ended June 30, 2013
	Commercial			Real estate mortgage			Real estate construction			Consumer			Total
Beginning balance	$	4,338		$	6,841		$	2,604		$	3,143		$	16,926
Provision	275			319			—			256			850
Charge-offs	(373		)	(108		)	(32		)	(533		)	(1,046		)
Recoveries	76			3			3			155			237
Ending Balance	$	4,316		$	7,055		$	2,575		$	3,021		$	16,967

(dollars in thousands)	Three Months Ended June 30, 2012
	Commercial			Real estate mortgage			Real estate construction			Consumer			Total
Beginning balance	$	4,041		$	6,538		$	4,095		$	3,319		$	17,993
Provision	807			1,284			20			239			2,350
Charge-offs	(391		)	(2,004		)	(133		)	(427		)	(2,955		)
Recoveries	14			26			1			136			177
Ending Balance	$	4,471		$	5,844		$	3,983		$	3,267		$	17,565

-13-

WASHINGTON BANKING COMPANY AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

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

(dollars in thousands)	Six Months Ended June 30, 2013
	Commercial			Real estate mortgage			Real estate construction			Consumer			Total
Beginning balance	$	4,405		$	6,516		$	3,050		$	3,176		$	17,147
Provision	246			660			(409		)	803			1,300
Charge-offs	(436		)	(194		)	(70		)	(1,260		)	(1,960		)
Recoveries	101			73			4			302			480
Ending Balance	$	4,316		$	7,055		$	2,575		$	3,021		$	16,967

(dollars in thousands)	Six Months Ended June 30, 2012
	Commercial			Real estate mortgage			Real estate construction			Consumer			Total
Beginning balance	$	4,034		$	6,500		$	4,046		$	3,452		$	18,032
Provision	1,380			1,865			667			438			4,350
Charge-offs	(976		)	(2,565		)	(733		)	(914		)	(5,188		)
Recoveries	33			44			3			291			371
Ending Balance	$	4,471		$	5,844		$	3,983		$	3,267		$	17,565

The following tables provides a summary of the allowance for non-covered loan losses and related non-covered loans, by portfolio segment, at June 30, 2013 and December 31, 2012:

(dollars in thousands)	June 30, 2013
	Commercial		Real estate mortgage		Real estate construction		Consumer		Total
Allowance for non-covered loan losses:
Individually evaluated for impairment	$	1,419	$	1,561	$	691	$	50	$	3,721
Collectively evaluated for impairment	2,897		5,494		1,884		2,971		13,246
Total allowance for non-covered loan losses	$	4,316	$	7,055	$	2,575	$	3,021	$	16,967
Non-covered loans:
Individually evaluated for impairment	$	9,443	$	11,906	$	15,566	$	686	$	37,601
Collectively evaluated for impairment	157,681		450,410		49,829		155,952		813,872
Total non-covered loans (1)	$	167,124	$	462,316	$	65,395	$	156,638	$	851,473

⁽¹⁾ Total non-covered loans excludes deferred loan costs of $1.8 million.

-14-

WASHINGTON BANKING COMPANY AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

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

(dollars in thousands)	December 31, 2012
	Commercial		Real estate mortgage		Real estate construction		Consumer		Total
Allowance for non-covered loan losses:
Individually evaluated for impairment	$	1,468	$	1,154	$	881	$	52	$	3,555
Collectively evaluated for impairment	2,937		5,362		2,169		3,124		13,592
Total allowance for non-covered loan losses	$	4,405	$	6,516	$	3,050	$	3,176	$	17,147
Non-covered loans:
Individually evaluated for impairment	$	9,974	$	11,357	$	19,607	$	916	$	41,854
Collectively evaluated for impairment	152,507		441,270		61,791		153,974		809,542
Total non-covered loans (1)	$	162,481	$	452,627	$	81,398	$	154,890	$	851,396

⁽¹⁾ Total non-covered loans excludes deferred loan costs of $1.7 million.

Credit Quality and Nonperforming Non-Covered Loans

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

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

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

-15-

WASHINGTON BANKING COMPANY AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

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

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

Non-Covered Impaired Loans

At June 30, 2013 and December 31, 2012, the Company had non-covered impaired loans which consisted of nonaccrual loans and restructured loans.  As of June 30, 2013, the Company had no commitments to extend additional credit on these non-covered impaired loans.  Non-covered impaired loans and the related allowance for loan losses at June 30, 2013 and December 31, 2012 were as follows:

(dollars in thousands)	June 30, 2013				December 31, 2012
	Recorded investment		Allowance		Recorded investment		Allowance
With no related allowance recorded:
Nonaccrual loans	$	10,499	$	—	$	15,479	$	—
Restructured loans	9,682		—		8,635		—
Total with no related allowance	$	20,181	$	—	$	24,114	$	—
With an allowance recorded:
Nonaccrual loans	$	376	$	26	$	72	$	5
Restructured loans	17,045		3,694		17,668		3,550
Total with an allowance recorded	17,421		3,720		17,740		3,555
Total	$	37,602	$	3,720	$	41,854	$	3,555

-16-

WASHINGTON BANKING COMPANY AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

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

The following table further summarizes impaired non-covered loans, by class, at June 30, 2013 and December 31, 2012:

(dollars in thousands)	June 30, 2013						December 31, 2012
	Recorded investment		Unpaid principal balance		Related allowance		Recorded investment		Unpaid principal balance		Related allowance
With no related allowance recorded:
Commercial	$	3,656	$	4,256	$	—	$	3,737	$	4,231	$	—
Real estate mortgages:
One-to-four family residential	672		826		—		938		1,132		—
Multi-family and commercial	3,366		3,914		—		3,605		4,283		—
Total real estate mortgages	4,038		4,740		—		4,543		5,415		—
Real estate construction:
One-to-four family residential	12,128		16,449		—		15,251		23,133		—
Total real estate construction	12,128		16,449		—		15,251		23,133		—
Consumer:
Direct	359		487		—		583		1,017		—
Total consumer	359		487		—		583		1,017		—
Total with no related allowance recorded	$	20,181	$	25,932	$	—	$	24,114	$	33,796	$	—
With an allowance recorded:
Commercial	$	5,787	$	5,795	$	1,418	$	6,237	$	6,237	$	1,468
Real estate mortgages:
One-to-four family residential	519		520		57		524		524		53
Multi-family and commercial	7,349		7,725		1,505		6,290		6,657		1,101
Total real estate mortgages	7,868		8,245		1,562		6,814		7,181		1,154
Real estate construction:
One-to-four family residential	3,182		3,182		670		4,094		4,112		855
Multi-family and commercial	256		256		21		262		262		26
Total real estate construction	3,438		3,438		691		4,356		4,374		881
Consumer:
Direct	328		328		49		333		333		52
Total consumer	328		328		49		333		333		52
Total with an allowance recorded	17,421		17,806		3,720		17,740		18,125		3,555
Total impaired non-covered loans	$	37,602	$	43,738	$	3,720	$	41,854	$	51,921	$	3,555

The average recorded investment in non-covered impaired loans was $37.6 million and $39.7 million for the three and six months ended June 30, 2013, compared to $49.7 million and $48.8 million for the same periods a year ago.  For the three and six months ended June 30, 2013, the Company recognized interest income on non-covered impaired loans of $130 thousand and $288 thousand, respectively.  For the same periods a year ago, interest income on non-covered impaired loans was $150 thousand and $204 thousand, respectively. Additional interest income of $64 thousand and $83 thousand would have been recognized had the non-covered impaired loans accrued interest, in accordance with their original terms, for the three and six months ended June 30, 2013, compared to $205 thousand and $280 thousand for the three and six months ended June 30, 2012, respectively.

-17-

WASHINGTON BANKING COMPANY AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

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

Troubled Debt Restructurings

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

Troubled debt restructurings at June 30, 2013 and December 31, 2012 were as follows:

(dollars in thousands)	June 30, 2013						December 31, 2012
	Accrual status		Nonaccrual status		Total modifications		Accrual status		Nonaccrual status		Total modifications
Troubled debt restructurings:
Commercial	$	6,554	$	783	$	7,337	$	7,008	$	1,160	$	8,168
Real estate mortgages:
One-to-four family residential	557		331		888		573		340		913
Multi-family and commercial	9,596		1,061		10,657		7,993		1,823		9,816
Total real estate mortgage	10,153		1,392		11,545		8,566		2,163		10,729
Real estate construction:
One-to-four family residential	9,436		5,808		15,244		10,135		9,013		19,148
Multi-family and commercial	256		—		256		262		—		262
Total real estate construction	9,692		5,808		15,500		10,397		9,013		19,410
Consumer:
Direct	328		16		344		332		20		352
Total consumer	328		16		344		332		20		352
Total restructured loans	$	26,727	$	7,999	$	34,726	$	26,303	$	12,356	$	38,659

The Company’s policy is that loans placed on nonaccrual will typically remain on nonaccrual status until all principal and interest payments are brought current and the prospect for future payment in accordance with the loan agreement appear relatively certain.  The Company’s policy generally refers to six months of payment performance as sufficient to warrant a return to accrual status.

-18-

WASHINGTON BANKING COMPANY AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

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

Troubled Debt Restructurings Modification Terms

The Company offers a variety of modifications to borrowers. In restructuring a loan with a borrower, the Company normally employs several types of modifications terms. The modification terms offered by the Company are as follows:

Rate Modification: A modification in which the interest rate is changed.

Term Modification: A modification in which the maturity date, the timing of payments, or frequency of payments is changed.

Interest Only Modification: A modification in which the loan is converted to interest only payments for a period of time.

Payment Modification: A modification in which the dollar amount of the payment is changed, other than an interest only modification described above.

Combination Modification: Any other type of modification, including the use of multiple terms above.

The following tables present loans restructured during the three and six months ended June 30, 2013 and 2012. During the periods presented, all modification terms were a combination of terms employed by the Company.

(dollars in thousands)	For the Three Months Ended June 30, 2013
	Number of contracts	Pre-modification recorded investment		Post-modification recorded investment
Troubled debt restructurings:
Real estate mortgages:
Multi-family and commercial	3	1,382		1,382
Total real estate mortgage	3	1,382		1,382
Real estate construction:
One-to-four family residential	2	178		93
Total real estate construction	2	178		93
Total restructured loans	5	$	1,560	$	1,475

(dollars in thousands)	For the Three Months Ended June 30, 2012
	Number of contracts	Pre-modification recorded investment		Post-modification recorded investment
Troubled debt restructurings:
Commercial	8	$	4,013	$	3,892
Real estate mortgages:
One-to-four family residential	1	173		173
Multi-family and commercial	1	376		376
Total real estate mortgage	2	549		549
Real estate construction:
One-to-four family residential	1	631		631
Multi-family and commercial	1	265		265
Total real estate construction	2	896		896
Total restructured loans	12	$	5,458	$	5,337

-19-

WASHINGTON BANKING COMPANY AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

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

(dollars in thousands)	For the Six Months Ended June 30, 2013
	Number of contracts	Pre-modification recorded investment		Post-modification recorded investment
Troubled debt restructurings:
Commercial	1	$	4	$	3
Real estate mortgages:
Multi-family and commercial	4	1,708		1,708
Total real estate mortgage	4	1,708		1,708
Real estate construction:
One-to-four family residential	2	178		93
Total real estate construction	2	178		93
Total restructured loans	7	$	1,890	$	1,804

(dollars in thousands)	For the Six Months Ended June 30, 2012
	Number of contracts	Pre-modification recorded investment		Post-modification recorded investment
Troubled debt restructurings:
Commercial	12	$	4,983	$	4,862
Real estate mortgages:
One-to-four family residential	1	173		173
Multi-family and commercial	1	376		376
Total real estate mortgage	2	549		549
Real estate construction:
One-to-four family residential	1	631		631
Multi-family and commercial	1	265		265
Total real estate construction	2	896		896
Total restructured loans	16	$	6,428	$	6,307

There were no loans modified as troubled debt restructurings, within the previous twelve months, for which there was a payment default for the three and six months ended June 30, 2013 and 2012.

-20-

WASHINGTON BANKING COMPANY AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

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

Non-Covered Nonaccrual Loans and Loans Past Due

The following table summarizes non-covered nonaccrual loans and past due loans, by class, as of June 30, 2013 and December 31, 2012:

(dollars in thousands)	June 30, 2013
	30 - 59 Days past due		60 - 89 Days past due		Greater than 90 days and accruing		Total past due		Nonaccrual		Current		Total non-covered loans
Commercial	$	150	$	11	$	—	$	161	$	2,889	$	164,074	$	167,124
Real estate mortgages:
One-to-four family residential	608		—		—		608		633		34,799		36,040
Multi-family and commercial	—		—		—		—		1,119		425,157		426,276
Total real estate mortgages	608		—		—		608		1,752		459,956		462,316
Real estate construction:
One-to-four family residential	45		—		—		45		5,875		32,960		38,880
Multi-family and commercial	—		—		—		—		—		26,515		26,515
Total real estate construction	45		—		—		45		5,875		59,475		65,395
Consumer:
Indirect	654		64		—		718		—		76,806		77,524
Direct	348		137		—		485		359		78,270		79,114
Total consumer	1,002		201		—		1,203		359		155,076		156,638
Total	$	1,805	$	212	$	—	$	2,017	$	10,875	$	838,581	851,473
Deferred loan costs, net													1,817
Total non-covered loans													$	853,290

-21-

WASHINGTON BANKING COMPANY AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

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

(dollars in thousands)	December 31, 2012
	30 - 59 Days past due		60 - 89 Days past due		Greater than 90 days and accruing		Total past due		Nonaccrual		Current		Total non-covered loans
Commercial	$	232	$	373	$	—	$	605	$	2,966	$	158,910	$	162,481
Real estate mortgages:
One-to-four family residential	—		—		—		—		889		35,984		36,873
Multi-family and commercial	—		—		—		—		1,903		413,851		415,754
Total real estate mortgages	—		—		—		—		2,792		449,835		452,627
Real estate construction:
One-to-four family residential	—		63		—		63		9,210		37,199		46,472
Multi-family and commercial	—		—		—		—		—		34,926		34,926
Total real estate construction	—		63		—		63		9,210		72,125		81,398
Consumer:
Indirect	966		112		—		1,078		—		76,518		77,596
Direct	469		415		—		884		583		75,827		77,294
Total consumer	1,435		527		—		1,962		583		152,345		154,890
Total	$	1,667	$	963	$	—	$	2,630	$	15,551	$	833,215	851,396
Deferred loan costs, net													1,738
Total non-covered loans													$	853,134

Non-Covered Credit Quality Indicators

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

Pass/Watch: Pass/watch loans, risk rated 1 through 5, range from minimal credit risk to lower than average, but still acceptable, credit risk.

Special Mention:  Special mention loans, risk rated 6,are loans that present certain potential weaknesses that require management’s attention.  Those weaknesses, if left uncorrected, may result in deterioration of the borrower’s repayment ability or the Company’s credit position in the future.

Substandard:  Substandard loans, risk rated 7, are inadequately protected by the current worth and paying capacity of the borrower or of the collateral pledged, if any.  There are well-defined weaknesses that may jeopardize the repayment of debt.  Such weaknesses include deteriorated financial condition of the borrower resulting from insufficient income, excessive expenses or other factors that result in inadequate cash flows to meet all scheduled obligations.

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WASHINGTON BANKING COMPANY AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

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

Doubtful/Loss:  Doubtful/loss loans are risk rated 8 and 9.  Loans assigned as doubtful have all the weaknesses inherent with substandard loans, with the added characteristic that the weaknesses make collection in full, on the basis of currently existing facts, conditions and values, highly questionable.  The possibility of loss is high, but because of certain important and reasonably specific pending factors that may work to the advantage of, and strengthen the credit, its classification as an estimated loss is deferred until a more exact status may be determined.  The Company charges off loans that would otherwise be classified loss.

The following table summarizes our internal risk rating, by class, as of June 30, 2013 and December 31, 2012:

(dollars in thousands)	June 30, 2013
	Pass/Watch		Special mention		Substandard		Doubtful/Loss		Total
Commercial	$	143,731	$	5,034	$	18,359	$	—	$	167,124
Real estate mortgages:
One-to-four family residential	30,778		640		4,622		—		36,040
Multi-family and commercial	369,118		30,743		26,415		—		426,276
Total real estate mortgages	399,896		31,383		31,037		—		462,316
Real estate construction:
One-to-four family residential	21,943		2,412		14,525		—		38,880
Multi-family and commercial	23,282		366		2,867		—		26,515
Total real estate construction	45,225		2,778		17,392		—		65,395
Consumer:
Indirect	76,270		14		1,240		—		77,524
Direct	73,318		1,596		4,200		—		79,114
Total consumer	149,588		1,610		5,440		—		156,638
Total	$	738,440	$	40,805	$	72,228	$	—	851,473
Deferred loan costs, net									1,817
									$	853,290

(dollars in thousands)	December 31, 2012
	Pass/Watch		Special mention		Substandard		Doubtful/Loss		Total
Commercial	$	140,809	$	4,412	$	17,260	$	—	$	162,481
Real estate mortgages:
One-to-four family residential	31,511		1,139		4,223		—		36,873
Multi-family and commercial	363,408		26,287		26,059		—		415,754
Total real estate mortgages	394,919		27,426		30,282		—		452,627
Real estate construction:
One-to-four family residential	25,389		776		20,307		—		46,472
Multi-family and commercial	32,166		472		2,288		—		34,926
Total real estate construction	57,555		1,248		22,595		—		81,398
Consumer:
Indirect	76,076		16		1,504		—		77,596
Direct	71,176		450		5,668		—		77,294
Total consumer	147,252		466		7,172		—		154,890
Total	$	740,535	$	33,552	$	77,309	$	—	851,396
Deferred loan costs, net									1,738
									$	853,134

-23-

WASHINGTON BANKING COMPANY AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(6)  Covered Assets and FDIC Indemnification Asset

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

The following table presents the major types of covered loans at June 30, 2013 and December 31, 2012. The classification of covered loan balances presented is reported in accordance with the regulatory reporting requirements.

(dollars in thousands)	June 30, 2013
	City Bank			North County Bank			Total
Commercial	$	11,123		$	13,040		$	24,163
Real estate mortgages:
One-to-four family residential	2,921			9,219			12,140
Multi-family residential and commercial	110,883			46,235			157,118
Total real estate mortgages	113,804			55,454			169,258
Real estate construction:
One-to-four family residential	4,200			2,615			6,815
Multi-family and commercial	9,912			4,299			14,211
Total real estate construction	14,112			6,914			21,026
Consumer - direct	2,438			6,583			9,021
Subtotal	141,477			81,991			223,468
Fair value discount	(18,860		)	(12,528		)	(31,388		)
Total covered loans	122,617			69,463			192,080
Allowance for loan losses	(12,772		)	(2,571		)	(15,343		)
Total covered loans, net	$	109,845		$	66,892		$	176,737

(dollars in thousands)	December 31, 2012
	City Bank			North County Bank			Total
Commercial	$	13,863		$	15,148		$	29,011
Real estate mortgages:
One-to-four family residential	3,783			10,412			14,195
Multi-family residential and commercial	132,280			52,303			184,583
Total real estate mortgages	136,063			62,715			198,778
Real estate construction:
One-to-four family residential	4,764			3,000			7,764
Multi-family and commercial	12,369			6,374			18,743
Total real estate construction	17,133			9,374			26,507
Consumer - direct	2,698			7,521			10,219
Subtotal	169,757			94,758			264,515
Fair value discount	(28,980		)	(18,196		)	(47,176		)
Total covered loans	140,777			76,562			217,339
Allowance for loan losses	(2,727		)	(525		)	(3,252		)
Total covered loans, net	$	138,050		$	76,037		$	214,087

-24-

WASHINGTON BANKING COMPANY AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

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

The following table presents the changes in the accretable yield for the three and six months ended June 30, 2013 and 2012, for each respective acquired loan portfolio:

(dollars in thousands)	Three Months Ended June 30,
	2013						2012
	City Bank			North County Bank			City Bank			North County Bank
Balance, beginning of period	$	40,520		$	15,447		$	71,017		$	23,637
Accretion to interest income	(3,512		)	(2,396		)	(5,555		)	(3,841		)
Disposals	(2,223		)	(918		)	(1,508		)	(691		)
Reclassification (to) from nonaccretable difference	(5,562		)	3,866			(331		)	7,740
Balance, end of period	$	29,223		$	15,999		$	63,623		$	26,845

(dollars in thousands)	Six Months Ended June 30,
	2013						2012
	City Bank			North County Bank			City Bank			North County Bank
Balance, beginning of period	$	49,168		$	19,567		$	78,004		$	29,574
Accretion to interest income	(7,768		)	(4,992		)	(11,305		)	(7,749		)
Disposals	(6,628		)	(2,442		)	(2,723		)	(2,721		)
Reclassification (to) from nonaccretable difference	(5,549		)	3,866			(353		)	7,741
Balance, end of period	$	29,223		$	15,999		$	63,623		$	26,845

-25-

WASHINGTON BANKING COMPANY AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

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

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

The following tables summarize the activity related to covered OREO for the three and six months ended June 30, 2013 and 2012:

(dollars in thousands)	Three Months Ended June 30, 2013
	City Bank			North County Bank			Total
Balance, beginning of period	$	9,519		$	5,934		$	15,453
Additions to covered OREO	2,324			58			2,382
Dispositions of covered OREO, net	(2,171		)	(1,598		)	(3,769		)
Valuation adjustments	(547		)	(592		)	(1,139		)
Balance, end of period	$	9,125		$	3,802		$	12,927

(dollars in thousands)	Three Months Ended June 30, 2012
	City Bank			North County Bank			Total
Balance, beginning of period	$	18,295		$	7,678		$	25,973
Additions to covered OREO	591			3,145			3,736
Dispositions of covered OREO, net	(4,039		)	(582		)	(4,621		)
Valuation adjustments	$	(1,267	)	$	(821	)	$	(2,088	)
Balance, end of period	$	13,580		$	9,420		$	23,000

(dollars in thousands)	Six Months Ended June 30, 2013
	City Bank			North County Bank			Total
Balance, beginning of period	$	7,399		$	6,061		$	13,460
Additions to covered OREO	6,777			526			7,303
Dispositions of covered OREO, net	(4,477		)	(2,164		)	(6,641		)
Valuation adjustments	(574		)	(621		)	(1,195		)
Balance, end of period	$	9,125		$	3,802		$	12,927

(dollars in thousands)	Six Months Ended June 30, 2012
	City Bank			North County Bank			Total
Balance, beginning of period	$	19,341		$	7,281		$	26,622
Additions to covered OREO	956			6,217			7,173
Dispositions of covered OREO, net	(4,759		)	(3,237		)	(7,996		)
Valuation adjustments	(1,958		)	(841		)	(2,799		)
Balance, end of period	$	13,580		$	9,420		$	23,000

-26-

WASHINGTON BANKING COMPANY AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

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

(c) FDIC Indemnification Asset:

The following table summarizes the activity related to the FDIC indemnification asset for the three and six months ended June 30, 2013 and 2012:

(dollars in thousands)	Three Months Ended June 30, 2013
	City Bank			North County Bank			Total
Balance, beginning of period	$	17,113		$	11,027		$	28,140
Change in FDIC indemnification asset	5,865			1,637			7,502
Reduction due to loans paid in full	(273		)	(545		)	(818		)
Transfers to (due from) FDIC	(726		)	(1,266		)	(1,992		)
Balance, end of period	$	21,979		$	10,853		$	32,832

(dollars in thousands)	Three Months Ended June 30, 2012
	City Bank			North County Bank			Total
Balance, beginning of period	$	40,976		$	19,922		$	60,898
Change in FDIC indemnification asset	(2,898		)	(247		)	(3,145		)
Reduction due to loans paid in full	(751		)	(420		)	(1,171		)
Transfers to (due from) FDIC	260			(1,975		)	(1,715		)
Balance, end of period	$	37,587		$	17,280		$	54,867

(dollars in thousands)	Six Months Ended June 30, 2013
	City Bank			North County Bank			Total
Balance, beginning of period	$	20,390		$	14,181		$	34,571
Change in FDIC indemnification asset	5,683			1,645			7,328
Reduction due to loans paid in full	(1,410		)	(1,191		)	(2,601		)
Transfers to (due from) FDIC	(2,684		)	(3,782		)	(6,466		)
Balance, end of period	$	21,979		$	10,853		$	32,832

(dollars in thousands)	Six Months Ended June 30, 2012
	City Bank			North County Bank			Total
Balance, beginning of period	$	43,235		$	22,351		$	65,586
Change in FDIC indemnification asset	(5,763		)	(373		)	(6,136		)
Reduction due to loans paid in full	(1,324		)	(2,300		)	(3,624		)
Transfers to (due from) FDIC	1,439			(2,398		)	(959		)
Balance, end of period	$	37,587		$	17,280		$	54,867

-27-

WASHINGTON BANKING COMPANY AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(7)  Non-Covered Other Real Estate Owned

The following table presents the changes in non-covered other real estate owned for the three and six months ended June 30, 2013 and 2012:

(dollars in thousands)	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2013			2012			2013			2012
Balance, beginning of period	$	5,297		$	1,830		$	3,023		$	1,976
Additions to OREO	328			3,228			3,640			3,742
Capitalized improvements	202			—			202			—
Dispositions of OREO, net	(963		)	(303		)	(1,783		)	(755		)
Valuation adjustments	(138		)	(341		)	(356		)	(549		)
Balance, end of period	$	4,726		$	4,414		$	4,726		$	4,414

(8)  Earnings per Common Share

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

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

(dollars in thousands)	Three Months Ended				Six Months Ended
	June 30,				June 30,
	2013		2012		2013		2012
Income available to common shareholders	$	2,908	$	2,847	$	7,492	$	7,620
Weighted average number of common shares, basic	15,506,000		15,411,000		15,487,000		15,414,000
Effect of dilutive stock awards	46,000		35,000		42,000		35,000
Weighted average number of common shares, diluted	15,552,000		15,446,000		15,529,000		15,449,000
Earnings per common share
Basic	$	0.19	$	0.18	$	0.48	$	0.49
Diluted	$	0.19	$	0.18	$	0.48	$	0.49
Antidulitive stock awards excluded from the
computation of diluted earnings per common share (in shares)	41,000		45,000		41,000		45,000

(9)  Stock-Based Compensation

(a)Stock Options:  The Company measures the fair value of each stock option grant at the date of the grant, using the Black-Scholes option pricing model.  There were no options granted during the three and six months ended June 30, 2013 and 2012.

The Company recognizes compensation expense for stock option grants on a straight-line basis over the requisite service period of the grant.  No stock-based compensation expense was recognized for the three and six months ended June 30, 2013.   The Company recognized $2 thousand and $8 thousand in stock-based compensation expense, as a component of salaries and benefits, for the three and six months ended June 30, 2012, respectively. As of June 30, 2013, there was no remaining unrecognized compensation costs related to nonvested stock option grants.

-28-

WASHINGTON BANKING COMPANY AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(9)  Stock-Based Compensation (continued)

The following table summarizes information on stock option activity during 2013:

	Shares		Weighted average exercise price per share		Weighted average remaining contractual terms (in years)	Total intrinsic value (in thousands)
Outstanding, January 1, 2013	107,845		$	11.58
Granted	—		—
Exercised	(120	)	9.11			$	1
Forfeited, expired or cancelled	—		—
Outstanding, June 30, 2013	107,725		$	11.58	4.34	$	338
Exercisable at June 30, 2013	107,725		$	11.58	4.34	$	338

The aggregate intrinsic value in the table above represents the total pre-tax intrinsic value (i.e., the difference between the Company’s closing stock price on June 30, 2013, 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, 2013.  This amount changes based upon the fair market value of the Company’s stock.

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

The following table summarizes information on RSU activity during 2013:

	Shares		Weighted average fair value per share		Weighted average remaining contractual terms (in years)
Outstanding, January 1, 2013	99,811		$	13.16
Granted	80,100		13.91
Vested	(45,938	)	13.15
Forfeited, expired or cancelled	(2,732	)	13.48
Outstanding, June 30, 2013	131,241		$	13.61	2.33

For the three and six months ended June 30, 2013, the Company recognized $277 thousand and $478 thousand in RSU compensation expense, respectively, as a component of salaries and benefits, compared to $196 thousand and $327 thousand for the same periods a year ago.  As of June 30, 2013, there was $1.5 million of total unrecognized compensation costs related to nonvested RSUs.

-29-

WASHINGTON BANKING COMPANY AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(10)  Fair Value Measurements

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

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

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

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

The following table presents the Company’s financial instruments measured at fair value on a recurring basis at June 30, 2013 and December 31, 2012:

(dollars in thousands)	Fair value at June 30, 2013
	Level 1		Level 2		Level 3		Total
U.S. government agencies	$	—	$	87,823	$	—	$	87,823
Residential pass-through securities	—		161,584		—		161,584
Taxable state and political subdivisions	—		2,509		—		2,509
Tax exempt state and political subdivisions	—		71,497		—		71,497
Corporate obligations	5,715		4,997		—		10,712
Agency-issued collateralized mortgage obligations	—		26,854		—		26,854
Asset-backed securities	—		23,213		—		23,213
Investments in mutual funds and other equities	1,919		—		—		1,919
Total	$	7,634	$	378,477	$	—	$	386,111

(dollars in thousands)	Fair value at December 31, 2012
	Level 1		Level 2		Level 3		Total
U.S. government agencies	$	—	$	88,586	$	—	$	88,586
Residential pass-through securities	—		168,423		—		168,423
Taxable state and political subdivisions	—		5,312		—		5,312
Tax exempt state and political subdivisions	—		58,985		—		58,985
Corporate obligations	2,985		7,450		—		10,435
Agency-issued collateralized mortgage obligations	—		14,046		—		14,046
Asset-backed securities	—		25,188		—		25,188
Investments in mutual funds and other equities	1,993		—		—		1,993
Total	$	4,978	$	367,990	$	—	$	372,968

There were no transfers between Level 1, Level 2 and Level 3 during the six months ended June 30, 2013 or during the year ended December 31, 2012.

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

Certain financial assets of the Company may be measured at fair value on a non-recurring basis. These assets are subject to fair value adjustments that result from application of lower-of-cost-or-market accounting or write-downs of individual assets.

-30-

WASHINGTON BANKING COMPANY AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(10)  Fair Value Measurements (continued)

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

(dollars in thousands)	Fair value at June 30, 2013
	Level 1		Level 2		Level 3		Total		Total losses for the period
Non-covered impaired loans (1)	$	—	$	—	$	33,882	$	33,882	$	(3,920	)
Non-covered other real estate owned (2)	—		—		4,726		4,726		(356		)
Covered other real estate owned (2)	—		—		12,927		12,927		(1,195		)
Total	$	—	$	—	$	51,535	$	51,535	$	(5,471	)

(dollars in thousands)	Fair value at December 31, 2012
	Level 1		Level 2		Level 3		Total		Total losses for the period
Non-covered impaired loans (1)	$	—	$	—	$	38,299	$	38,299	$	(8,485	)
Non-covered other real estate owned (2)	—		—		3,023		3,023		(844		)
Covered other real estate owned (2)	—		—		13,460		13,460		(3,704		)
Total	$	—	$	—	$	54,782	$	54,782	$	(13,033	)

⁽¹⁾ Represents carrying value and related specific valuation allowances, which are included in the allowance for loan losses.

⁽²⁾ Represents the fair value and related losses of foreclosed real estate and other collateral owned that were measured at fair value subsequent to their initial classification as non-covered other real estate owned and covered other real estate owned.

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

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

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

Impaired loans that are collateral dependent are reviewed quarterly.  The review involves a collateral valuation review, which also contemplates an assessment of whether the last appraisal is outdated.  Recent appraisals, adjustments to outdated appraisals, knowledgeable third party opinions of value and current market conditions are combined to determine whether a specific reserve and/or a loan charge-off is required.  Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value.  For the period ended June 30, 2013, one non-covered impaired loan totaling $105 thousand had an adjustment to the appraisal, based on unobservable inputs, of 30%.

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

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

-31-

WASHINGTON BANKING COMPANY AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(10)  Fair Value Measurements (continued)

The Company deducts 10% of the appraised value for selling costs on non-covered and covered other real estate owned.  If the property has been actively listed for sale for more than nine months and has had limited interest, the Company will typically reduce the fair value further based upon input from third party industry experts and knowledgeable management and may include adjustments for outdated appraisals (Level 3).

(b)Disclosures about Fair Value of Financial Instruments: The table below is a summary of fair value estimates for financial instruments at June 30, 2013 and December 31, 2012, excluding financial instruments recorded at fair value on a recurring and nonrecurring basis (summarized in the table above). The carrying amounts in the following table are recorded in the statement of financial condition under the indicated captions. The Company has excluded non-financial assets and non-financial liabilities such as Bank premises and equipment, deferred taxes and other liabilities.  

(dollars in thousands)	June 30, 2013
			Fair value measurements using:
	Carrying value		Total		Level 1		Level 2		Level 3
Financial assets:
Cash and cash equivalents	$	25,183	$	25,183	$	25,183	$	—	$	—
Interest-bearing deposits	46,059		46,059		46,059		—		—
Investment securities available for sale	386,111		386,111		7,634		378,477		—
FHLB stock	7,307		7,307		7,307		—		—
Loans held for sale	9,749		9,749		—		9,749		—
Non-covered loans	853,290		853,029		—		—		853,029
Covered loans	192,080		185,067		—		—		185,067
Bank owned life insurance	17,779		17,779		17,779		—		—
FDIC indemnification asset	32,832		28,832		—		—		28,832
Financial liabilities:
Deposits	1,404,372		1,409,340		1,000,345		408,995		—
Junior subordinated debentures	25,774		12,132		—		—		12,132

(dollars in thousands)	December 31, 2012
			Fair value measurements using:
	Carrying value		Total		Level 1		Level 2		Level 3
Financial assets:
Cash and cash equivalents	$	32,145	$	32,145	$	32,145	$	—	$	—
Interest-bearing deposits	75,428		75,428		75,428		—		—
Investment securities available for sale	372,968		372,968		4,978		367,990		—
FHLB stock	7,441		7,441		7,441		—		—
Loans held for sale	18,043		18,043		—		18,043		—
Non-covered loans	853,134		858,660		—		—		858,660
Covered loans	217,339		234,396		—		—		234,396
Bank owned life insurance	17,704		17,704		17,704		—		—
FDIC indemnification asset	34,571		22,630		—		—		22,630
Financial liabilities:
Deposits	1,462,973		1,468,189		1,015,075		453,114		—
Junior subordinated debentures	25,774		12,155		—		—		12,155

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WASHINGTON BANKING COMPANY AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(10)  Fair Value Measurements (continued)

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

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

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

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

FHLB stock: The Bank’s investment in FHLB stock is carried at par value, which approximates its fair value.

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

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

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

Bank Owned Life Insurance: Fair values of insurance policies owned are based on the insurance contract’s cash surrender value.

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

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

Trust Preferred Securities/Junior Subordinated Debentures: The fair value of trust preferred securities is estimated using discounted cash flow analysis based on current rates for similar types of debt.

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

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WASHINGTON BANKING COMPANY AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(11)  Commitments and Contingencies

Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements, including commercial paper, bond financing and similar transactions.  Except for certain long-term guarantees, most guarantees expire within one year. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Collateral supporting those commitments, for which collateral is deemed necessary, generally amounted to one hundred percent of the commitment amount at June 30, 2013. 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, 2013.  At June 30, 2013, the commitments under these agreements totaled $1.3 million.

At June 30, 2013, the Company was the guarantor of trust preferred securities. The Company issued junior subordinated debentures to a wholly owned special purpose trust, which has issued trust preferred securities.  The sole assets of the special purpose trust are the junior subordinated debentures issued by the Company.  Washington Banking Company has fully and unconditionally guaranteed the capital securities along with all obligations of the Trust under the trust agreements. The maximum amount of future payments the Company will be required to make under these agreements is the principal and interest of the trust preferred securities, the principal of which totaled $25.8 million at June 30, 2013 and December 31, 2012.

(12)  Subsequent Events

On July 25, 2013, the Company announced that its Board of Directors declared a cash dividend of $0.09 per common share to shareholders of record as of August 5, 2013, payable on August 19, 2013.

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

Note Regarding Forward-Looking Statements: This Quarterly Report on Form 10-Q includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended and Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking statements describe Washington Banking Company’s (the “Company”) management’s expectations regarding future events and developments such as future operating results, growth in loans and deposits, the FDIC indemnification asset and covered loans, 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 economic conditions; (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.  Prior to 2010, the Company’s growth had been achieved organically.  On April 16, 2010 and September 24, 2010, the Bank acquired certain assets and assumed certain liabilities of City Bank and North County Bank, respectively, from the Federal Deposit Insurance Corporation (“FDIC”) in FDIC-assisted transactions.

The Company 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.

The Company’s geographical expansion to date has primarily been concentrated along the I-5 corridor from King to Whatcom Counties; however, additional areas will be considered if they meet the Company’s criteria.  Acquisition of banks or branches may also be used as a means of expansion if appropriate opportunities are presented.  The primary factors considered in determining the areas of geographic expansion are the availability of knowledgeable personnel, such as managers and lending officers with experience in their fields of expertise, longstanding community presence and extensive banking relationships, customer demand and perceived market potential.  

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Executive Overview

Significant items for the second quarter of 2013 were as follows:

• Net income available to common shareholders per diluted share was $0.19 and $0.48 for the three and six months ended June 30, 2013, compared to $0.18 and $0.49 for the three and six months ended June 30, 2012, respectively.

• The Company recorded a $10.9 million impairment charge related to the credit deterioration in the covered loan portfolio. Related to the impairment charge, the Company also recorded an $8.7 million write up of the indemnification asset and a $626 thousand reversal of a portion of the FDIC clawback liability.

• Net interest margin, on a tax equivalent basis, was 4.68% and 4.76% for the three and six months ended June 30, 2013, respectively, compared to 5.67% and 5.74% for the same periods a year ago.

• Non-covered loans, net of allowance for loan losses, totaled $836.3 million at June 30, 2013, compared to $836.0 million at December 31, 2012.

• Nonperforming non-covered assets to total assets improved to 0.96% at June 30, 2013, compared to 1.10% at December 31, 2012.

• Total risk-based capital for the Company was 19.86% at June 30, 2013, compared to 19.39% at December 31, 2012.  The FDIC requires a minimum total risk-based capital ratio of 10% to be considered “well-capitalized.”

• Tangible book value per common share totaled $11.04 at June 30, 2013, compared to $11.41 at December 31, 2012.

• Authorized a stock repurchase program allowing for the buyback of up to 775,000 shares (approximately 5%) of current outstanding common stock.

Summary of Critical Accounting Policies

The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect amounts reported in the consolidated financial statements and the accompanying notes.  Changes in these estimates and assumptions are considered reasonably possible and may have a material impact on the consolidated financial statements and thus actual results could differ from the amounts reported and disclosed herein.  Significant accounting policies are described in Note (1) of the Notes to Consolidated Financial Statements for the year ended December 31, 2012, as filed with the SEC on Form 10-K.  Not all of these accounting policies require management to make difficult, subjective or complex judgments or estimates. Management believes that the following accounting policies could be considered critical under the SEC’s definition.

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

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

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

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

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

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

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

Fair Value: FASB ASC 820, Fair Value Measurements and Disclosures, establishes a hierarchical disclosure framework associated with the level of pricing observability utilized in measuring financial instruments at fair value. The degree of judgment utilized in measuring the fair value of financial instruments generally correlates to the level of pricing observability. Financial instruments with readily available active quoted prices or for which fair value can be measured from actively quoted prices generally will have a higher degree of pricing observability and a lesser degree of judgment utilized in measuring fair value. Conversely, financial instruments rarely traded or not quoted will generally have little or no pricing observability and a higher degree of judgment utilized in measuring fair value. Pricing observability is impacted by a number of factors, including the type of financial instrument, whether the financial instrument is new to the market and not yet established and the characteristics specific to the transaction.

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Results of Operations Overview

For the three months ended June 30, 2013, net income available to common shareholders totaled $2.9 million, or $0.19 per diluted common share, compared to net income available to common shareholders of $2.8 million, or $0.18 per diluted common share, for the same period a year ago.  Net income available to common shareholders for the period was primarily attributable to continued improvement in asset quality and strong mortgage banking income.

For the six months ended June 30, 2013, net income available to common shareholders totaled $7.5 million, or $0.48 per diluted common share, compared to net income available to common shareholders of $7.6 million, or $0.49 per diluted common share, for the six months ended June 30, 2012.

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

Fully tax-equivalent net interest income and fully tax-equivalent net interest margin are non-GAAP performance measurements that management believes provide investors with a more accurate picture of the Company's operational performance and are consistent with industry practice. The calculation for both measurements involves grossing up interest income on tax-exempt loans and investments by an amount that makes it comparable to taxable income.

Neither fully tax-equivalent net interest income nor fully tax-equivalent net interest margin should be considered in isolation nor as a substitute for net interest income or net interest margin or any other measure calculated in accordance with GAAP. Moreover, the manner in which the Company calculates fully tax-equivalent net interest income and fully tax-equivalent net interest margin may differ from that of other companies reporting measures with similar names.

The following table provides the reconciliation of the Company's net interest income (GAAP) to a fully tax-equivalent net interest income (non-GAAP) and net interest margin (GAAP) to a fully tax-equivalent net interest margin (non-GAAP) for the periods presented:

(dollars in thousands)	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2013			2012			2013			2012
GAAP net interest income	$	17,357		$	20,889		$	35,539		$	42,191
Tax-equivalent adjustment	216			277			422			542
Tax-equivalent net interest income	$	17,573		$	21,166		$	35,961		$	42,733
Average interest earning assets	$	1,507,438		$	1,501,373		$	1,523,229		$	1,497,348
Net interest margin	4.62		%	5.60		%	4.70		%	5.67		%
Tax-equivalent net interest margin	4.68		%	5.67		%	4.76		%	5.74		%

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

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

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

(dollars in thousands)	June 30, 2013			December 31, 2012
Total shareholders' equity	$	177,250		$	182,624
Adjustments to shareholders' equity
Goodwill and other intangible assets, net	(5,809		)	(6,027		)
Tangible common equity	$	171,441		$	176,597
Total assets	$	1,617,493		$	1,687,677
Adjustments to total assets
Goodwill and other intangible assets, net	(5,809		)	(6,027		)
Total tangible assets	$	1,611,684		$	1,681,650
Common shares outstanding at end of period	15,527,037			15,483,598
Tangible common equity ratio	10.64		%	10.50		%
Tangible book value per common share	$	11.04		$	11.41

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

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

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

• The volume of noninterest-earning assets;

• Market interest rate fluctuations; and

• Asset quality.

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

(dollars in thousands)	Three Months Ended June 30,
	2013						2012
			Interest						Interest
	Average		earned/		Average		Average		earned/		Average
	balance		paid		yield/rate		balance		paid		yield/rate
Assets
Non-covered loans (1)(2)	$	856,046	$	10,989	5.15	%	$	825,779	$	11,746	5.72	%
Covered loans	189,099		5,972		12.67	%	248,079		9,382		15.21	%
Interest-bearing deposits	62,533		39		0.25	%	99,484		68		0.27	%
Investments:
Taxable	325,926		1,344		1.65	%	285,784		1,387		1.95	%
Non-taxable (2)	73,834		598		3.25	%	42,247		420		4.00	%
Interest-earning assets	1,507,438		18,942		5.04	%	1,501,373		23,003		6.16	%
Noninterest-earning assets	134,248						170,452
Total assets	$	1,641,686					$	1,671,825
Liabilities and shareholders' equity
Deposits:
NOW accounts and MMA	$	636,172	$	255	0.16	%	$	602,616	$	336	0.22	%
Savings	117,230		14		0.05	%	102,106		26		0.10	%
Time deposits	414,531		979		0.95	%	512,760		1,342		1.05	%
Total interest-bearing deposits	1,167,933		1,248		0.43	%	1,217,482		1,704		0.56	%
Federal funds purchased	—		—		—	%	244		—		—	%
Junior subordinated debentures	25,774		121		1.88	%	25,774		133		2.08	%
Total interest-bearing liabilities	1,193,707		1,369		0.46	%	1,243,500		1,837		0.60	%
Noninterest-bearing deposits	248,941						242,784
Other liabilities	14,996						10,976
Total liabilities	1,457,644						1,497,260
Total shareholders' equity	184,042						174,565
Total liabilities and
shareholders' equity	$	1,641,686					$	1,671,825
Net interest income/spread			$	17,573	4.58	%			$	21,166	5.56	%
Credit for interest-bearing funds					0.10	%					0.11	%
Net interest margin (2)					4.68	%					5.67	%

⁽¹⁾ Average balance includes nonaccrual loans.

⁽²⁾ Interest income on non-taxable investments and loans is presented on a taxable-equivalent basis using the federal statutory rate of 35%. These adjustments totaled $216 thousand and $277 thousand for the three months ended June 30, 2013 and 2012, 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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(dollars in thousands)	Six Months Ended June 30,
	2013						2012
			Interest						Interest
	Average		earned/		Average		Average		earned/		Average
	balance		paid		yield/rate		balance		paid		yield/rate
Assets
Non-covered loans (1)(2)	$	856,147	$	22,154	5.22	%	$	826,153	$	23,632	5.75	%
Covered loans	197,937		12,685		12.92	%	255,329		19,250		15.16	%
Federal funds sold	—		—		—	%	—		—		—	%
Interest-bearing deposits	78,192		98		0.25	%	91,593		119		0.26	%
Investments:
Taxable	319,762		2,657		1.68	%	284,015		2,743		1.94	%
Non-taxable (2)	71,191		1,164		3.30	%	40,258		807		4.03	%
Interest-earning assets	1,523,229		38,758		5.13	%	1,497,348		46,551		6.25	%
Noninterest-earning assets	133,932						171,363
Total assets	$	1,657,161					$	1,668,711
Liabilities and shareholders' equity
Deposits:
NOW accounts and MMA	$	636,974	$	512	0.16	%	$	603,047	$	731	0.24	%
Savings	116,235		28		0.05	%	101,511		52		0.10	%
Time deposits	428,491		2,018		0.95	%	522,521		2,766		1.06	%
Total interest-bearing deposits	1,181,700		2,558		0.44	%	1,227,079		3,549		0.58	%
Federal funds purchased	—		—		—	%	122		—		—	%
Junior subordinated debentures	25,774		239		1.87	%	25,774		269		2.10	%
Total interest-bearing liabilities	1,207,474		2,797		0.47	%	1,252,975		3,818		0.61	%
Noninterest-bearing deposits	250,622						232,702
Other liabilities	15,707						9,764
Total liabilities	1,473,803						1,495,441
Total shareholders' equity	183,358						173,270
Total liabilities and
shareholders' equity	$	1,657,161					$	1,668,711
Net interest income/spread			$	35,961	4.66	%			$	42,733	5.64	%
Credit for interest-bearing funds					0.10	%					0.10	%
Net interest margin (2)					4.76	%					5.74	%

⁽¹⁾ Average balance includes nonaccrual loans.

⁽²⁾ Interest income on non-taxable investments and loans is presented on a taxable-equivalent basis using the federal statutory rate of 35%. These adjustments totaled $422 thousand and $542 thousand for the six months ended June 30, 2013 and 2012, 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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The following table details the effects of changes in rates and volume on interest income and expense for the periods indicated:

(dollars in thousands)	Three months ended June 30,									Six Months Ended June 30,
	2013 compared to 2012									2013 compared to 2012
	Increase (decrease) in interest income and expense due to changes in (2)									Increase (decrease) in interest income and expense due to changes in (2)
	Volume			Rate			Total			Volume			Rate			Total
Assets
Non-covered loans (1)(3)	$	439		$	(1,196	)	$	(757	)	$	949		$	(2,427	)	$	(1,478	)
Covered loans	(2,002		)	(1,408		)	(3,410		)	(3,962		)	(2,603		)	(6,565		)
Interest-bearing deposits	(23		)	(6		)	(29		)	(17		)	(4		)	(21		)
Investments: (1)
Taxable	493			(536		)	(43		)	957			(1,043		)	(86		)
Non-taxable	239			(61		)	178			468			(111		)	357
Interest-earning assets	$	(854	)	$	(3,207	)	$	(4,061	)	$	(1,605	)	$	(6,188	)	$	(7,793	)
Liabilities
Deposits:
NOW accounts and money market	$	18		$	(99	)	$	(81	)	$	38		$	(257	)	$	(219	)
Savings	4			(16		)	(12		)	6			(30		)	(24		)
Time deposits	(238		)	(125		)	(363		)	(468		)	(280		)	(748		)
Total interest-bearing deposits	(216		)	(240		)	(456		)	(424		)	(567		)	(991		)
Junior subordinated debentures	—			(12		)	(12		)	—			(30		)	(30		)
Total interest-bearing liabilities	$	(216	)	$	(252	)	$	(468	)	$	(424	)	$	(597	)	$	(1,021	)

⁽¹⁾ Interest income on non-taxable investments and loans are presented on a fully tax-equivalent basis using the federal statutory rate of 35% for the three and six months ended June 30, 2013 and 2012.

⁽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.

Taxable-equivalent net interest income totaled $17.6 million for the three months ended June 30, 2013, compared to $21.2 million for the same period a year ago.  Changes in net interest income during the period reflect a $4.1 million decrease in interest income on interest-earning assets primarily related to decreases in volume and in the yield earned on covered loans and decreases in the yield earned on non-covered loan. Additionally, interest expense on interest-bearing liabilities decreased $468 thousand during the period and was primarily due to the decrease in volume of time deposits and the average rate paid on interest-bearing deposits.

Net interest margin (net interest income as a percentage of average interest-earning assets) on a taxable-equivalent basis was 4.68% for the three months ended June 30, 2013 compared to 5.67% for the same period a year ago.  The yield on interest-earning assets was 5.04% for the three months ended June 30, 2013, a decrease of 112 basis points as compared to the same period a year ago.  This decrease was primarily attributable to the decreases in average yields on non-covered and covered loans and investments during the period.  The average rate on interest-bearing liabilities was 0.46% for the three months ended June 30, 2013, a decrease of 14 basis points as compared to the same period in 2012. This decrease was primarily attributable to the decrease in rates offered on interest-bearing deposits.

For the six months ended June 30, 2013, taxable-equivalent net interest income totaled $36.0 million, compared to $42.7 million for the same period a year ago. Changes in net interest income during the period reflect a $7.8 million decrease in interest income on interest-earning assets primarily related to decreases in volume and in the yield earned on covered loans and decreases in the yield earned on non-covered loans. Additionally, interest expense on interest-bearing liabilities decreased $1.0 million during the period and was primarily due to the decrease in volume of time deposits and the average rate paid on interest-bearing deposits.

-42-

Net interest margin (net interest income as a percentage of average interest-earning assets) on a taxable-equivalent basis was 4.76% for the six months ended June 30, 2013 compared to 5.74% for the same period a year ago.  The yield on interest-earning assets was 5.13% for the six months ended June 30, 2013, a decrease of 112 basis points as compared to the same period a year ago.  This decrease was primarily attributable to the decreases in average yields on non-covered and covered loans and investments during the period.  The average rate on interest-bearing liabilities was 0.47% for the six months ended June 30, 2013, a decrease of 14 basis points as compared to the same period in 2012. This decrease was primarily attributable to the decrease in rates offered on interest-bearing deposits.

Due to the current low interest rate environment, together with the projected principal reduction in higher yielding covered loans, management expects net interest income and net interest margin will decline in future periods.

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

For the three and six months ended June 30, 2013, the Company recorded provisions for non-covered loan losses of $850 thousand and $1.3 million, respectively, compared to $2.4 million and $4.4 million for the same periods a year ago.  Net charge-offs for the three and six months ended June 30, 2013 were $809 thousand and $1.5 million, compared to $2.8 million and $4.8 million for the same periods in 2012.  At June 30, 2013 and 2012, the allowance for non-covered loan losses, as a percent of total non-covered loans, was 1.99% and 2.16%, respectively.

The Company recorded a $10.9 million and a $12.4 million provision for covered loan losses for the three and six months ended June 30, 2013, respectively, compared to a provision for covered loan losses of $398 thousand for the same periods a year ago. For the three and six months ended June 30, 2013, the provision for covered loan losses was primarily attributable to the deterioration of cash flows associated with several covered loan pools acquired from City Bank, particularly those in the hospitality portfolio. This provision, however, was partially offset by a significantly greater change in the FDIC indemnification asset, included in noninterest income, as noted in the table below.

-43-

Noninterest Income:  Noninterest income remains a key focus of the Company. The Company has focused on diversifying the noninterest income mix through the sale of mortgage loans and through the introduction of nondeposit investment products consisting primarily of annuity sales and investment service fees and income from the Company's Bank Owned Life Insurance policies. The following table presents the key components of noninterest income for the three and six months ended June 30, 2013 and 2012:

(dollars in thousands)	Three Months Ended					Six Months Ended					Three Month			Six Month
	June 30,					June 30,					Change			Change
	2013		2012			2013		2012			2013 vs. 2012			2013 vs. 2012
Service charges and fees	$	845	$	921		$	1,661	$	1,814		$	(76	)	$	(153	)
Electronic banking income	969		1,012			2,112		1,908			(43		)	204
Investment products	248		367			472		729			(119		)	(257		)
Gain on sale of investment securities, net	291		—			556		342			291			214
Bank owned life insurance income	37		55			75		115			(18		)	(40		)
Income from the sale of mortgage loans	1,061		776			2,072		1,481			285			591
SBA premium income	215		105			493		192			110			301
Change in FDIC indemnification asset	7,502		(3,145		)	7,328		(6,136		)	10,647			13,464
Gain on disposition of covered assets	213		556			593		1,185			(343		)	(592		)
Other	316		341			681		655			(25		)	26
Total noninterest income	$	11,697	$	988		$	16,043	$	2,285		$	10,709		$	13,758

The six month change in electronic banking income was primarily attributable to a fee received from Visa during the first quarter of 2013 for its exclusive branding for the Company's debit and credit cards.

Gain on sale of investment securities, net represents the net gain recognized on the sale of available for sale investment securities. Management reviews the investment securities portfolio regularly for sales opportunities and expects additional sales in future periods.

Income from the sale of mortgage loans increased due to an increase in premiums recognized on loans sold in the secondary market during the three and six months ended June 30, 2013, compared to the same periods a year ago.

SBA premium income is the income the Company recognizes when it sells the guaranteed portion of each SBA loan to investors in the secondary market. For the three and six months ended June 30, 2013, the Company sold total guaranteed portions of SBA loans in the amounts of $1.7 million and $4.4 million, compared to $922 thousand and $1.3 million for the same periods a year ago.

The change in FDIC indemnification asset for the three and six months ended June 30, 2013 represents the accretion of income on the FDIC indemnification asset, compared to the amortization of expense for the three and six months ended June 30, 2012. Based upon the collections madeon the indemnification asset and the subsequent quarterly revaluations of the estimated remaining cash flows of covered loans, accretion was required to increase the asset in order to match the projected cashflows over the remaining term of the asset. For the three months ended June 30, 2013, the Company recorded a $10.9 million impairment charge related to the credit deterioration in the covered loan portfolio. Related to the impairment charge, the Company also recorded an $8.7 million write up of the indemnification asset and a $626 thousand reversal of a portion of the FDIC clawback liability.

The gain on disposition of covered assets is the income the Company recognizes when a covered asset is paid off or sold and the proceeds exceed its carrying value. The gain on disposition of covered assets is expected to continue to decline as the balance of covered assets decrease.

-44-

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

(dollars in thousands)	Three Months Ended					Six Months Ended					Three Month			Six Month
	June 30,					June 30,					Change			Change
	2013			2012		2013			2012		2013 vs. 2012			2013 vs. 2012
Salaries and benefits	$	7,181		$	7,242	$	14,857		$	14,576	$	(61	)	$	281
Occupancy and equipment	1,836			1,659		3,637			3,388		177			249
Office supplies and printing	390			425		790			838		(35		)	(48		)
Data processing	569			536		1,104			1,064		33			40
Consulting and professional fees	141			273		474			516		(132		)	(42		)
Intangible amortization	110			128		218			254		(18		)	(36		)
FDIC premiums	281			317		570			653		(36		)	(83		)
FDIC clawback liability adjustment	(463		)	1,098		(263		)	1,138		(1,561		)	(1,401		)
Non-covered OREO and repossession expenses, net	379			739		904			1,113		(360		)	(209		)
Covered OREO and repossession expenses, net	437			578		573			1,152		(141		)	(579		)
Other	2,065			2,114		3,929			4,072		(49		)	(143		)
Total noninterest expense	$	12,926		$	15,109	$	26,793		$	28,764	$	(2,183	)	$	(1,971	)

FDIC clawback liability expense represents the Bank’s provision for the estimated liabilities under the provisions of the loss sharing arrangements under the Purchase and Assumption Agreements entered into with the FDIC for the acquisitions of City Bank on April 16, 2010 and North County Bank on September 24, 2010.  Approximately ten years following the respective acquisition dates, the Bank is required to make a payment to the FDIC in the event that losses on covered assets under the loss share agreements have been less than the stated threshold level per the Agreements.

Non-covered and covered OREO and repossession expense represents costs the Company incurs in reclaiming, repairing and selling real estate properties and automobiles, as well as any write-downs or losses on the sale of non-covered and covered OREO properties. The expense on covered OREO is expected to continue to decline as the balance of covered OREO decreases and credit quality and economic conditions improve. At June 30, 2013, covered OREO totaled $12.9 million, down from $23.0 million at June 30, 2012.

Income Taxes: The Company’s consolidated effective tax rate for the three and six months ended June 30, 2013, was 33.4% and 32.4%, compared to 29.2% and 30.5% for the same periods a year ago. The quarterly effective tax rates are below the federal statutory rate of 35% principally due to nontaxable income generated from investments in bank owned life insurance, tax-exempt municipal bonds and loans. Additionally, the Company’s tax rate for three and six months ended June 30, 2012 reflects a benefit from the New Market Tax Credit Program. The tax benefits related to these credits were recognized in the same periods that the credits were recognized on the Company’s income tax returns and expired at the ended of 2012.

-45-

Financial Condition Overview

Total assets at June 30, 2013, were $1.62 billion, compared to $1.69 billion at December 31, 2012.  For the period, net covered loans decreased $37.4 million, investment securities increased $13.1 million and total non-covered loans, net of allowance for loan losses, remained relatively flat.  Total shareholders’ equity was $177.3 million at June 30, 2013, compared to $182.6 million at December 31, 2012, a decrease of $5.3 million. The decrease in shareholders’ equity was primarily attributable to net income of $7.5 million reduced by an $8.7 million other comprehensive loss related to the investment securities portfolio and $4.6 million in cash dividends paid on common stock during the first half of 2013.

Investment Securities:The composition of the Company's investment portfolio reflects management's investment strategy of maintaining an appropriate level of liquidity while providing a relatively stable source of investment income. The investment securities portfolio provides a vehicle for the investment of available funds and a source of liquidity. At June 30, 2013, total investment securities increased $13.1 million to $386.1 million, compared to $373.0 million at December 31, 2012. The increase was a result of the Company actively purchasing investment securities during the first half of 2013 as it continued to deploy funds generated through the resolution of acquired assets and the reinvestment of funds generated from maturities and principal payments of investment securities.

At June 30, 2013, net unrealized losses on investment securities totaled $6.2 million, compared to unrealized gains of $7.2 million at December 31, 2012. The increase in net unrealized losses for the period can be attributed to the increase in interest rates at the end of the second quarter of 2013. At June 30, 2013, the Company's investment portfolio had a duration of 4.5 years.

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

(dollars in thousands)	June 30, 2013		December 31, 2012
U.S. government agencies	$	87,823	$	88,586
Residential pass-through securities	161,584		168,423
State and political subdivisions	74,006		64,297
Corporate obligations	10,712		10,435
Agency-issued collateralized mortgage obligations	26,854		14,046
Asset-backed securities	23,213		25,188
Investments in mutual funds and other equity securities	1,919		1,993
Total investment securities available for sale	$	386,111	$	372,968

Non-Covered Loans: Non-covered loans, net of allowance for loan losses, totaled $836.3 million at June 30, 2013, compared to $836.0 million at December 31, 2012. 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.

-46-

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

(dollars in thousands)	June 30, 2013					December 31, 2012
	Balance			% of total		Balance			% of total
Commercial	$	167,124		19.6	%	$	162,481		19.1	%
Real estate mortgages:
One-to-four family residential	36,040			4.2	%	36,873			4.3	%
Multi-family and commercial	426,276			50.1	%	415,754			48.8	%
Total real estate mortgages	462,316			54.3	%	452,627			53.1	%
Real estate construction:
One-to-four family residential	38,880			4.6	%	46,472			5.5	%
Multi-family and commercial	26,515			3.1	%	34,926			4.1	%
Total real estate construction	65,395			7.7	%	81,398			9.6	%
Consumer:
Indirect	77,524			9.1	%	77,596			9.1	%
Direct	79,114			9.3	%	77,294			9.1	%
Total consumer	156,638			18.4	%	154,890			18.2	%
Subtotal	851,473			100.0	%	851,396			100.0	%
Deferred loan costs, net	1,817					1,738
Allowance for loan losses	(16,967		)			(17,147		)
Total non-covered loans	$	836,323				$	835,987

-47-

Credit Risks and Asset Quality

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

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

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

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

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

Non-Covered Nonperforming Assets

The following table summarizes the Company’s non-covered, nonperforming assets at June 30, 2013 and December 31, 2012:

(dollars in thousands)	June 30, 2013			December 31, 2012
Non-covered nonperforming loans	$	10,875		$	15,551
Non-covered other real estate owned	4,726			3,023
Total non-covered nonperforming assets	$	15,601		$	18,574
Restructured Loans (1)	$	26,727		$	26,303
Total non-covered impaired loans	$	37,602		$	41,854
Non-covered accruing loans past due 90 days or more	$	—		$	—
Non-covered potential problem loans (2)	$	1,966		$	2,601
Allowance for loan losses	$	16,967		$	17,147
Non-covered nonperforming loans to total gross non-covered loans	1.27		%	1.82		%
Allowance for loan losses to total gross non-covered loans	1.99		%	2.01		%
Allowance for loan losses to total non-covered nonperforming loans	156.02		%	110.26		%
Non-covered nonperforming assets to total assets	0.96		%	1.10		%

⁽¹⁾ Represents accruing restructured loans performing according to their restructured terms.

⁽²⁾ Non-covered 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.

-48-

The following table summarizes the Company’s non-covered, nonperforming assets, by location, at June 30, 2013:

(dollars in thousands)	Island County			San Juan County			Skagit County			Snohomish County			Whatcom County			Total			Percent of total non-covered NPA by loan type
Commercial loans	$	3		$	139		$	795		$	1,467		$	485		$	2,889		18.52	%
Real estate mortgage loans:
One-to-four family residential	48			—			254			—			331			633			4.06	%
Multi-family and commercial	—			188			570			—			360			1,118			7.16	%
Real estate construction loans:
One-to-four family residential	1,836			—			1,557			—			2,482			5,875			37.66	%
Multi-family and commercial	—			—			—			—			—			—			—	%
Consumer loans:
Direct	197			—			—			102			61			360			2.31	%
Other Real Estate Owned	885			—			2,856			187			798			4,726			30.29	%
Total	$	2,969		$	327		$	6,032		$	1,756		$	4,517		$	15,601		100.00	%
Percent of total non-covered NPA by location	19.03		%	2.10		%	38.66		%	11.26		%	28.95		%	100.00		%

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

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

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

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

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

-49-

The following table summarizes the Company’s allocation of allowance for non-covered loan losses at June 30, 2013 and December 31, 2012:

(dollars in thousands)	June 30, 2013				December 31, 2012
	Amount		% of Loans (1)		Amount		% of Loans (1)
Commercial	$	4,316	19.6	%	$	4,405	19.1	%
Real estate mortgage	7,055		54.3	%	6,516		53.1	%
Real estate construction	2,575		7.7	%	3,050		9.6	%
Consumer	3,021		18.4	%	3,176		18.2	%
Total	$	16,967	100.0	%	$	17,147	100.0	%

⁽¹⁾ Represents the total outstanding non-covered loans in each category as a percentage of total non-covered loans outstanding.

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

The following table sets forth historical information regarding the Company's allowance for non-covered loan losses and net charge-offs for the three and six months ended June 30, 2013 and 2012:

(dollars in thousands)	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2013			2012			2013			2012
Balance at beginning of period	$	16,926		$	17,993		$	17,147		$	18,032
Provision for non-covered loan losses	850			2,350			1,300			4,350
Charge-offs:
Commercial	(373		)	(391		)	(436		)	(976		)
Real estate mortgage	(108		)	(2,004		)	(194		)	(2,565		)
Real estate construction	(32		)	(133		)	(70		)	(733		)
Consumer:
Direct	(372		)	(292		)	(926		)	(488		)
Indirect	(161		)	(135		)	(334		)	(426		)
Total charge-offs	(1,046		)	(2,955		)	(1,960		)	(5,188		)
Recoveries:
Commercial	76			14			101			33
Real estate mortgage	3			26			73			44
Real estate construction	3			1			4			3
Consumer:
Direct	41			27			73			47
Indirect	114			109			229			244
Total recoveries	237			177			480			371
Net charge-offs	(809		)	(2,778		)	(1,480		)	(4,817		)
Balance at end of period	$	16,967		$	17,565		$	16,967		$	17,565

-50-

Deposits: Total deposits decreased $58.6 million for the period ended June 30, 2013, compared to December 31, 2012.

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

(dollars in thousands)	June 30, 2013				December 31, 2012
	Balance		% of total		Balance		% of total		Change
Noninterest-bearing demand	$	245,505	17.5	%	$	261,310	17.9	%	$	(15,805	)
NOW accounts	343,180		24.4	%	345,599		23.6	%	(2,419		)
Money market	293,590		20.9	%	295,441		20.2	%	(1,851		)
Savings	118,070		8.4	%	112,725		7.7	%	5,345
Time deposits	404,027		28.8	%	447,898		30.6	%	(43,871		)
Total deposits	$	1,404,372	100.0	%	$	1,462,973	100.0	%	$	(58,601	)

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

(dollars in thousands)	June 30, 2013					December 31, 2012
	Balance			% of total		Balance			% of total
Mutual fund money market deposits	14,704			92.5	%	14,704			53.9	%
CDARS deposits	1,189			7.5	%	12,579			46.1	%
Total wholesale deposits	$	15,893		100.0	%	$	27,283		100.0	%
Wholesale deposits to total deposits	1.1		%			1.9		%

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.

Borrowings: At June 30, 2013 and December 31, 2012, borrowings totaled $25.8 million. The Company’s sources of funds consist of borrowings from correspondent banks, the FHLB, the FRB and junior subordinated debentures.  

• Federal Funds Purchased: The Company can use lines of credit at correspondent banks to purchase federal funds for short-term funding. There were no outstanding borrowings at June 30, 2013.  Available borrowings under these lines of credit totaled $35.0 million at June 30, 2013.

• FHLB Overnight Borrowings:  The Company can use advances from the FHLB to supplement funding needs. The FHLB provides credit for member financial institutions in the form of overnight borrowings, short term and long term advances. As a member, the Bank is required to own capital stock in the FHLB and is authorized to apply for advances on the pledge of certain of its mortgage loans and other assets (principally, securities which are obligations of, or guaranteed by, the United States) provided certain standards related to creditworthiness have been met. At June 30, 2013, the Company had no outstanding overnight borrowings, with an unused line of credit of $181.2 million, subject to certain collateral and stock requirements.

• Federal Reserve Bank Overnight Borrowings: The Company can use advances from the Federal Reserve Bank (“FRB”) of San Francisco to supplement funding needs. The FRB provides credit for financial institutions in the form of overnight borrowings. The Bank is required to pledge certain of its loans and other assets (principally, securities which are obligations of, or guaranteed by, the United States) provided certain standards related to creditworthiness have been met.  There were no outstanding overnight borrowings at June 30, 2013, with an unused line of credit of $17.6 million.

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• Junior Subordinated Debentures: Washington Banking Master Trust (the “Master Trust”), a wholly-owned subsidiary of the Company, issued $25.8 million of trust preferred securities with a quarterly adjustable rate based upon the London Interbank Offered Rate (“LIBOR”) plus 1.56%. The debentures, within certain limitations, are considered Tier 1 capital for regulatory capital requirements.  The Company does not expect to issue any additional junior subordinated debentures in the future.

Capital

Shareholders’ Equity: Shareholders’ equity decreased $5.3 million to $177.3 million at June 30, 2013, from $182.6 million at December 31, 2012. The decrease in shareholders’ equity was primarily attributable to net income of $7.5 million reduced by an $8.7 million other comprehensive loss related to the investment securities portfolio and $4.6 million in cash dividends paid on common stock during the first half of 2013.

On July 25, 2013, the Company announced that its Board of Directors declared a cash dividend of $0.09 per share to shareholders of record as of August 5, 2013, payable on August 19, 2013.  Cash dividends are approved by the Board of Directors in connection with its review of the Company’s capital plan. The cash dividend is subject to regulatory limitation. There is no assurance that future cash dividends will be declared or increased.

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 1 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 2 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, 2013 and December 31, 2012:

	Regulatory Requirements				Actual Ratios
	Adequately-capitalized		Well-capitalized		June 30, 2013		December 31, 2012
Total risk-based capital ratio			��
Company (consolidated)	8.00	%	10.00	%	19.86	%	19.39	%
Whidbey Island Bank	8.00	%	10.00	%	19.19	%	18.77	%
Tier 1 risk-based capital ratio
Company (consolidated)	4.00	%	6.00	%	18.59	%	18.13	%
Whidbey Island Bank	4.00	%	6.00	%	17.92	%	17.51	%
Tier 1 leverage ratio
Company (consolidated)	4.00	%	5.00	%	12.25	%	11.78	%
Whidbey Island Bank	4.00	%	5.00	%	11.81	%	11.36	%

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.

On July 2, 2013, the Federal Reserve Board approved the final rules implementing the Basel Committee on Banking Supervision's capital guidelines for U.S. banks. Under the final rules, minimum requirements will increase for both the quantity and quality of capital held by the Bank. The rules include a new common equity Tier 1 capital to risk-weighted assets ratio of 4.5% and a common equity Tier 1 capital conservation buffer of 2.5% of risk-weighted assets. The final rules also raise the minimum ratio of Tier 1 capital to risk-weighted assets from 4.0% to 6.0% and require a minimum leverage ratio of 4.0%. The final rules also implement strict eligibility criteria for regulatory capital instruments. On July 9, 2013, the FDIC also approved, as an interim final rule, the regulatory capital requirements for U.S. banks, following the actions of the Federal Reserve Board. The FDIC's rule is identical in substance to the final rules issued by the FRB.   The phase-in period for the final rules will begin for us on January 1, 2015, with full compliance with all of the final rule's requirements phased in over a multi-year schedule. We are currently evaluating

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the provisions of the final rules and their expected impact on us. Based on a preliminary analysis of the new rules, management believes that it would be fully compliant with the revised standards as of June 30, 2013 if they were effective on that date.

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.

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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 disclosedin the Condensed Consolidated Statements of Cash Flows, net cash provided by operating activities was $30.3 million for the six months ended June 30, 2013, and primarily consisted of net income and the sale of loans held for sale.  For the same period, net cash used in investing activities was $3.4 million.  Purchases of available for sale investment securities accounted for $73.0 million, which was partially offset by $45.3 million in maturities, calls and principal payments of investment securities and mortgage-backed securities and $15.0 million in net decreases in non-covered and covered loans.  Net cash used in financing activities was $63.2 million for the six months ended June 30, 2013, and primarily consisted of the net decrease in deposits of $58.6 million and the $4.6 million payment of cash dividends on common stock.

Capital Resources:

Off-Balance Sheet Items: The Company is a party to financial instruments with off-balance sheet risk.  Among the off-balance sheet items entered into in the ordinary course of business are commitments to extend credit and the issuance of letters of credit. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amounts recognized on the balance sheet.  Certain commitments are collateralized. At June 30, 2013 and December 31, 2012, the Company’s commitments under letters of credit and financial guarantees amounted to $1.3 million and $1.1 million, respectively. Since many of the commitments are expected to expire without being drawn upon, these total commitment amounts do not necessarily represent future cash requirements.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

At June 30, 2013, based on the measures used to monitor and manage interest rate risk, there has not been a material change in the Company's interest rate risk since December 31, 2012.  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, 2012 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, including our Chief Executive Officer and Chief Financial Officer (Principal Financial and Accounting Officer), evaluated the effectiveness of the design and operation of the Company’s disclosure controls and procedures.  Based on this evaluation, they concluded that the Company’s disclosure controls and procedures are effective in timely alerting them to material information required to be included in the periodic reports to the SEC.  The design of any system of controls is based in part upon various assumptions about the likelihood of future events, and there can be no assurance that any of the Company’s plans, products, services or procedures will succeed in achieving their intended goals under future conditions. Management found no facts that would require the Company to take any corrective actions with regard to significant deficiencies or material weaknesses.

Changes in Internal Control over Disclosure and Reporting

There was no change in the Company’s internal control over financial reporting that occurred during the period ended June 30, 2013, 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 is involved in legal proceedings from time to time in the regular course of business. At this time, based on information currently available, we believe that the eventual outcome of such pending litigation will not have a material adverse effect on the Company’s financial condition, results of operations or cash flows.

Item 1A. Risk Factors

In addition to the other information set forth in this report, you should carefully consider the factors discussed under Part I, Item 1A in the Company’s Annual Report on Form 10-K for the year ended December 31, 2012.  These factors could materially and adversely affect our business, financial condition, liquidity, results of operations and capital position, and could cause our actual results to differ materially from our historical results or the results contemplated by the forward-looking statements contained in this report.

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

(a) – (c) None

Item 3. Defaults Upon Senior Securities

(a) – (b) None

Item 4. Mine Safety Disclosures

Not applicable

Item 5. Other Information

Not applicable

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Item 6. Exhibits

3.1	Amended and Restated Articles of Incorporation (incorporated by reference to Exhibit 3.1 to Form 10-Q filed August 9, 2011)
3.2	Bylaws of the Company (1)
4.1	Form of Common Stock Certificate (1)
4.2	Pursuant to Section 601(b)(4)(iii)(A) of Regulation S-K, copies of instruments defining the rights of holders of long-term debt are not filed.  The Company agrees to furnish a copy thereof to the Securities and Exchange Commission upon request.
31.1	Certification of Chief Executive Officer required by Rule 13a-14(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
101.INSXBRL Instance Document **
101.SCHXBRL Taxonomy Extension Scheme Document **
101.CALXBRL Taxonomy Extension Calculation Linkbase Document **
101.DEFXBRL Taxonomy Extension Definition Linkbase Document **
101.LABXBRL Taxonomy Extension Label Linkbase Document **
101.PREXBRL Taxonomy Extension Presentation Linkbase Document **
** Pursuant to Rule 406T of Regulation S-T, these interactive data files are deemed not filed or part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933, as amended, or Section 18
of the Securities and Exchange Act of 1934, as amended, and otherwise are not subject to liability under those sections.
(1)	Incorporated by reference to the Company's registration statement Form SB-2 (File No. 333-49925), filed April 10, 1998

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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 8, 2013	By: /s/ John L. Wagner
		President and Chief Executive Officer
		(Principal Executive Officer)

Date:	August 8, 2013	By: /s/ Richard A. Shields
		Executive Vice President and Chief Financial Officer
		(Principal Financial and Accounting Officer)

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