Cowlitz Bancorporation (CWLZ) 10-Q 2010 Q1 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

x Quarterly report pursuant to section 13 or 15(d) of the Securities and Exchange act of 1934

For the quarter ended March 31, 2010

OR

¨ Transition report pursuant to section 13 or 15(d) of the Securities and Exchange act of 1934

For the transition period from            to            

Commission file number 0-23881

COWLITZ BANCORPORATION

(Exact name of registrant as specified in its charter)

Washington	91-1529841
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)

927 Commerce Ave., Longview, Washington 98632

(Address of principal executive offices) (Zip Code)

(360) 423-9800

(Registrant’s telephone number, including area code)

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 (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ¨    No  ¨

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

Large accelerated filer	¨	Accelerated filer	¨
Non-accelerated filer	¨	Smaller reporting company	x

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).    Yes  ¨    No  x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

Common Stock, no par value on April 30, 2010: 514,638 shares

COWLITZ BANCORPORATION AND SUBSIDIARY

TABLE OF CONTENTS

		PAGE
Part I	FINANCIAL INFORMATION
Item 1.	Financial Statements
	Consolidated Statements of Condition - March 31, 2010 and December 31, 2009	4
	Consolidated Statements of Operations - Three months ended March 31, 2010 and March 31, 2009	5
	Consolidated Statements of Changes in Shareholders’ Equity and Comprehensive Loss Three months ended March 31, 2010 and year ended December 31, 2009	6
	Consolidated Statements of Cash Flows - Three months ended March 31, 2010 and March 31, 2009	7
	Notes to Consolidated Financial Statements	8
Item 2.	Management’s Discussion and Analysis of Financial Condition And Results of Operations	19
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	37
Item 4T.	Controls and Procedures	37
Part II	OTHER INFORMATION
Item 1.	Legal Proceedings	38
Item 1A.	Risk Factors	38
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	38
Item 3.	Defaults upon Senior Securities	38
Item 4.	(Removed and Reserved)	38
Item 5.	Other Information	38
Item 6.	Exhibits	38
	Signatures	39

Forward-Looking Statements

Management’s discussion and the information in this document and the accompanying financial statements contain forward-looking statements, within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements, which are based on certain assumptions and describe future plans, strategies and expectations of the Company, are generally identifiable by words such as “expect”, “believe”, “intend”, “anticipate”, “estimate” or similar expressions, and are subject to risks and uncertainties that could cause actual results to differ materially from those stated. Examples of such risks and uncertainties that could have a material adverse effect on the operations and future prospects of the Company, and could render actual results different from those expressed in the forward-looking statements, include, without limitation: those set forth in our most recent Form 10-K, this Form 10Q and other filings with the SEC; changes in general economic conditions; competition for financial services in the market area of the Company; the impact of the current national and regional economy (including real estate values) on loan demand and borrower’s financial capacity in the Company’s market; quality of the loan and

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investment portfolio; deposit flows; legislative and regulatory initiatives; regulatory restrictions on our operations and monetary and fiscal policies of the U.S. Government affecting interest rates. The reader is advised that this list of risks is not exhaustive and should not be construed as any prediction by the Company as to which risks would cause actual results to differ materially from those indicated by the forward-looking statements. Forward-looking statements in this document include, without limitation, statements regarding the adequacy of our allowance for loan losses, effect of hedged forecasted transactions potential regulatory restrictions and sources and adequacy of liquidity, including replacement of brokered deposits with retail deposits. We undertake no obligation to update publicly or revise any forward-looking statements. You should not place undue reliance on forward-looking statements, which speak only as of the date on which they are made.

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Part I. FINANCIAL INFORMATION

Item 1. Financial Statements

COWLITZ BANCORPORATION AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CONDITION

(UNAUDITED)

(dollars in thousands)	March 31, 2010			December 31, 2009
Assets
Cash and cash equivalents	$	133,764		$	139,705
Investment securities		54,507			48,491
Restricted equity securities		1,247			1,247
Loans, net of deferred loan fees		322,286			343,327
Allowance for loan losses		(11,976	)		(10,164	)
Total loans, net		310,310			333,163
Cash surrender value of bank-owned life insurance		15,400			15,560
Premises and equipment		5,277			5,489
Foreclosed assets		4,262			4,348
Accrued interest receivable and other assets		4,942			4,409
Total assets	$	529,709		$	552,412
Liabilities
Deposits:
Non-interest-bearing demand	$	45,292		$	46,510
Savings and interest-bearing demand		58,236			59,615
Money market		34,233			34,452
Certificates of deposit		375,821			383,194
Total deposits		513,582			523,771
Junior subordinated debentures and other borrowings		12,376			12,378
Accrued interest payable and other liabilities		3,877			4,208
Total liabilities		529,835			540,357
Commitments and contingencies (Note 10)
Shareholders’ equity
Preferred stock, no par value; 5,000,000 shares authorized; no shares issued and outstanding at March 31, 2010 and December 31, 2009		—			—
Common stock, no par value; 25,000,000 shares authorized with 514,638 shares issued and outstanding at March 31, 2010 and December 31, 2009		29,357			29,357
Additional paid-in capital		2,585			2,581
Accumulated deficit		(33,351	)		(21,120	)
Accumulated other comprehensive income		1,283			1,237
Total shareholders’ equity		(126	)		12,055
Total liabilities and shareholders’ equity	$	529,709		$	552,412

See accompanying notes

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COWLITZ BANCORPORATION AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF OPERATIONS

(UNAUDITED)

	Three Months Ended March 31,
(dollars in thousands, except per share amounts)	2010			2009
Interest income
Interest and fees on loans	$	4,941		$	6,960
Interest on taxable investment securities		385			545
Interest on non-taxable investment securities		225			231
Other interest and dividend income		77			29
Total interest income		5,628			7,765
Interest expense
Savings and interest-bearing demand deposits		19			44
Money market		128			165
Certificates of deposit		2,798			3,257
Junior subordinated debentures and other borrowings		61			110
Total interest expense		3,006			3,576
Net interest income (loss) before provision for credit losses		2,622			4,189
Provision for credit losses		9,727			3,505
Net interest income after provision for credit losses		(7,105	)		684
Noninterest income
Service charges on deposit accounts		188			230
Fiduciary income		244			226
Increase in cash surrender value of bank-owned life insurance		157			150
International trade fees		12			63
Wire fees		7			29
Mortgage brokerage fees		60			60
Securities losses		—			(11	)
Other income		327			116
Total noninterest income		995			863
Noninterest expense
Salaries and employee benefits		1,986			2,185
Net occupancy and equipment		644			640
Professional services		622			570
Data processing and communications		248			311
Federal deposit insurance		515			491
Foreclosed asset expense		886			60
Loan collection and related expenses		534			52
Other expense		773			827
Total noninterest expense		6,208			5,136
Loss before income taxes		(12,318	)		(3,589	)
Income tax benefit		(87	)		(1,687	)
Net loss	$	(12,231	)	$	(1,902	)
Loss per common share:
Basic	$	(23.77	)	$	(3.72	)
Diluted	$	(23.77	)	$	(3.72	)
Weighted average shares outstanding:
Basic		514,638			511,545
Diluted		514,638			511,545

See accompanying notes

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COWLITZ BANCORPORATION AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’

EQUITY AND COMPREHENSIVE INCOME (LOSS)

(UNAUDITED)

					Additional Paid-in Capital		Retained Earnings (Accumulated Deficit)			Accumulated Other Comprehensive Income (Loss)			Total Shareholders’ Equity
	Common stock
(dollars in thousands, except per share amounts)	Shares		Amount
Balance, December 31, 2008	511,036		$	29,270	$	2,539	$	13,655		$	3,317		$	48,781
Comprehensive loss:
Net loss	—			—		—		(34,775	)		—			(34,775	)
Net change in unrealized gain (loss) on:
Investments available-for-sale	—			—		—		—			1,653			1,653
Cash flow hedges	—			—		—		—			(3,733	)		(3,733	)
Comprehensive loss														(36,855	)
Proceeds from exercise of stock options and stock purchase plan	3,720			87		—		—			—			87
Fractional shares surrendered due to reverse stock split	(118	)		—		—		—			—			—
Share-based compensation	—			—		42		—			—			42
Balance, December 31, 2009	514,638			29,357		2,581		(21,120	)		1,237			12,055
Comprehensive loss:
Net loss	—			—		—		(12,231	)		—			(12,231	)
Net change in unrealized gain (loss) on:								—
Investments available-for-sale	—			—		—		—			155			155
Cash flow hedges	—			—		—		—			(109	)		(109	)
Comprehensive loss														(12,185	)
Share-based compensation	—			—		4		—			—			4
Balance, March 31, 2010	514,638		$	29,357	$	2,585	$	(33,351	)	$	1,283		$	(126	)

See accompanying notes

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COWLITZ BANCORPORATION AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED)

	Three Months Ended March 31,
(dollars in thousands)	2010			2009
Cash flows from operating activities
Net loss	$	(12,231	)	$	(1,902	)
Adjustments to reconcile net loss to net cash from operating activities:
Deferred tax benefit		(93	)		(1,687	)
Share-based compensation		4			(43	)
Depreciation and amortization		307			396
Provision for credit losses		9,727			3,505
Increase in cash surrender value of bank-owned life insurance		(157	)		(150	)
Investment securities impairment		—			11
Interest rate contracts adjustments		(109	)		(287	)
Net (gain) loss on sales of foreclosed assets		159			(11	)
Write-down of foreclosed assets		630			—
Net increase in accrued interest receivable and other assets		(123	)		(340	)
Net decrease in accrued interest payable and other liabilities		(234	)		(695	)
Net cash used by operations activities		(2,120	)		(1,203	)
Cash flows from investing activities
Proceeds from maturities and sales of investment securities		3,322			2,959
Purchases of investment securities		(9,190	)		—
Net decrease in loans		12,117			3,359
Proceeds from sale of foreclosed assets		209			2,549
Proceeds from termination of interest rate contract		—			3,807
Purchases of premises and equipment		(16	)		(35	)
Net cash from investment activities		6,442			12,639
Cash flows from financing activities
Net increase (decrease) in deposits		(10,261	)		7,678
Repayment of Federal Home Loan Bank and other borrowings		(2	)		(15	)
Proceeds from exercise of stock options and stock purchase plan		—			57
Net cash from (used by) financing activities		(10,263	)		7,720
Net increase (decrease) in cash and cash equivalents		(5,941	)		19,156
Cash and cash equivalents, beginning of period		139,705			55,106
Cash and cash equivalents, end of period	$	133,764		$	74,262
Supplemental disclosure of cash flow information
Cash paid for interest	$	3,559		$	4,432
Cash paid for income taxes	$	6		$	—
Supplemental disclosure of investing and financing activities
Loans transferred to foreclosed assets	$	912		$	2,926
Change in unrealized gains on available-for-sale investment securities and interest rate contracts, net of tax	$	46		$	151

See accompanying notes

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

1. Organization and Summary of Significant Accounting Policies

Organization–Cowlitz Bancorporation (the Company) was organized in 1991 under Washington law to become the holding company for Cowlitz Bank (the “Bank”), a Washington state chartered bank that commenced operations in 1978. The principal executive offices of the Company are located in Longview, Washington. The Bank operates four branches in Cowlitz County in southwest Washington. Outside of Cowlitz County, the Bank does business under the name Bay Bank with branches in Bellevue, Seattle, and Vancouver, Washington, and Portland and Wilsonville, Oregon. The Bank also provides mortgage banking services through its Bay Mortgage division with offices in Longview and Vancouver, Washington.

The Company offers or makes available a broad range of financial services to its customers, primarily small- and medium-sized businesses, professionals, and retail customers. The Bank’s commercial and personal banking services include commercial and real estate lending, consumer lending, international banking services, internet banking, cash management, mortgage banking and trust services.

Principles of consolidation – The accompanying consolidated financial statements include the accounts of the Company and its subsidiary. All significant intercompany transactions and balances have been eliminated. The Company has one wholly-owned trust, Cowlitz Statutory Trust I (the Trust), for purposes of issuing guaranteed undivided beneficial interests in junior subordinated debentures (Trust Preferred Securities). In accordance with Accounting Standards Codification Section 810-10-15 “Consolidation of Variable Interest Entities,” the Company does not consolidate the Trust.

The interim financial statements have been prepared without an audit and in accordance with the instructions to Form 10-Q, generally accepted accounting principles, and banking industry practices. Accordingly, they do not include all the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments, including normal recurring accruals necessary for a fair presentation of the financial condition and results of operations for the interim periods included herein, have been made. The results of operations for the three month period ended March 31, 2010 are not necessarily indicative of results to be anticipated for the year ending December 31, 2010. The interim consolidated financial statements should be read in conjunction with the December 31, 2009 consolidated financial statements, including the notes thereto, included in the Company’s 2009 Annual Report on Form 10-K.

Use of estimates in preparation of the consolidated financial statements–Preparation of the consolidated financial statements, in conformity with accounting principles generally accepted in the United States of America, requires management to make certain estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Significant estimates relate to the determination of the allowance for credit losses, fair value of investment securities and the valuation of goodwill, other real estate owned and deferred tax assets.

Recently Issued Accounting Standards–In January 2010, the FASB issued ASU No. 2010-06, “Fair Value Measurements and Disclosures (Topic 820)-Improving Disclosures about Fair Value Measurements.” FASB ASU No. 2010-06 requires (i) fair value disclosures by each class of assets and liabilities (generally a subset within a line item as presented in the statement of financial position) rather than major category, (ii) for items measured at fair value on a recurring basis, the amounts of significant transfers between Levels 1 and 2, and transfers into and out of Level 3, and the reasons for those transfers, including separate discussion related to the transfers into each level apart from transfers out of each level, and (iii) gross presentation of the amounts of purchases, sales, issuances, and settlements in the Level 3 recurring measurement reconciliation. Additionally, the ASU clarifies that a description of the valuation technique(s) and inputs used to measure fair values is required for both recurring and nonrecurring fair value measurements. Also, if a valuation technique has changed, entities should disclose that change and the reason for the change. Disclosures other than the gross presentation changes in the Level 3 reconciliation were adopted as of January 1, 2010 and did not have a significant effective on the Company’s condensed consolidated financial statements. The requirement to present the Level 3 activity of purchases, sales, issuances, and settlements on a gross basis will be effective for fiscal years beginning after December 15, 2010. The Company is currently evaluating the impact of adoption of FASB ASU No. 2010-06 and does not expect the adoption of this ASU will have a material impact on the Company’s consolidated financial statements.

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2. Going Concern

The condensed consolidated financial statements have been prepared assuming that the Company will continue as a going concern. The Company and the Bank will be categorized as “critically under-capitalized” as of March 31, 2010 due to its risk-based capital ratios as of that date. Due to market conditions discussed below and other factors, there is uncertainty about the Company’s ability to satisfy regulatory requirements, including restoration of the Bank to capital levels stipulated in the Consent Order (the “Order”) issued by the Federal Deposit Insurance Corporation (the “FDIC”) and the Washington Department of Financial Institutions (the “DFI”) in January 2010. The Order required the Bank, among other things, to attain a 10 percent Tier 1 leverage capital ratio by April 27, 2010, which was not achieved. The additional capital required to satisfy the requirements of the Order as of March 31, 2010 was approximately $45 million.

As a part of its capital raising efforts launched during the fourth quarter of 2008, the Company engaged a highly qualified investment banking firm with expertise in the financial services sector to assist with a review of all strategic opportunities available to the Company. The principal focus of this effort has been on securing a significant private equity investment. While the Company’s financial condition has been weakened by the severe downturn in the real estate markets and higher levels of expenses associated with nonperforming assets, as well as an increase in FDIC insurance assessments, it is the Company’s belief that general concern about the U.S. economy and prospects for expanded government regulation of financial institutions has also been a significant impediment to securing capital commitments.

While there are a number of financial institutions of similar size and condition that have been attempting to raise capital over the past year, there has been a very limited amount of private equity that has been raised. Although the Company has not been successful to date in obtaining private equity, it has engaged in numerous discussions and due diligence with qualified institutional and private investors. The Company will continue to vigorously pursue contacts and discussions with prospective investors and is confident that if the conditions in the capital markets improve over the coming months, the prospects for success in these efforts will increase. The Company also is continuing its strategy to significantly reduce loans, thereby reducing the required level of capital.

Since the latter part of 2008, the Company has taken decisive actions to address the deterioration in the construction and development sector of the loan portfolio resulting from a general and severe deterioration in the residential real estate valuations and sales activity. Loan charge-offs totaling $46.1 million were recognized in the first quarter of 2008 through the first quarter of 2010, of which over 62 percent were related to construction and land development loans.

Despite the restrictions on issuance and renewal of brokered certificates of deposit which became effective in 2009, the Bank is maintaining a significant on-balance sheet liquidity position at March 31, 2010 through its core deposit base, issuance of internet service listing deposits and benefit of the increased higher FDIC deposit insurance limits. At March 31, 2010, the Bank had $188.3 million of cash, cash equivalent investments and securities.

Efforts to improve the Bank’s capital levels through improved internal equity generation were also initiated in the first quarter of 2010 in conjunction with a review of the Bank’s business model. Management is implementing cost reduction strategies involving wage controls, reductions in discretionary spending, and may consider merging certain branches and eliminating unprofitable business lines to reduce staffing and operating expense levels. However, narrow interest spreads and elevated loan loss provisions, higher FDIC assessments and expenses related to problem loans and OREO precluded the Company from generating internal equity in the first quarter of 2010. Efforts to identify additional expense reductions are ongoing.

There are no assurances that plans to achieve objectives set forth in the Order will successfully improve the Bank’s results of operation or financial condition or result in termination of the Order from the FDIC and the DFI. In addition, failure to increase capital levels consistent with the requirements of the Order will result in further enforcement actions by the FDIC and/or DFI. Full satisfaction of the Order’s requirements will depend almost exclusively on raising a significant amount of additional capital. The Company will also face additional restrictions from the Board of Governors of the Federal Reserve based on the Bank’s and Company’s capitalization and other conditions giving rise to the Order.

The consolidated financial statements have been prepared assuming that the Company will continue as a going concern. There can be no assurances that the Company’s actions referred to above will be successful, and these events raise substantial doubt about the Company’s ability to continue as a going concern. The consolidated financial statements do not include any adjustments that might result from the outcome of these uncertainties.

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3. Reverse Stock Split

Effective March 1, 2010, the Company affected a one-for-ten reverse stock split of shares of its common stock issued and outstanding, with payment of cash for any resulting fractional shares. The Company’s number of authorized shares of 25,000,000 was maintained. All references to number of common shares and per share amounts have been restated to reflect the reverse stock split.

4. Cash and Cash Equivalents

For the purpose of presentation in the statements of cash flows, cash and cash equivalents include cash on hand, amounts due from banks including short-term certificates of deposit (original maturities of 90 days or less), and federal funds sold. Federal funds sold generally mature the day following purchase.

5. Earnings (Loss) Per Share

The Company’s basic earnings (loss) per common share is computed by dividing net income (loss) by the weighted-average number of common shares outstanding during the period. The Company’s diluted earnings (loss) per common share is computed similar to basic earnings (loss) per share except the denominator is increased to include the number of additional common shares that would have been outstanding if potentially dilutive common shares had been issued. Included in the denominator is the dilutive effect of stock options computed by the treasury stock method.

For the quarters ended March 31, 2010 and 2009, the Company’s diluted loss per common share is the same as the basic loss per common share due to the anti-dilutive effect of common stock equivalents. Options to purchase 63,051 and 64,251 shares with prices ranging from $44.40 to $168.10 were not included in the computation of diluted loss per share for the quarters ended March 31, 2010 and 2009, respectively.

6.Share-Based Compensation

The Company has a stock option plan, a stock appreciation rights (SAR) plan and an employee stock purchase plan, which are described below. Compensation expense charged against income for the plans was $4,000 in the first quarter of 2010, compared with a net credit of $43,000, in the comparable period in 2009. The net credit in 2009 was primarily due to the reversal of previously accrued expense of $52,000, related to the SAR plan. The estimated liability for expenses under the SAR plan are directly related to the price of the Company’s stock, which has declined subsequent to the issuance of SARs to employees. Income tax expense recognized in the income statement for share-based compensation for the three month periods ended March 31, 2010 and 2009 were none and $15,500, respectively. At March 31, 2010, unrecognized estimated compensation cost related to non-vested SARs and stock options was not significant.

The average fair value of stock options and SARs is estimated on the date of grant using the Black-Scholes option pricing model. There were no stock options or SARs granted in the first three months of 2010 or the year 2009.

Stock Option Plan

The Company has one active shareholder approved stock option plan (the 2003 Plan) that permits the grant of stock options and stock awards for up to 50,000 shares, of which 2,380 were available for issue at March 31, 2010. Under the 2003 Plan, options may be granted to the Company’s employees, non-employee directors, and others whom management believes contributed to the long-term financial success of the Company. From time-to-time, the Company also grants stock options outside the 2003 Plan in the process of recruiting senior management. The exercise price of all stock option awards must be at least equal to the fair value of the common stock on the date of grant and can vest immediately or over time at the discretion of the Board of Directors’ Compensation Committee and expire ten years after the date of grant. It is the Company’s policy to issue new shares for stock options exercised or stock awards.

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The following table summarizes stock option activity for the three months ended March 31, 2010:

(dollars in thousands)	Options Outstanding		Weighted- Average Exercise Price		Weighted- Average Remaining Life (years)	Aggregate Intrinsic Value (in thousands)
Balance, beginning of period	63,061		$	111.01
Granted	—			—
Exercised	—			—
Forfeited/Expired	(10	)		44.40
Balance, end of period	63,051		$	111.02	3.0	$	—
Exercisable, end of period	62,911		$	110.90	2.9	$	—

During the first three months of 2010, no cash was received from the exercise of stock options and $56,600 was received in the comparable period of 2009. The total intrinsic value of options exercised was not significant in the first three months of 2009.

Stock Appreciation Rights

In January 2007, the Company’s Board of Directors approved the 2007 Stock Appreciation Rights Plan (SAR Plan). The SAR Plan provides for the award of SARs to directors and officers of the Company. Each stock appreciation right represents the right to receive an amount in cash equal to the excess of the fair market value of a share of the Company’s common stock on the award date. The amount of the cash liability under the SAR Plan is estimated quarterly using the Black-Scholes option pricing model with updated assumptions. SARs vest 20 percent on the date of grant and 20 percent on each anniversary of the grant with accelerated vesting upon death, disability, a change in control and upon retirement after reaching age 62 while employed with at least five years of service. Unvested SARs are forfeited upon termination. SARs automatically convert into a deemed investment account at 10 years from the date of grant and can be converted into the deemed investment account at any time upon election of the recipient. SARs do not have dividend or voting rights or any other rights of the owner of an actual share of common stock. Recipient accounts are distributed in cash upon termination or, if elected by the recipient in advance, a specific distribution date not later than the later of termination or the January following the date the recipient reaches age 65.

Employee Stock Purchase Plan

The Company maintains an employee stock purchase plan (ESPP). The ESPP allows eligible employees to defer a whole percentage of their salary, from 1 percent to 10 percent, over a period of six months in order to purchase Company shares of common stock. The price is determined at 85 percent of the lowest market price on either the first or last day of the six-month deferral period. The Company is authorized to issue up to 17,500 shares of common stock under the ESPP. As of March 31, 2010, there were 5,262 shares remaining under the ESPP.

7. Comprehensive Income (Loss)

Comprehensive income (loss) includes net income (loss) reported on the statements of operations and changes in the fair value of available-for-sale investment securities and interest rate contracts accounted for as cash flow hedges. These amounts are included in “Accumulated Other Comprehensive Income (Loss)” on the consolidated statement of changes in shareholders’ equity and comprehensive income (loss).

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The components of other comprehensive income (loss) related to investment securities and cash flow hedges for the three months ended March 31 were as follows:

	Three Months Ended March 31
(dollars in thousands)	2010			2009
Net loss reported	$	(12,231	)	$	(1,902	)
Unrealized gain from securities:
Net unrealized gain on available-for-sale securities arising during the period, net of tax		155			741
Reclassification adjustment of losses included in income, net of tax		—			7
Net change in unrealized gains from securities		155			748
Unrealized gain from cash flow hedging instruments:
Net unrealized loss from cash flow hedging instruments arising during the period, net of tax		—			(410	)
Reclassification adjustment of gains included in income, net of tax		(109	)		(187	)
Net change in unrealized gains from cash flow hedging instruments		(109	)		(597	)
Total comprehensive loss	$	(12,185	)	$	(1,751	)

8. Investment Securities

The following table presents the composition, amortized cost and estimated fair value of the Company’s available for sale investment portfolio:

(dollars in thousands) March 31, 2010:	Amortized Cost		Unrealized Gains		Unrealized Losses			Fair Value
U.S. Agency mortgage-backed securities	$	18,722	$	1,047	$	—		$	19,769
Non-agency mortgage-backed securities		13,042		54		(826	)		12,270
Municipal bonds		21,322		734		(137	)		21,919
Other securities		535		14		—			549
	$	53,621	$	1,849	$	(963	)	$	54,507
December 31, 2009:	Amortized Cost		Unrealized Gains		Unrealized Losses			Fair Value
U.S. Agency mortgage-backed securities	$	21,714	$	1,022	$	—		$	22,736
Non-agency mortgage-backed securities		4,186		22		(823	)		3,385
Municipal bonds		21,326		652		(153	)		21,825
Other securities		535		10		—			545
	$	47,761	$	1,706	$	(976	)	$	48,491

The following table presents the gross unrealized losses and fair value of the Company’s investment securities aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at March 31, 2010:

	Less Than 12 Months					12 Months or More					Total
(dollars in thousands)	Fair Value		Unrealized Losses			Fair Value		Unrealized Losses			Fair Value		Unrealized Losses
Non-agency mortgage-backed securities	$	7,839	$	(291	)	$	2,845	$	(535	)	$	10,684	$	(826	)
Municipal bonds		674		(1	)		4,839		(136	)		5,513		(137	)
	$	8,513	$	(292	)	$	7,684	$	(671	)	$	16,197	$	(963	)

At March 31, 2010, there were 23 investment securities in an unrealized loss position, of which 13 were in a continuous loss position for 12 months or more. The Company uses an independent third party to determine current market values of the securities it holds. These fair market values are compared to current carrying values to determine if a security is in a gain or loss position.

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Management evaluates securities for other-than-temporary impairment (“OTTI”) quarterly. Consideration is given to, among other things: (1) the length of time and extent to which the fair value has been less than cost, (2) the financial condition and near term prospects of the issuer, (3) our intent and ability to retain a security for a period of time sufficient to allow for any anticipated recovery in fair value and (4) whether we expect to recover the amortized cost basis of the security.

The Company holds ten non-agency mortgage-backed securities, two of which have been in a loss position for greater than twelve months. Management has reviewed these securities for the presence of OTTI, taking into consideration current market conditions, fair value in relationship to cost, credit agency ratings, credit enhancements and coverage ratios, historical experience of prepayment rates, collateral default rates and default loss severity. The Company’s analysis in 2009 on one non-agency mortgage-backed security rated less than investment grade, with an amortized cost basis of $2.4 million, indicated a shortfall of estimated contractual cash flows to the tranche of this security owned by the Company. The difference between management’s estimate of the present value of the cash flows expected to be collected and the amortized cost basis was considered to be uncollectible and accordingly, the Company recorded OTTI losses of $76,000 and $9,000 in the second and fourth quarters of 2009, respectively. The analysis on this security in the first quarter of 2010 indicated no additional OTTI charges were warranted. The amount of unrealized loss included in OCI at March 31, 2010 related to this security was $451,000. Management continues to monitor the credit performance of this security and if the performance deteriorates from current levels, additional OTTI losses may be recognized in the future. The unrealized losses on the other non-agency mortgage backed securities, including the other security in a loss position greater than twelve months, were due to changes in market interest rates or widening of market spreads subsequent to the initial purchase of the securities and not credit quality. The Company does not have the intent to sell these securities and does not anticipate that these securities will be required to be sold before anticipated recovery, and currently expects full principal and interest to be collected. Therefore, the Company does not consider these investments to be OTTI at March 31, 2010.

The Company recorded an OTTI charge of $11,000 on its FNMA preferred securities in the first quarter of 2009 and none in the same period of 2010. In reaching the determination to record this impairment, management reviewed the facts and circumstances available regarding these securities, the financial condition of the issuer and the prospects for a change in market value within a reasonable period of time.

The unrealized losses on the Company’s investments in state and political subdivisions are due to market conditions, not in estimated cash flows. The Company does not have the intent to sell these securities and does not anticipate that these securities will be required to be sold before anticipated recovery, and expects full principal and interest to be collected. Therefore, the Company does not consider these investments to be OTTI at March 31, 2010.

The following table summarizes the fair value of the contractual or estimated maturities of the Company’s investment securities at March 31, 2010.

(dollars in thousands)	One year or less		One through 5 years		After 5 through 10 years		After 10 years		Total
U.S. Agency mortgage-backed securities	$	3,439	$	16,330	$	—	$	—	$	19,769
Non-agency mortgage-backed securities		726		5,809		1,917		3,818		12,270
Municipal bonds		417		2,246		11,399		7,857		21,919
Other securities		—		—		—		549		549
Total	$	4,582	$	24,385	$	13,316	$	12,224	$	54,507

For the purposes of the maturity schedule, mortgage-backed securities, which are not due at a single maturity date, have been allocated over maturity groupings based on the expected maturity of the underlying collateral. Mortgage-backed securities may mature earlier than their stated contractual maturities because of accelerated principal repayments of the underlying loans. As of March 31, 2010 and December 31, 2009, investment securities in the amounts of $49.3 million and $47.4 million, respectively, were pledged as collateral to secure public deposits and borrowing lines.

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9. Loans and Allowance for Credit Losses

The following table presents the loan portfolio, in accordance with Bank regulatory guidance for the preparation of the Call report, as of March 31, 2010 and December 31, 2009:

(dollars in thousands)	March 31, 2010			December 31, 2009
Commercial	$	63,914		$	69,726
Real estate:
Construction
1-4 family residential		2,875			4,601
Multi-family/condominimums		463			557
Residential land development		17,576			21,253
Commercial		9,648			15,647
Total construction		30,562			42,058
Residential 1-4 family		35,424			38,792
Multifamily		15,683			15,535
Commercial real estate		174,533			175,105
Total real estate		256,202			271,490
Installment and other consumer		2,522			2,604
Total loans, gross		322,638			343,820
Deferred loan fees		(352	)		(493	)
Loans, net of deferred loan fees	$	322,286		$	343,327

The allowance for credit losses is based upon estimates of probable losses inherent in the loan portfolio and the Company’s commitments to extend credit to borrowers. The amount of loss ultimately incurred for these loans can vary significantly from the estimated amounts. An analysis of the change in the allowance for credit losses is as follows for the periods indicated:

	Quarter Ending
(dollars in thousands)	March 31, 2010			March 31, 2009
Balance at beginning of period	$	10,356		$	13,994
Provision for credit losses		9,727			3,505
Recoveries		461			500
Charge-offs		(8,473	)		(9,230	)
Balance at end of period	$	12,071		$	8,769
Components:
Allowance for loan losses	$	11,976		$	8,427
Liability for unfunded loan commitments		95			342
Total allowance for credit losses	$	12,071		$	8,769

Loans on which the accrual of interest has been discontinued totaled $40.8 million and $48.5 million at March 31, 2010 and December 31, 2009, respectively. At March 31, 2010, the recorded investment in loans classified as impaired totaled $40.8 million with a specific allowance totaling $2.2 million. At December 31, 2009, the recorded investment in impaired loans was $48.5 million, with a specific allowance totaling $1.7 million. The average recorded investment in impaired loans was approximately $44.5 million and $40.4 million for the three months ended March 31, 2010 and 2009, respectively. The amount of interest recognized on impaired loans during the periods they were impaired was not significant.

10. Commitments and Contingencies

In the normal course of business, the Bank enters into agreements with customers that give rise to various commitments and contingent liabilities that involve elements of credit risk, interest rate risk, and liquidity risk. These commitments and contingent liabilities are commitments to extend credit, credit card arrangements, and standby letters of credit.

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A summary of the Bank’s undisbursed commitments and contingent liabilities at March 31, 2010, was as follows:

(dollars in thousands)
Commitments to extend credit	$	19,462
Credit card commitments		3,224
Standby letters of credit		837
	$	23,523

Commitments to extend credit, credit card arrangements, and standby letters of credit all include exposure to some credit loss in the event of non-performance of the customer. The Bank’s credit policies and procedures for credit commitments and financial guarantees are the same as those for extension of credit that are recorded in the consolidated statements of condition. Because most of these instruments have fixed maturity dates and many of them expire without being drawn upon, they do not generally present a significant liquidity risk to the Bank.

11. Income Taxes

As of March 31, 2010 and December 31, 2009, the Company had net deferred income tax assets, before valuation allowances, of $23.0 million and $17.6 million, respectively, comprised of tax-effected cumulative temporary differences primarily related to the provision for credit losses and net operating loss and tax credit carry-forwards. The Company has provided a 100 percent valuation allowance against its net deferred tax assets at March 31, 2010 and December 31, 2009, as there is no assurance that the Company will generate future taxable income to utilize such assets, in accordance with ASC Topic 740, “Income Taxes”. Management will review the valuation allowance periodically and make adjustments as warranted.

Recent tax legislation lengthened the period to carry back tax losses from two to five years for financial institutions. As a result, the Company reduced its deferred tax asset valuation allowance by $93,000 in the first quarter of 2010 to reflect a receivable of alternative minimum tax paid in prior years. In addition, the Company paid and expensed $6,000 of Oregon state income taxes.

The Company and its subsidiary file income tax returns in the U.S. federal jurisdiction and the state of Oregon. The years 2006 through 2008 remain open for federal and state income tax examination. The Company’s policy is to recognize interest related to unrealized tax benefits and penalties as operating expenses. There were no interest or penalties paid during the three-month period ended March 31, 2010 or the twelve-month period ended December 31, 2009. No accrued interest or penalties were recorded as of March 31, 2010 or December 31, 2009. The Company believes that it has appropriate support for the income tax positions taken and to be taken on its tax returns, and that its accruals for tax liabilities are adequate for all open years based on an assessment of many factors including past experience and interpretations of tax law applied to the facts of each matter.

12. Derivative Instruments and Hedging Activities

The Company holds loans that have variable rates, thus creating exposure to the variability or uncertainty of future cash flows due to changes in interest rates. The Company periodically uses interest rate contracts to manage the risk of overall changes in cash flows associated with interest receipts on its prime-based variable-rate loans. During 2006, the Company purchased a $50 million five-year prime-based interest rate floor and two interest rate swaps with an aggregate notional value totaling $75 million. The interest rate contracts were scheduled to expire in the first half of 2011.

The Company began applying cash flow hedge accounting treatment as of December 12, 2006 to all of its interest rate contracts. In a cash flow hedge, the effective portion of the change in the fair value of the hedging derivative is recorded in accumulated other comprehensive income (loss) and is subsequently reclassified into earnings during the same period in which the hedged item affects earnings. The change in fair value of any ineffective portion of the hedging derivative is recognized immediately in earnings. When a hedged item is de-designated prior to maturity, previous adjustments to accumulated other comprehensive income or loss are recognized in earnings to match the earnings recognition pattern over the life of the hedged item if the expected cash flows are probable of occurring as originally specified at inception of the initial hedging relationship.

One interest rate swap contract was terminated in the second quarter of 2008 for a pre-tax gain of $482,000. The other interest rate swap contract was terminated in the first quarter of 2009 for a pre-tax gain of $3.8 million. At the time of the terminations of the interest rate swaps, the forecasted interest receipts at the inception of the hedging relationship remained probable. Therefore, the realized gains were being amortized into earnings over the original term of the interest rate hedges. The Company terminated its interest rate floor contract in the third quarter of 2009 for a pre-tax gain of $2.6 million. As of the end of the third quarter of 2009, the Company determined that the amount of interest receipts currently eligible for hedge accounting under the terms of its hedge designation documentation had significantly decreased and that it was not probable that the Company would have enough interest receipts eligible for hedge accounting as established under the terms of it hedge documentation. At September 30, 2009, interest receipts on approximately $40 million of loans were eligible for hedge accounting under the terms of the Company’s hedge designation and, therefore, $629,200 of gains remained in Accumulated Other Comprehensive Income at that date to be amortized over the remaining term of the designated hedging

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relationship. Gains recognized on terminated interest rate contracts no longer qualifying for hedge accounting totaled $3.1 million and were recorded in noninterest income in the third quarter of 2009. At March 31, 2010 and December 31, 2009, the unrealized gain on interest rate hedges included in Accumulated Other Comprehensive Income was $398,400 and $506,600, respectively.

The following table shows the location and amount of gains and losses reported in the Consolidated Statement of Operations on the Company’s interest rate contracts, designated as hedging instruments, for the three months ended March 31, 2010:

(dollars in thousands)
Location of Gain Reclassified from Accumulated OCI Into Income (Effective Portion)	Amount of Gain Reclassified from Accumulated OCI Into Income (Effective Portion)		Location of Loss Recognized in Income (Ineffective Portion)	Amount of Loss Recognized in Income (Ineffective Portion)
Interest Income	$	181	Noninterest Expense	$	(72)

In the next twelve months, it is estimated that the hedged forecasted transactions will affect earnings such that a non-cash credit of $369,100 will be reclassified into pre-tax earnings from accumulated other comprehensive income.

13. Fair Value Measurements

ASC 820 (formerly FSP FAS 157-4, “Fair Value Measurements and Disclosures”), defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. ASC 820 also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value:

Level 1. Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date. An active market is a market in which transactions for the asset or liability occur with significant frequency and volume to provide pricing information on an ongoing basis.

Level 2. Significant other observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, and other inputs that are observable or can be corroborated by observable market data by correlation or other means.

Level 3. Significant unobservable inputs that reflect a company’s own assumptions about the assumptions that market participants would use in pricing an asset or liability developed based on the best information available in the circumstances.

The Company used the following methods and significant assumptions to estimate fair value.

Securities: The fair values of securities available for sale are determined by obtaining quoted prices on nationally recognized securities exchanges or matrix pricing, which is a mathematical technique used widely in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted securities.

Impaired Loans: Impaired loans are evaluated and valued at the time the loan is identified as impaired, at the lower of cost or fair value. As a practical expedient, fair value may be measured based on a loan’s observable market price or the underlying collateral securing the loan. Collateral may be real estate or business assets including equipment. The value of collateral is determined based on independent appraisals.

Other Real Estate Owned and Other Repossessed Assets: OREO is real property that the Bank has taken ownership of in partial or full satisfaction of a loan or loans. Other repossessed assets are personal property that the Bank has taken ownership of in partial or full satisfaction of a loan or loans. These assets are recorded at the lower of the carrying amount of the loan or fair value less estimated costs to sell. This amount becomes the property’s new basis. Any write-downs based on the property fair value less estimated cost to sell at the date of acquisition are charged to the allowance for loan and lease losses. Management periodically reviews OREO and other repossessed assets in an effort to ensure the property is carried at the lower of its new basis or fair value, net of estimated costs to sell. Any write-downs subsequent to acquisition are charged to earnings.

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Certain assets and liabilities are measured at fair value on a recurring or nonrecurring basis. Recurring assets are initially measured at fair value and are required to be remeasured at fair value in the financial statements at each reporting date. Assets measured on a nonrecurring basis are assets that due to an event or circumstance were required to be remeasured at fair value after initial recognition in the financial statements at some time during the reporting period. The following tables present fair value measurements for assets that are measured at fair value on a recurring basis subsequent to initial recognition for the periods shown:

(dollars in thousands)	Balance		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
March 31, 2010
Available for sale securities
U.S. Agency mortgage-backed securities	$	19,769	$	—	$	19,769	$	—
Non-agency mortgage-backed securities		12,270		—		12,270		—
Municipal bonds		21,919		—		21,919		—
Other securities		549		514		35		—
Total recurring basis	$	54,507	$	514	$	53,993	$	—
December 31, 2009
Available for sale securities
U.S. Agency mortgage-backed securities	$	22,736	$	—	$	22,736	$	—
Non-agency mortgage-backed securities		3,385		—		3,385		—
Municipal bonds		21,825		—		21,825		—
Other securities		545		510		35		—
Total recurring basis	$	48,491	$	510	$	47,981	$	—

The following tables present fair value measurements for assets that have been measured at fair value on a nonrecurring basis during the reporting period:

(dollars in thousands)	Balance		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
March 31, 2010
Loans measured for impairment (1)	$	27,193	$	—	$	—	$	27,193
Other real estate owned (2)		4,262		—		—		4,262
Total nonrecurring basis	$	31,455	$	—	$	—	$	31,455
December 31, 2009
Loans measured for impairment (1)	$	19,480	$	—	$	—	$	19,480
Other real estate owned (2)		4,348		—		—		4,348
Goodwill (3)		—		—		—		—
Total nonrecurring basis	$	23,828	$	—	$	—	$	23,828

(1) Impaired loans included in the table above are collateral dependent and have been adjusted to fair value based on the estimated fair value of the underlying collateral, less selling costs. If the Bank determines that the value of an impaired loan is less than the recorded investment in the loan, the carrying value is adjusted through a charge-off recorded through the allowance for loan losses.

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(2) Loans receivable transferred to foreclosed assets during the three month period ended March 31, 2010 with a carrying value totaling $949,000 were written down to their fair value less cost to sell totaling $912,300, resulting in a loss of $37,000 which was charged to the allowance for loan losses. Loans receivable transferred to foreclosed assets during the year ended December 31, 2009 with a carrying value totaling $8.8 million were written down to their fair value less cost to sell totaling $6.2 million, resulting in a loss of $2.6 million, which was charged to the allowance for loan losses.

(3) A 100 percent goodwill impairment charge of $1.8 million was charged to earnings during the year ended December 31, 2009.

The following tables present losses recognized in the statement of operations that arose from present fair value measurements of nonrecurring assets for the periods presented:

	Three months ended March 31,
(dollars in thousands)		2010		2009
Other real estate owned	$	630	$	—
Total loss from nonrecurring measurements	$	630	$	—

Financial Disclosures about Fair Value of Financial Instruments

ASC Subtopic 825-10 requires disclosure of the estimated fair value of certain financial instruments and the methods and significant assumptions used to estimate their fair values. Certain financial instruments and all nonfinancial instruments are excluded from the scope of the Subtopic. Accordingly, the fair value disclosures required by the Subtopic are only indicative of the value of individual financial instruments and should not be considered an indication of the fair value of the Company.

The estimated fair values of all of the Company’s financial instruments at March 31, 2010 and December 31, 2009 were as follows:

	March 31, 2010				December 31, 2009
(dollars in thousands)	Carrying Amount		Fair Value		Carrying Amount		Fair Value
Financial assets:
Cash and cash equivalents	$	133,764	$	133,764	$	139,705	$	139,705
Investment securities		54,507		54,507		48,491		48,491
Restricted equity securities		1,247		1,247		1,247		1,247
Loans, net of allowance for loan losses and deferred loan fees		310,310		296,811		333,163		311,264
Financial liabilities:
Non-interest-bearing demand deposits	$	45,292	$	45,292	$	46,510	$	46,510
Savings and interest-bearing demand deposits		58,236		58,236		59,615		59,615
Money market deposits		34,233		34,233		34,452		34,452
Certificates of deposit		375,821		377,969		383,194		385,465
Junior subordinated debentures		12,372		2,036		12,372		2,944

The following methods and assumptions were used to estimate the fair value of each class of financial instrument not stated above, for which it is practicable to estimate that value:

Cash and cash equivalents– For these short-term instruments, the carrying amount is a reasonable estimate of fair value.

Restricted equity securities–The carrying amount approximates fair value.

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Loan receivables – Fair values are estimated for portfolios of loans with similar financial characteristics. Loans are segregated by type, including commercial, real estate and consumer loans. Each loan category is further segregated by fixed and variable rate, performing and nonperforming categories. The carrying values of variable rate loans approximate fair value. The fair values of fixed rate loans are calculated by discounting contractual cash flows at rates which similar loans are currently being made. The 2010 and 2009 fair value calculations of real estate construction and development loans and nonperforming loans have been further discounted by a liquidity factor related to the current market environment.

Deposit liabilities – The fair values disclosed for demand deposits are, by definition, equal to the amount payable on demand at the reporting date (that is, their carrying amounts). The carrying amounts of variable rate money market accounts and savings accounts approximate their fair values at the reporting date. Fair values for fixed rate CDs are estimated using a discounted cash flow calculation that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits.

Junior subordinated debentures – The fair value is estimated using discounted cash flow analysis, based on the current rate for similar debentures.

Commitments to extend credit, credit card commitments and standby letters of credit– The fair values of off-balance sheet commitments to extend credit, credit card commitments and standby letters of credit are not considered practicable to estimate because of the lack of quoted market prices and the inability to estimate fair value without incurring excessive costs.

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

Critical Accounting Policies and Estimates

Allowance for Credit Losses

The allowance for credit losses represents the estimate of probable losses associated with the Bank’s loan portfolio and commitments to extend credit. The Company utilizes both quantitative and qualitative considerations in establishing the allowance for credit losses believed to be appropriate as of each reporting date.

Quantitative factors include:

• the volume and severity of non-performing loans and adversely classified credits,

• the level of net charge-offs experienced on previously classified loans,

• the nature and value of collateral securing the loans,

• the trend in loan growth and the percentage of change,

• the level of geographic and/or industry concentration,

• the relationship and trend over the past several years of recoveries in relation to charge-offs, and

• other known factors regarding specific loans.

Qualitative factors include:

• the effectiveness of credit administration,

• the adequacy of loan review,

• the adequacy of loan operations personnel and processes,

• the effect of competitive issues that impact loan underwriting and structure,

• the impact of economic conditions, including interest rate trends,

• the introduction of new loan products or specific marketing efforts,

• large credit exposure and trends, and

• industry segments that are exhibiting stress.

Changes in the above factors could significantly affect the determination of the adequacy of the allowance for credit losses. Management performs a full analysis, no less often than quarterly, to ensure that changes in estimated loan loss levels are adjusted on a timely basis. For further discussion of this significant management estimate, see “Allowance for Credit Losses.”

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Income Taxes

The Company uses the asset and liability method of accounting for income taxes. Determination of the deferred and current provision requires analysis by management of certain transactions and the related tax laws and regulations. Management exercises significant judgment in evaluating the amount and timing of recognition of the resulting tax liabilities and assets. Those judgments and estimates are re-evaluated on a continual basis as regulatory and business factors change.

The Company periodically reviews the carrying amount of its deferred tax assets to determine if the establishment of a valuation allowance is necessary. If, based on the available evidence, it is more likely than not that all or a portion of the Company’s deferred tax assets will not be realized in future periods, a deferred tax valuation allowance is established. Consideration is given to all positive and negative evidence related to the realization of the deferred tax assets.

In evaluating the available evidence, management considers historical financial performance, expectation of future earnings, the ability to carryback losses to recoup taxes previously paid, length of statutory carryforward periods, experience with operating loss and tax credit carryforwards not expiring unused, tax planning strategies and timing of reversals of temporary differences. Significant judgment is required in assessing future earnings trends and the timing of reversals of temporary differences. The Company’s evaluation is based on current tax laws as well as management’s expectations of future performance based on its strategic initiatives. Changes in existing tax laws and future results that differ from expectations may result in significant changes in the deferred tax asset valuation allowance.

The Company’s deferred tax position has been affected by several significant transactions in the past three years. These transactions included other-than-temporary impairment charges of certain investments and continued elevated levels of provision for credit losses and, as a result, the Company is in a cumulative net loss position since the fourth quarter of 2007. Under the applicable accounting guidance, the Company has concluded that it is not “more likely than not” that the Company will be able to realize its deferred tax assets and, accordingly has established a full valuation allowance totaling $23.0 million and $17.6 million against its net deferred tax asset at March 31, 2010 and December 31, 2009, respectively. The valuation allowance will be analyzed quarterly for changes affecting the deferred tax assets. If, in the future, the Company generates taxable income on a sustained basis, management’s conclusion regarding the need for a deferred tax asset valuation allowance could change, resulting in the reversal of a portion or all of the deferred tax asset valuation allowance.

Foreclosed Real Estate and Other Foreclosed Assets

As of March 31, 2010, approximately 79 percent of the Company’s loan portfolio was secured by real estate. In the event of customer default, the Company’s principal source of repayment is derived through the foreclosure and ultimate liquidation of real estate collateral. Upon receiving title to a property, the Company transfers the related balance from loans to other real estate owned in an amount equal to the lesser of the carrying value of the loan less estimated selling costs, or the appraised amount of the property less estimated selling costs and market discount. Any loss realized upon the initial transfer to other real estate owned is recognized as a loan charge-off.

The estimated selling costs are based upon current real estate commission rates for comparable properties. Appraised values are discounted if, in the opinion of management, the values do not fully reflect current market conditions. In determining the amount of a market discount, if any, management considers bona fide offers received on the subject or similar properties, the level of supply of similar properties, management’s judgment of other property specific attributes and expectations about future market conditions. Any additional impairment, along with any costs associated with insurance or maintenance, are recognized as a charge to current period earnings.

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Recent Developments

As reported in the Company’s Form 8-K dated February 2, 2010, the Bank stipulated to the issuance of a Consent Order (the “Order”) with the Federal Deposit Insurance Corporation (the “FDIC”) and the Washington Department of Financial Institutions (the “DFI”), based on certain findings from an examination of the Bank concluded in August 2009. In entering into the stipulation and consenting to entry of the Order, the Bank did not concede the findings or admit to any of the assertions therein. Copies of the Stipulation and the Order were included as Exhibit 99.1 to the Form 10-K filed March 31, 2010.

On May 6, 2010, the FDIC and DFI concluded a visitation of the Bank as part of its normal regulatory oversight process for banks with outstanding Orders. The financial statements as of March 31, 2010 incorporate all adjustments as a result of the visitation. Due to the asset quality deterioration and the significant provisions for loan losses the Company has made in current and prior periods, the Company’s and Bank’s capital levels have been significantly reduced and, in the case of the Company, is now negative. The Company expects the Bank to be categorized as “critically under-capitalized” by the FDIC and DFI upon completion of their report. The Bank’s Tier 1 leverage ratio at March 31, 2010 was 1.89 percent, which is under the 2.00 percent threshold for being categorized as “critically undercapitalized”.

The FDI Act and related regulations require or permit the FDIC to take certain mandatory and discretionary actions when an institution becomes critically under-capitalized. Mandatory requirements of the FDI Act include submission of a capital restoration plan and restrictions on asset growth, acquisitions, new activities, and new branches. Further restrictions apply to the payment of dividends or making any other capital distribution, management fees, or senior executive compensation. Unless otherwise determined, the FDIC must impose restrictions on affiliate transactions and on the interest rates paid on deposits and must require either the recapitalization or sale of the Bank. Other mandatory actions for critically under-capitalized institutions include prohibition of the following without the FDIC’s prior written approval: entering into any material transaction other than in the usual course of business, extending credit for any highly leveraged transaction, amending the institution’s charter or bylaws, making any material change in accounting methods, paying excessive compensation or bonuses, and paying interest on deposits above specified levels. As a result of being critically under-capitalized, the Bank will also be subject to various actions that the FDIC may take, including requiring recapitalization, restriction transactions with affiliates, restricting interest rates paid on deposits, restricting asset growth, improving management, prohibiting deposits from correspondent banks, prohibiting dividends and distributions from the holding company and requiring divestitures. By June 30, 2010, the FDIC is required to take further action to require the Bank to improve its condition.

Under the terms of the Consent Order, the Bank cannot declare dividends or make distributions to Cowlitz Bancorporation without the prior written approval of the FDIC and the DFI. Other material provisions of the Order require the Bank to:

• Recapitalize the Bank. The Order required the Bank to increase the Bank’s Tier 1 leverage capital to 10 percent of total assets by April 27, 2010 and prepare a risk-based capital maintenance plan. The Bank did not achieve the 10 percent Tier 1 leverage capital by the required date. Management and its financial advisers are continuing aggressive efforts to enhance the Bank’s regulatory capital ratios primarily through sale of new equity securities to private investors.

• Retain qualified senior executive officers, with written authority from the Board to implement the provisions of the Order. The Bank believes that it has the appropriate management as required by the Order.

• Provide 30 days’ prior notice to the FDIC and DFI in advance of proposed changes in senior management or the Board of Directors. The Bank has not added anyone to the Board of Directors or employed any new senior executive officer since the effective date of the Order.

• Establish a comprehensive policy for determining and documenting the level of the Bank’s allowance for loan and lease loss (ALLL), to include a review of the ALLL at least quarterly and correction of any deficiency in the ALLL indicated by the review. The Board of Directors has reviewed the Bank’s policies and procedures with respect to determining the adequacy of the ALLL and believes that such policies and procedures are adequate and appropriate. The Board of Directors has reviewed the ALLL quarterly and believes that it has been adequate.

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• Develop a written plan to reduce the amount of construction, development and commercial real estate loans and strictly limit new acquisition, development and construction lending. As of March 31, 2010, construction, development and commercial real estate loans have been reduced $58.7 million since the Report of Visitation (“ROV”) dated April 20, 2009 and $12.1 million since year end 2009.

• Develop a written plan to reduce assets adversely classified “substandard” or “doubtful” in excess of $50,000 to an acceptable level as determined by the FDIC and DFI at subsequent examinations and/or visitations. Since the date of the Order, the amount of adversely classified assets has decreased but the level of capital has also decreased.

• Refrain from extending credit to or for the benefit of (i) any borrower who has an extension of credit from the Bank that has been charged off or classified, in whole or in part, “Loss,” or (ii) any borrower who has an extension of credit from the Bank that has been classified, in whole or in part, “Doubtful or Substandard,” without prior approval of the Board of Directors or the Bank’s loan committee and collection of all interest due. Since the date of the Order, the Bank has not made any extensions of credit in violation of the limitations.

• Develop a written plan, approved by its Board of Directors, to systematically reduce the Bank’s level of nonperforming and/or watch list assets to a level determined acceptable by the FDIC at subsequent examinations and/or visitations. At its March 24, 2010 meeting, the Board of Directors approved management’s plan to reduce the Bank’s nonperforming and/or watch list assets.

• Formulate and implement a three-year business plan to improve the Bank’s financial performance. Management submitted a three-year business plan addressing the improvement of the Bank’s financial performance to the Board of Directors. This plan was approved by the Board in April, 2010 and copies were furnished to the FDIC and DFI.

• Eliminate or correct all violations of law and contraventions of policy. The Bank has eliminated or corrected all violations of law and contraventions of policy since the ROV dated April 29, 2009 and has taken appropriate steps to ensure future compliance with all applicable laws, regulations, Interagency Guidelines and Policy Statements.

• Prepare and submit to the FDIC and DFI a written plan to reduce the Bank’s level of brokered deposits, and maintain compliance with deposit interest rate restrictions as defined in Section 337.6 of the FDIC Rules and Regulations. The Bank provided a written plan to the FDIC and DFI on February 26, 2010. The Bank has reduced the level of brokered deposits from $199.4 million at July 31, 2009 to $134.7 million at March 31, 2010. The Bank is complying with the deposit pricing requirements of Section 337.6 and continues to monitor interest rates to maintain compliance with such requirements.

With the exception of achieving a 10 percent Tier 1 leverage ratio requirement by April 27, 2010, the Bank believes it has taken steps to comply with all of the other provisions of the Order. The Company expects to submit to the FDIC a written capital restoration plan by May 24, 2010. The additional capital required to satisfy the requirements of the Order as of March 31, 2010 was approximately $45 million.

Although management has undertaken actions to comply with all aspects of the Order, there is no assurance that full compliance will be achieved. As a result, the Bank could become subject to further restrictions or to penalties. The Company will also face additional restrictions from the Board of Governors of the Federal Reserve based on the Bank’s and Company’s capitalization and other conditions giving rise to the Order. Full satisfaction of the Order’s requirements depends almost exclusively on raising a significant amount of additional capital.

While there are a number of financial institutions of similar size and condition that have been attempting to raise capital over the past year, there has been a very limited amount of private equity that has been raised. Although the Company has not been successful to date in obtaining private equity, it has engaged in numerous discussions and due diligence with private equity investors. The Company will continue to vigorously pursue contacts and discussions with prospective investors. The Company also is continuing its strategy to significantly reduce loans, thereby reducing the required level of capital.

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Results of Operations for the Three Months Ended March 31, 2010 and 2009

Executive Overview

Results of Operations

The Company’s net loss for the first quarter of 2010 was $12.2 million, or $23.77 per diluted share, compared with net loss of $1.9 million or $3.72 per diluted share for the first quarter of 2009. The 2009 per share amounts have been adjusted to reflect the one-for-ten reverse stock split effective for the Company’s common shares as of March 1, 2010.

Significant items affecting the first quarter 2010 financial results were:

• Loans decreased $21.0 million, or six percent, as of March 31, 2010 from December 31, 2009, reflecting goals to reduce real estate loan concentrations and reduce assets and related capital requirements, as well as charge-offs.

• Nonperforming assets decreased $7.8 million, or 15 percent, from December 31, 2009. Nonperforming assets equaled 8.50 percent of total assets at March 31, 2010 compared with 9.56 percent at December 31, 2009.

• Provision for credit losses was $9.7 million and net charge-offs were $8.0 million compared with a $3.5 million provision and net charge-offs of $8.7 million in the first quarter of the prior year. The level of provisioning and charge-offs in 2010 continues to reflect the decline in appraised values in collateral dependent loans, especially in the residential land development portfolio. The allowance for credit losses, as a percentage of total loans, was 3.75 percent at March 31, 2010.

• Net interest margin decreased 110 basis points in the first quarter of 2010 compared with the first quarter of 2009 mainly due to the increase in nonaccrual loans and maintaining significant levels of on-balance sheet liquidity. The average cost of interest-bearing liabilities decreased to 2.49 percent from 3.05 percent in the prior year quarter.

• Noninterest income increased $132,000 in the first quarter of 2010 over the first quarter of 2009, primarily due to death benefits from the settlement of a Bank owned life insurance policy. International trade fees and wire fees decreased $73,000, or 79 percent, due to the planned reduction in the number of non-resident relationships serviced by the Bank’s international trade and wire department. Service charges decreased $42,000, or 18 percent.

• Total noninterest expense was $6.2 million in the first quarter of 2010 compared with $5.1 million in the respective quarter of 2009:

• Salaries and employee benefits decreased $199,000.

• Professional services increased $52,000, or nine percent, and loan collection and related expenses increased $482,000, primarily due to the higher level of nonperforming loans.

• Foreclosed asset expenses increased $826,000, primarily due to write-downs on five real estate properties totaling $630,000 and $159,000 of losses on sale of other real estate owned.

Analysis of Net Interest Income

The primary component of the Company’s earnings is net interest income. Net interest income is the difference between interest income, principally from loans and the investment securities portfolio, and interest expense, principally on customer deposits and borrowings. Changes in net interest income, net interest spread, and net interest margin result from changes in asset and liability volume and mix, and to rates earned or paid. Net interest spread refers to the difference between the yield on interest-earning assets and the cost of interest-bearing liabilities. Net interest margin is the ratio of net interest income to total interest-earning assets and is influenced by the volume and relative mix of interest-earning assets and interest-bearing liabilities. Volume refers to the dollar level of interest-earning assets and interest-bearing liabilities.

Interest income from certain of the Company’s earning assets is non-taxable. The following tables present interest income and expense, including adjustments for non-taxable interest income, and the resulting tax-adjusted yields earned, rates paid, interest rate spread, and net interest margin for the periods indicated. Nonaccrual loans have been included in the table as loans carrying a zero yield. Loan fees are amortized to interest income over the life of the loan.

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	For the Quarter Ended March 31,
	2010							2009
(dollars in thousands)	Average Outstanding Balance			Interest Earned/ Paid		Yield/ Rate		Average Outstanding Balance			Interest Earned/ Paid		Yield/ Rate
Assets
Interest-Earning Assets:
Loans (1) (2) (3)	$	335,946		$	4,966	5.99	%	$	431,166		$	6,985	6.57	%
Taxable securities		28,717			385	5.44	%		41,702			545	5.30	%
Non-taxable securities (2)		22,006			343	6.32	%		21,903			350	6.48	%
Federal funds sold		—			—	—			44,165			28	0.26	%
Interest-earning balances due from banks and FHLB stock		135,872			77	0.23	%		2,484			1	0.16	%
Total interest-earning assets (2)		522,541			5,771	4.48	%		541,420			7,909	5.92	%
Cash and due from banks		8,602							15,713
Allowance for loan losses		(10,904	)						(13,241	)
Other assets		29,939							44,465
Total assets	$	550,178						$	588,357
Liabilities and Shareholders’ Equity
Interest-Bearing Liabilities:
Savings, money market and interest-bearing demand deposits	$	92,194		$	147	0.65	%	$	98,775		$	209	0.86	%
Certificates of deposit		384,792			2,798	2.95	%		364,243			3,257	3.63	%
Junior subordinated debentures		12,372			61	2.00	%		12,372			109	3.57	%
Other borrowings		5			—	9.00	%		41			1	8.83	%
Total interest-bearing liabilities		489,363			3,006	2.49	%		475,431			3,576	3.05	%
Noninterest-bearing deposits		46,979							59,686
Other liabilities		4,270							4,549
Total liabilities		540,612							539,666
Shareholders’ Equity		9,566							48,691
Total liabilities and shareholders’ equity	$	550,178						$	588,357
Net interest income (2)				$	2,765						$	4,333
Net interest spread						1.99	%						2.87	%
Yield on average interest-earning assets						4.48	%						5.92	%
Interest expense to average interest-earning assets						2.33	%						2.68	%
Net interest income to average interest-earning assets (net interest margin)						2.15	%						3.25	%

(1) Loans include loans on which the accrual of interest has been discontinued.

(2) Interest earned on non-taxable securities and loans has been computed on a 34 percent tax-equivalent basis.

(3) Loan interest income includes net loan fee amortization of $130,000 and $286,000 for the first quarter of 2010 and 2009, respectively.

The net interest margin as a percentage was 2.15 percent in the first quarter of 2010, compared with 3.25 percent in the same quarter last year. Tax-equivalent net interest income for the three month period ended March 31, 2010 was down $1.6 million from the same period in 2009. Net interest income in 2010 relative to net interest income in 2009 was affected by several factors, including lower loan volumes and fees, the termination of the Company’s interest rate contracts, higher levels of nonperforming loans, higher levels of low yielding cash-equivalent investments and a lower level of non-interest-bearing demand and low-cost money market deposit accounts.

The Company’s yield on average earning assets was 4.48 percent in the first quarter of 2010, compared with 5.92 percent in the first quarter of 2009. The Company estimates that foregone interest on nonaccrual loans of $695,000 reduced the net interest margins for the three month period ended March 31, 2010 by 53basis points. Foregone interest reduced the net interest margin by 47 basis points in the same period of 2009.

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The average rate on interest-bearing liabilities fell to 2.49 percent in the first quarter of 2010 from 3.05 percent in the first quarter of 2009. Average funding costs have improved as higher cost deposits that have matured in the past 15 months have been replaced in a lower interest rate environment.

Provision for Credit Losses

The amount of the allowance for credit losses is analyzed by management on a regular basis to ensure that it is adequate to absorb losses inherent in the loan portfolio as of the reporting date. When a provision for credit losses is recorded, the amount is based on, among other things, the current volume of loans and commitments to extend credit, industry concentrations, delinquency trends, past charge-off experience, management’s assessment of the risk of loss on current loans, the level of nonperforming and impaired loans, evaluation of future economic trends in the Company’s market area, and other factors relevant to the loan portfolio. An internal loan risk grading system is used to evaluate potential losses of individual loans. The Company does not, as part of its analysis, group loans together by loan type to assign risk. See “Allowance for Credit Losses” disclosure for a more detailed discussion.

The Company recorded a provision for credit losses of $9.7 million and $3.5 million for the three months ended March 31, 2010 and 2009, respectively. Net charge-offs of $8.0 million and $8.7 million were recorded for the three months ended March 31, 2010 and 2009, respectively. Charge-offs in the first quarter of 2010 consisted primarily of $4.4 million in real estate construction loans. The level of charge-offs in 2010 to-date primarily reflected the continued decline in appraised values of residential land development properties.

Non-Interest Income

Non-interest income consisted of the following components:

	Three Months Ended March 31,
(dollars in thousands)	2010		2009
Service charges on deposit accounts	$	188	$	230
Fiduciary income		244		226
Increase in cash surrender value of bank-owned life insurance		157		150
International trade fees		12		63
Wire fees		7		29
Mortgage brokerage fees		60		60
Other income		327		116
Other-than-temporary impairment charges on securities		—		(11	)
Total noninterest income	$	995	$	863

Total non-interest income for the three months ended 2010 was $995,000 compared with $863,000 in the respective period of last year. The increase in non-interest income in the first quarter of 2010 was primarily attributable to $208,000 in death benefits from the settlement of a Bank owned life insurance policy. Service charges on deposit accounts were down $42,000 in the first quarter of 2010 when compared with the first quarter of 2009, partially due to a reduction in the number of non-resident relationships served by the Seattle-based international trade department which took place in the first quarter of 2009. Average transaction account balances were down $19.3 million from the first quarter of 2009. The reduction in the number of non-resident relationships also contributed to the reduction in international trade fees and wire fees of $73,000 when compared to the first quarter of 2009.

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Non-Interest Expense

Non-interest expense consisted of the following components:

	Three Months Ended March 31,
(dollars in thousands)	2010		2009
Salaries and employee benefits	$	1,986	$	2,185
Net occupancy and equipment		644		640
Professional services		622		570
Data processing and communications		248		311
Federal deposit insurance		515		491
Foreclosed asset expense		886		60
Loan collection and related expenses		534		52
Other expense		773		827
Total noninterest expense	$	6,208	$	5,136

Noninterest expenses in the first quarter of 2010 were $6.2 million, compared with $5.1 million in the same period of 2009. Salaries and employee benefits decreased $199,000, or nine percent, in the first quarter of 2010 compared with the respective period of 2009, primarily due to elimination of incentive compensation plans for 2010.

Professional services increased $52,000 over the same period in 2009. Legal expense for loans increased $150,000 in the first quarter of 2010 primarily due to the higher volume of nonperforming loans. Consulting fees decreased $69,000 in the first three months of 2010 when compared to the same period in 2009, primarily due to external assistance with information technology initiatives that were incurred in the first quarter of 2009 and none in the same period in 2010.

Data processing and communications were down $63,000 as fewer costs were incurred related to the core processing system and communications network in the first quarter of 2010 compared with the first quarter of 2009.

Foreclosed asset expense increased $826,000 in the first quarter of 2010 when compared with the respective quarter in 2009, primarily due to first quarter 2010 write-downs on five real estate properties totaling $630,000 and other real estate properties sold in the same period for a net loss of $159,000.

Loan collection and related expenses were higher by $482,000 in the first three months of 2010 due to an increase in appraisal and collection expenses associated with nonperforming loans.

Income Taxes

As discussed in Note 11 to the Consolidated Financial Statements in Part I, Item 1, all tax benefits from operating losses in 2010 and 2009 have been deferred and all net deferred tax assets have been fully reserved. A 100 percent valuation allowance has been established against the Company’s net deferred tax assets of $23.0 million at March 31, 2010. Excluding the impact of the deferred tax valuation allowance, the benefit for income taxes would have been 40.9 percent for the first quarter of 2010. This compares with a benefit rate of 47.0 percent for the first quarter of 2009. The Company’s annual tax benefit or expense is affected by the amounts of non-taxable loan, investment security and bank-owned life insurance income, as well as available tax credits.

Recent tax legislation lengthened the period to carry back tax losses from two to five years for financial institutions. As a result, the Company reduced its deferred tax asset valuation allowance by $93,000 in the first quarter of 2010 to reflect a receivable of alternative minimum tax paid in prior years. In addition, the Company paid and expensed $6,000 of Oregon state income taxes.

The ability of the Company to recognize any tax benefit from its deferred tax assets in the future, even if it is successful in raising additional capital and attaining future profitability, may be limited by the current Internal Revenue Code. In addition, due to restrictions regarding the amount of deferred tax assets allowable in the determination of regulatory capital, the Company does not expect any material positive impact on the Company’s or Bank’s regulatory capital ratios related to the benefits of its deferred tax assets.

Financial Condition

Investment Securities

All of the Bank’s securities are classified as available for sale and carried at fair value. From time to time securities may be sold to reposition the portfolio in response to strategies developed by the Bank’s asset-liability committee.

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The following table presents the composition and carrying value of the Company’s available for sale investment portfolio:

(dollars in thousands)	March 31, 2010		December 31, 2009
U.S. Agency mortgage-backed securities	$	19,769	$	22,736
Non-agency mortgage-backed securities		12,270		3,385
Municipal bonds		21,919		21,825
Other securities		549		545
	$	54,507	$	48,491

Total investment securities as of March 31, 2010 increased $6.0 million from December 31, 2009 due primarily to the purchase of seven non-agency mortgage-backed securities. The Company’s securities portfolio consisted of 36 percent of U.S. Agency mortgage-backed securities, 40 percent municipal bonds, and 23 percent non-agency mortgage-backed securities and one percent other securities. The following table presents the composition, amortized cost and estimated fair value of the Company’s available for sale investment portfolio:

(dollars in thousands) March 31, 2010:	Amortized Cost		Unrealized Gains		Unrealized Losses			Fair Value
U.S. Agency mortgage-backed securities	$	18,722	$	1,047	$	—		$	19,769
Non-agency mortgage-backed securities		13,042		54		(826	)		12,270
Municipal bonds		21,322		734		(137	)		21,919
Other securities		535		14		—			549
	$	53,621	$	1,849	$	(963	)	$	54,507
December 31, 2009:	Amortized Cost		Unrealized Gains		Unrealized Losses			Fair Value
U.S. Agency mortgage-backed securities	$	21,714	$	1,022	$	—		$	22,736
Non-agency mortgage-backed securities		4,186		22		(823	)		3,385
Municipal bonds		21,326		652		(153	)		21,825
Other securities		535		10		—			545
	$	47,761	$	1,706	$	(976	)	$	48,491

At March 31, 2010, the market value of securities available for sale had net unrealized gains of $886,000 compared with $730,000 at December 31, 2009. Gross unrealized gains totaled $1.8 million and gross unrealized losses totaled $963,000 at March 31, 2010 compared with gross unrealized gains of $1.7 million and gross unrealized losses of $976,000 at December 31, 2009. The majority of unrealized losses at March 31, 2010 related to non-agency mortgage-backed securities (“MBS”), with the balance related to certain municipal bonds. The Company believes the unrealized losses on municipal bonds are due to market conditions, not in estimated cash flows. The Company does not have the intent to sell these securities and does not anticipate that these securities will be required to be sold before anticipated recovery, and expects full principal and interest to be collected. Therefore, the Company does not consider its municipal bonds to be other-than-temporarily impaired (“OTTI”).

As of March 31, 2010, gross unrealized losses related to the Company’s non-agency MBS was $826,000, or six percent, of the aggregate cost basis of these securities. The gross unrealized losses associated with these securities were primarily due to extraordinarily high investor yield requirements resulting from an extremely illiquid market, significant uncertainty about the future condition of the mortgage market and economy, and continued deterioration in the credit performance of loan collateral underlying these securities, causing these securities to be valued at significant discounts to their acquisition cost. The Company has ten non-agency MBS, two of which have been in a loss position for greater than 12 months. The Company’s analysis on one non-agency MBS rated less than investment grade indicated a shortfall of estimated contractual cash flows to the tranche of this security owned by the Company. Accordingly, the Company recorded OTTI losses of $86,000 in 2009 because the loss was credit related and it is probable the Company will not recover the entire cost basis of the security. No OTTI charges related to this security were recorded in the first quarters of 2010 and 2009. Management will continue to monitor the credit performance of this security and if the performance deteriorates from current levels, additional OTTI losses may be recognized in the future. The unrealized losses on the other non-agency mortgage backed securities were due to changes in market interest rates or widening of market spreads subsequent to the initial purchase of the securities and not credit quality. The Company does not have the intent to sell these securities and does not anticipate that these securities will be required to be sold before anticipated recovery, and expects full principal and interest to be collected. Therefore, the Company does not consider these investments to be OTTI at March 31, 2010.

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Restricted Equity Securities

Restricted equity securities were $1.2 million at March 31, 2010 and December 31, 2009, and consisted primarily of the Bank’s investment in the Federal Home Loan Bank of Seattle (“FHLB”). FHLB stock is carried at par and does not have a readily determinable fair value. Ownership of FHLB stock is restricted to the FHLB and member institutions, and can only be purchased and redeemed at par.

Management periodically evaluates FHLB stock for other-than-temporary or permanent impairment. Management’s determination of whether these investments are impaired is based on its assessment of the ultimate recoverability of cost rather than by recognizing temporary declines in value. The determination of whether a decline affects the ultimate recoverability of cost is influenced by criteria such as: (1) the significance of any decline in net assets of the FHLB as compared to the capital stock amount for the FHLB and the length of time this situation has persisted; (2) commitments by the FHLB to make payments required by law or regulation and the level of such payments in relation to the operating performance of the FHLB; (3) the impact of legislative and regulatory changes on institutions and, accordingly, the customer base of the FHLB; and (4) the liquidity position of the FHLB.

Under Federal Housing Finance Agency regulations, a FHLB that fails to meet any regulatory capital requirement may not declare a dividend or redeem or repurchase capital stock in excess of what is required for members’ current loans. Moody’s Investors Service (Moody’s) current assessment of the FHLB’s portfolios indicates that the true economic losses embedded in these securities are significantly less than the accounting impairments would suggest and are manageable given the FHLB’s capital levels. According to Moody’s, the large difference between the expected economic losses and the mark-to-market impairment losses for accounting purposes is attributed to market illiquidity, de-leveraging and stress in the credit market in general. The FHLBs have access to the U.S. Government-Sponsored Enterprise Credit Facility, a secured lending facility that serves as a liquidity backstop, substantially reducing the likelihood that the FHLBs would need to sell securities to raise liquidity and, thereby, cause the realization of large economic losses. In addition, the Federal Reserve has begun to purchase direct debt obligations of Freddie Mac, Fannie Mae and the FHLBs. Based on the above, the Company has determined there is not an other-than-temporary impairment of the FHLB stock investment as of March 31, 2010.

Loans

Total loans outstanding were $322.3 million and $343.3 million at March 31, 2010 and December 31, 2009, respectively. The Company reduced loans $21.0 million, or six percent, from year-end 2009 balances. This loan reduction reflected the Company’s goals of reducing real estate loan concentrations and decreasing assets to reduce its capital requirements. Loan reductions have been achieved primarily through non-renewal of loans. Loan charge-offs also contributed to reduced loan balances. Unfunded loan commitments were $23.5 million at March 31, 2010 and $28.0 million at December 31, 2009. Management believes that the Bank’s available resources will be sufficient to fund its commitments in the normal course of business.

The following table presents the composition of the Company’s loan portfolio, in accordance with bank regulatory guidelines for preparation of the call report at the dates indicated:

	March 31, 2010				December 31, 2009
(dollars in thousands)	Amount		Percent		Amount		Percent
Commercial	$	63,914	19.8	%	$	69,726	20.3	%
Real estate:
Construction		30,562	9.5	%		42,058	12.2	%
Residential 1-4 family		35,424	11.0	%		38,792	11.3	%
Multifamily		15,683	4.9	%		15,535	4.5	%
Commercial		174,533	54.0	%		175,105	50.9	%
Total real estate		256,202	79.4	%		271,490	78.9	%
Installment and other consumer		2,522	0.8	%		2,604	0.8	%
Total loans	$	322,638	100.0	%	$	343,820	100.0	%
Loans with fixed interest rates	$	152,682			$	152,926
Loans with variable interest rates		169,956				190,894
Total loans	$	322,638			$	343,820

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The Company’s real estate construction and land development loans were 10 percent of the loan portfolio at March 31, 2010, down from 12 percent at year-end 2009. The decrease primarily related to loan payoffs and the suspension of solicitation of additional business in construction and land development loans, as well as charge-offs. The following table illustrates real estate construction loans by project type.

	March 31, 2010				December 31, 2009
	Amount		Percent		Amount		Percent
Residential construction
1-4 family residential	$	2,875	9.4	%	$	4,601	10.9	%
Multi-family/condominiums		463	1.5	%		557	1.3	%
Residential land development		17,576	57.5	%		21,253	50.6	%
Commercial construction		9,648	31.6	%		15,647	37.2	%
	$	30,562	100.0	%	$	42,058	100.0	%

The Company’s commercial real estate loans as of March 31, 2010 were 54 percent of the loan portfolio compared to 51 percent at December 31, 2009. Management believes that commercial real estate collateral may provide an additional measure of security for these loans, and that lending to owner-occupied businesses mitigates, but does not eliminate, commercial real estate risk. The Company’s commercial real estate portfolio to-date has experienced low delinquency rates and only modest deterioration in the present downturn. However, no assurance can be given that residential real estate or other economic factors will not affect this portfolio. The table below illustrates the breakdown of the commercial real estate portfolio.

	March 31, 2010				December 31, 2009
	Amount		Percent		Amount		Percent
Commercial real estate
Owner occupied	$	98,418	56.4	%	$	103,468	59.1	%
Non-owner occupied		76,115	43.6	%		71,637	40.9	%
	$	174,533	100.0	%	$	175,105	100.0	%

Allowance for Credit Losses and Credit Quality

Credit risk is inherent in the Bank’s lending activities. The allowance for credit losses represents management’s estimate of inherent losses in the portfolio as of the date of the financial statements. The loan portfolio is regularly reviewed to evaluate the adequacy of the allowance for credit losses. In determining the level of the allowance, the Company estimates losses inherent in all loans and commitments to make loans, and evaluates non-performing loans to determine the amount, if any, necessary for a specific reserve. An important element in determining the adequacy of the allowance for credit losses is an analysis of loans by loan risk-rating categories. At a loan’s inception and periodically throughout the life of the loan, management evaluates the credit risk by using a risk-rating system. This grading system currently includes eleven levels of risk. Risk ratings range from “1” for the strongest credits to “10” for the weakest. A “10” rated loan would normally represent a loss. All loans rated 7-10 collectively comprise the Company’s “Watch List”. The specific grades from 7-10 are “watch list” (risk-rating 7), “special mention” (risk-rating 7.5), “substandard” (risk-rating 8), “doubtful” (risk-rating 9), and “loss” (risk-rating 10). When indicators such as operating losses, collateral impairment or delinquency problems show that a credit may have weakened, the credit will be downgraded as appropriate. Similarly, as borrowers bring loans current, show improved cash flows or improve the collateral position of a loan, the credits may be upgraded. The result of management’s ongoing evaluations and the risk ratings of the portfolio is an allowance currently consisting of four components: specific; general; special; and an amount available for other factors.

Specific Allowance. Loans on the Bank’s Watch List, as described above, are specifically reviewed and analyzed. Management considers in its analysis expected future cash flows, the value of collateral and other factors that may impact the borrower’s ability to pay. When significant conditions or circumstances exist on an individual loan indicating greater risk, a specific allowance may be allocated in addition to the general allowance percentage for that particular risk-rating.

General Allowance. All loans that do not require a specific allocation are subject to a general allocation based upon historic loss factors. In developing these loss factors, the portfolio is segmented into four categories (consumer, commercial and industrial, real estate construction and term commercial real estate). For each segment, a three-year loss migration analysis is performed to determine the probability and severity of losses as loans migrate downward through the Company’s risk-rating categories. The three-year loss migration model is also weighted so as to provide more effect of recent loss experience on the results.

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Special Allowance.Special allowances are established to facilitate changes in the Bank’s strategy and other factors. Special allocations are to take into consideration various factors that include, but are not limited to:

• effectiveness of credit administration;

• adequacy of loan review;

• the adequacy of loan operations personnel and processes;

• the trend in loan growth and the percentage of change;

• the level of geographic and/or industry concentration;

• the effect of competitive issues that impact loan underwriting and structure;

• the impact of economic conditions, including interest rate trends;

• the introduction of new loan products or special marketing efforts;

• large credit exposure and trends

Amounts Available for Other Factors. Management also attempts to ensure that the overall allowance appropriately reflects a margin for the imprecision necessarily inherent in estimates of expected credit losses. The quarterly analysis of specific and general allocations of the allowance is the principal method relied upon by management to ensure that changes in estimated credit loss levels are adjusted on a timely basis. In the analysis of the overall level of the allowance, management considers bank regulatory exam results and findings of external credit examiners in its quarterly evaluation of the allowance for credit losses.

Liability for Unfunded Credit Commitments. Management determines the adequacy of the liability for unfunded credit commitments based upon reviews of individual credit facilities, current economic conditions, the risk characteristics of the various categories of commitments and other relevant factors. The liability is based on estimates, which are evaluated on a regular basis, and, as adjustments become necessary, they are reported in earnings in the period in which they become known.

The following table shows the components of the allowance for credit losses for the periods indicated:

	March 31, 2010				December 31, 2009
(dollars in thousands)	Amount		Percent		Amount		Percent
General	$	8,179	68	%	$	8,227	79	%
Specific		2,187	18	%		1,720	17	%
Special		416	3	%		379	4	%
Amounts available for other factors		1,289	11	%		30	—	%
Total allowance for credit losses	$	12,071	100	%	$	10,356	100	%

Management’s evaluation of the loan portfolio resulted in a total allowance for credit losses of $12.1 million at March 31, 2010, compared with $10.4 million at December 31, 2009. The allowance for credit losses, as a percentage of total loans, was 3.75 percent at March 31, 2010 compared with 3.02 percent on December 31, 2009. The amount of the general reserve at March 31, 2010 decreased to 68 percent of the allowance from 79 percent of the allowance at December 31, 2009. The specific allowance increased from year-end 2009 primarily due to specific reserves being recorded on six collateral dependent loans totaling $9.8 million.

The allowance for credit losses is based upon estimates of probable losses inherent in the loan portfolio and the Company’s commitments to extend credit to borrowers. Overall, management believes the allowance for credit losses is adequate to absorb losses in the loan portfolio at March 31, 2010, although there can be no assurance that future loan losses will not exceed management’s current estimates or that the level of nonperforming loans will subside.

Charge-offs in the first three months of 2010 and 2009 totaled $8.5 million and $9.2 million, respectively. Of these totals, 52 percent in 2010 and 57 percent in 2009 were related to real estate construction loans. Such loans accounted for 10 percent of the total loan portfolio at March 31, 2010 and 36 percent of the total loans on nonaccrual status.

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The following table shows the Company’s loan loss performance for the periods indicated.

	Three Months Ended March 31,
(dollars in thousands)	2010			2009
Loans outstanding at end of period, net of deferred fees	$	322,286		$	418,199
Average loans outstanding during the period	$	335,946		$	431,166
Allowance for credit losses, beginning of period	$	10,356		$	13,994
Loans charged off:
Commercial		1,120			2,540
Real estate:
Construction		4,366			5,298
Residential 1-4 family		1,669			223
Commercial		1,290			1,161
Consumer and other		28			8
Total loans charged off		8,473			9,230
Recoveries:
Commercial		401			490
Real estate
Construction		55			3
Residential 1-4 family		1			—
Commercial		—			2
Consumer and other		4			5
Total recoveries		461			500
Net loans charged off during the period		8,012			8,730
Provision for credit losses		9,727			3,505
Allowance for credit losses, end of period	$	12,071		$	8,769
Ratio of net loans charged off to average loans, annualized		9.67	%		8.21	%
Components:
Allowance for loan losses	$	11,976		$	8,427
Liability for unfunded credit commitments		95			342
Total allowance for credit losses	$	12,071		$	8,769
Allowance for loan losses/total loans		3.72	%		2.02	%
Allowance for credit losses/total loans		3.75	%		2.10	%
Allowance for loan losses/nonperforming loans		29	%		26	%
Allowance for credit losses/nonperforming loans		30	%		27	%

At March 31, 2010, the Company’s recorded investment in impaired loans was $40.8 million, compared with $48.5 million at December 31, 2009. A specific reserve of $2.2 million was recorded on six loans totaling $9.8 million at March 31, 2010. The remaining loans were carried at the lower of the loan’s contractual balance or the estimated fair value of collateral, with corresponding charges to the allowance for loan losses. The Company’s impaired loans are expected to be resolved over the coming quarters; however, further declines in collateral market prices could materially affect the Company’s results of operations and financial condition.

The Company reviews the loans in its portfolio regularly for impairment. A loan is impaired when, based on current information and events, it is probable that the Bank will be unable to collect all interest and principal due. A loan is not considered to be impaired during a period of minimal delay (less than 90 days) unless available information strongly suggests impairment. The Bank measures impaired loans based on the present value of expected future cash flows discounted at the loan’s effective interest rate or, as a practical expedient, at the loan’s observable market price or the fair market value of the collateral if the loan is collateral dependent. In determining the fair value of collateral, the Company obtains external appraisals. Appraisals are obtained at least annually and more frequently if market factors dictate. Although an external appraisal is the primary source to value collateral dependent loans, we may also utilize values obtained through purchase and sale agreements, broker price opinions, or the sales price of the note. These alternative sources of value are used only if deemed to be more representative of value based on updated information regarding collateral resolution. Impairment analyses are updated, reviewed and approved on a quarterly basis at or near the end of each reporting period. Based on these processes, we do not believe there are significant time lapses for the recognition of additional loan loss provisions or charge-offs from the date they become known.

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Non-performing assets include repossessed real estate or other assets and loans for which the accrual of interest has been suspended. The following table presents information on the Company’s non-performing assets, classified by bank regulatory guidelines for the preparation of the Call Report, and loans past due greater than 90 days and still accruing interest at the dates indicated:

(dollars in thousands)	March 31, 2010			December 31, 2009
Loans on nonaccrual status
Commercial	$	3,186		$	5,668
Real estate
Construction
1-4 family residential		2,055			2,394
Other construction		12,518			17,097
Total construction		14,573			19,491
Residential 1-4 family		7,771			7,476
Commercial real estate		15,252			15,846
Total real estate		37,596			42,813
Total nonaccrual loans		40,782			48,481
Other real estate owned		4,262			4,348
Total nonperforming assets	$	45,044		$	52,829
Total assets	$	529,709		$	552,412
Percentage of nonperforming assets to total assets		8.50	%		9.56	%
Percentage of nonaccrual loans to total loans		12.65	%		14.12	%
Loans past due greater than 90 days and accruing	$	—		$	—

Total nonperforming assets were $45.0 million at March 31, 2010, compared with $52.8 million at December 31, 2009, a decrease of $7.8 million, or 15 percent. Payments received on and charge-offs of nonaccrual loans exceeded the balance of new nonaccrual loans in the first quarter of 2010. The continued high level of nonperforming assets is attributable to continued stress on borrowers and their performance. The economy in the Bank’s market area is dependent to a significant degree on real estate and related industries (i.e. construction, housing). Although the Bank maintains a diversified loan portfolio, the present downturn in real estate, including construction, has had an adverse effect on borrowers’ ability to repay all types of loans and has affected the Company’s results of operations and financial condition. The Bank frequently reviews and updates its underwriting guidelines and monitors its delinquency levels for any negative or adverse trends and adjusts projected loan concentration limits and credit standards when necessary. Management remains concerned about the residential housing slowdown and the effect it has had on credit quality. Management has increased monitoring of construction and land acquisition loans and has ceased originations in these portfolios.

Generally, no interest is accrued on loans when factors indicate collection of interest is doubtful or when principal or interest payments become 90 days past due, unless collection of principal and interest are anticipated within a reasonable period of time and the loans are well secured. For such loans, previously accrued but uncollected interest is charged against current earnings, and income is only recognized to the extent payments are subsequently received and collection of the remaining recorded principal balance is considered probable.

There were no loans accounted for as troubled debt restructurings at March 31, 2010 and December 31, 2009. Restructuring of a loan may be granted in response to borrower financial difficulty and will generally provide for a temporary modification of loan repayment terms. Modification of terms such as one or a combination of the following would classify the debt as a troubled debt restructuring:

• Reduction of the stated interest rate for the remaining original life of the debt.

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• Extension of the maturity date or dates at a stated interest rate lower than the current market rate for new debt with similar risk.

• Reduction of the face amount or maturity amount of the debt as stated in the instrument or other agreement.

• Reduction of accrued interest.

Nonaccrual loans at March 31, 2010 totaled $40.8 million, compared with $48.5 million at December 31, 2009. At March 31, 2010, approximately 93 percent of nonaccrual loans were real estate secured. The majority of the real estate collateral is located in the Puget Sound area of northern Washington and the Portland, Oregon/Vancouver, Washington metropolitan area. Loans placed on nonaccrual during the first quarter totaled $4.2 million. Of these loans placed on nonaccrual, $2.8 million related to loans secured by 1-4 family, $588,400 related to real estate construction and development loans and $855,400 related to commercial real estate loans. Commercial and industrial loans placed on nonaccrual in the first quarter of 2010 totaled $399,700. The following table presents activity in nonaccrual loans for the first three months of 2010:

	Three Months Ended March 31,
(dollars in thousands)	2010			2009
Beginning balance, January 1	$	48,481		$	15,689
Additions to nonaccrual		4,181			31,276
Transfers to accrual		(546	)		(4,999	)
Payments		(4,142	)		(2,142	)
Charge-offs		(6,280	)		(4,859	)
Transfers to foreclosed assets		(912	)		(2,798	)
Ending balance, March 31	$	40,782		$	32.167

Upon acquisition of real estate collateral through foreclosure, the property is promptly marketed for sale. If offers or indication of interest are not received within a short period of time, the offering price is analyzed and market conditions reviewed to assess whether a lower price reflects the market value of the property and would enable a sale of the property. Property appraisals are updated at least annually and more frequently if market factors dictate. Increases in valuation adjustments recorded in a period are primarily based on updated appraisals or management’s authorization to reduce the selling price during the period. Foreclosed properties held as other real estate owned are recorded at the lower of the recorded investment in the loan or market value of the property less expected costs to sell.

Foreclosed assets (other real estate owned (“OREO”) and other repossessed assets) totaled $4.3 million at March 31, 2010 and December 31, 2009. At March 31, 2010, the Company had nine OREO properties. One property totaling $1.9 million, or approximately 45 percent of the balance at March 31, 2010, related to one residential real estate construction project in the Portland, Oregon metropolitan area. A residential real estate construction project and two single family residences totaling $912,300 were foreclosed on and transferred to OREO during the first quarter of 2010. Property carried at $368,300 was sold in the first quarter of 2010 for a loss of $159,100. The following table presents activity in the foreclosed assets portfolio for the first three months of 2010 and 2009:

	Three Months Ended March 31,
(dollars in thousands)	2010			2009
Beginning balance, January 1	$	4,348		$	4,838
Additions to foreclosed assets		912			2,926
Valuation adjustments		(630	)		—
Sales of foreclosed assets		(368	)		(2,538	)
Ending balance, March 31	$	4,262		$	5,226

Deposits

We offer various deposit accounts, including noninterest-bearing checking and interest-bearing checking, savings, money market and certificates of deposit. The accounts vary as to terms, with principal differences being minimum balances required, length of time the funds must remain on deposit, interest rate and deposit or withdrawal options. Our goal remains to maximize our noninterest-bearing demand deposits relative to other deposits and borrowings in order to minimize our interest expense. The following table presents the composition of the Company’s deposit liabilities on the dates indicated:

(dollars in thousands)	March 31, 2010		December 31, 2009
Noninterest-bearing demand deposits	$	45,292	$	46,510
Savings deposits		15,942		16,069
Interest-bearing demand deposits		42,294		43,546
Money market deposits		34,233		34,452
Certificates of deposit under $100,000		225,670		267,020
Certificates of deposit over $100,000		150,151		116,174
Total	$	513,582	$	523,771

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Total deposits decreased $10.2 million from year-end 2009, primarily due to a $28.4 million decrease in brokered deposits. As a result of the Bank’s regulatory capital classification, it has not been able to accept or renew any brokered deposits since mid-2009, and the Bank is subject to interest rate restrictions on deposits. The rates currently paid by the Bank on any new or renewed deposits are limited to 75 basis points over the average national rate for deposits with comparable terms. The Bank expects to be further restricted in the pricing of new or renewed deposits as a result of being critically under-capitalized. The FDIC may restrict the Bank from paying rates on deposits that would increase the Bank’s weighted average cost of funds to a level significantly exceeding the prevailing rates of interest on insured deposits in the Banks normal market areas. To the extent that competitors in the Bank’s market decide to pay higher rates than we are permitted to as a result of the Bank’s regulatory restrictions, the Bank may experience a disintermediation of deposit funds.

Total brokered deposits were $134.7 million at March 31, 2010, compared with $163.1 million at December 31, 2009. To offset reduced relationship deposits and maturing brokered CD’s and CDARs deposits, the Bank utilized internet listing service time deposits. Internet listing sourced deposits increased $22.6 million in the first quarter of 2010, as national brokered CD’s decreased $26.4 million and CDARs deposits decreased $1.9 million from December 31, 2009. Future restrictions on the Bank’s ability to accept internet deposits may occur as the result of the Bank’s declining capital levels. To increase core deposits, the Bank has begun a variety of marketing programs to attract additional local deposits targeted at the retail level, as well as more aggressive efforts towards acquiring business-customer demand deposits.

At March 31, 2010, the Bank had $35.7 million of public deposits and the largest public depositor balance was $31.2 million. The Washington Public Deposit Protection Commission (“WPDPC”), which governs all Washington public deposits, adopted a resolution in January, 2010, which requires public depositaries to have no more than 50 percent of public deposits in accounts under the FDIC’s Transaction Account Guarantee (“TAG”) program by March 31, 2010, 25 percent by April 30, 2010 and zero percent by May 31, 2010. Financial institutions are required to collateralize 100 percent of all uninsured public funds. In April 2010, the WPDPC suspended the requirements to reduce public deposits in TAG accounts below the 50 percent target, as a result of the FDIC’s extension of the TAG program through at least December 31, 2010. The Company does not anticipate any significant impact to its liquidity as a result of the WPDPC’s public deposit collateral requirements.

Borrowings

As of March 31, 2010, the Company had one wholly owned Delaware statutory business trust subsidiary, Cowlitz Statutory Trust I (the Trust), which issued $12.0 million of guaranteed undivided beneficial interests in the Company’s Junior Subordinated Deferrable Interest Debentures (Trust Preferred Securities). The proceeds from the issuance of the common securities and the Trust Preferred Securities were used by the Trust to purchase $12.4 million of junior subordinated debentures of the Company. These debentures qualify as Tier 1 capital under Federal Reserve Board guidelines that limit inclusion of trust-preferred securities and certain other preferred capital elements to 25 percent of core capital elements. However, as of March 31, 2010, trust preferred securities were excluded from Tier 1 capital since the Company’s equity balance was negative. The interest rate is based on the 3-month LIBOR plus 1.75% and is adjusted quarterly. The effective rate at March 31, 2010 was 2.01 percent.

Beginning with the payment that was due in September 2009, the Company has deferred regularly scheduled interest payments on its outstanding junior subordinated notes relating to its Trust Preferred Securities. Under the terms of the junior subordinated notes and the trust documents, the Company is allowed to defer payments of interest for up to 20 consecutive quarterly periods. The Company is not in default with respect to the Trust Preferred Securities, and the deferral of interest does not constitute an event of default. The Company will continue to accrue interest, but the Company will not make cash interest payments until such time as it elects to resume payments. This action is consistent with the Company’s current business strategy to preserve cash balances at the holding company. During the deferral period, the Company generally may not pay cash dividends on or repurchase its common stock. The amount of deferred interest was $212,300 at March 31, 2010.

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Liquidity

Liquidity represents the ability to meet deposit withdrawals and fund loan demand, while retaining the flexibility to take advantage of business opportunities. Daily and short-term liquidity needs have been principally met with deposits from customers, payments on loans, maturities and paydowns of investment securities, and wholesale borrowings, including brokered CDs, federal funds purchased, internet service listing deposits and, depending on the availability of collateral, borrowings from the FHLB. As mentioned elsewhere, the Bank is currently restricted by its Consent Order from issuing or renewing brokered deposits. Despite this restriction, the Bank maintained a significant on-balance sheet liquidity position at March 31, 2010 through its core deposit base, issuance of internet service listing deposits and benefit of the increased FDIC deposit insurance limits.

Secondary sources of liquidity include sale of investment securities which are not held for pledging purposes and other classes of assets. Securities classified as available for sale which are not pledged may be sold in response to changes in interest rates or liquidity needs. Investments in securities available for sale were $54.5 million at March 31, 2010, with $49.3 million of these securities pledged as collateral to secure public deposits and borrowing lines. The prices for loans and other assets are subject to market volatility that often discounts the value below the Bank’s carrying value of the asset. Consequently, even though the Bank may increase liquidity by the sale of assets, the Bank would recognize a loss and further reduce its capital if it were to sell assets at below their carrying value.

Longer term funding needs can be met through a variety of wholesale sources that have a broader range of maturities than customer deposits and add flexibility in liquidity planning and management. These wholesale sources include advances from the FHLB with longer maturities. In addition, the Company may also issue trust preferred securities, subordinated debt and common or preferred stock to address liquidity or capital needs, depending on market conditions.

Liquid assets, mainly balances held at the Federal Reserve Bank, totaled $125.3 million at March 31, 2010, compared with $130.9 million at December 31, 2009. As discussed previously, the Company has taken strategic actions to increase its short-term liquidity. The Company is selective in the renewal of loans at maturity and has declined loan renewals for borrowers that are loan-only credits where Cowlitz Bank is not the borrower’s primary bank. In addition, the Bank will likely decline loan renewals for borrowers who have risk factors the Bank deems unacceptable going forward, such as violation of loan terms and poor repayment history. Lastly, the Bank is working diligently to reduce nonperforming assets as quickly as possible. The Company can provide no assurance to its successful implementation of these plans or that further deterioration in economic conditions and deposit trends will not have a material adverse affect on the Company’s liquidity.

The Bank’s primary counterparty for borrowing purposes is the Federal Home Loan Bank of Seattle (the “FHLB”) that permits it to borrow up to 20 percent of the Bank’s assets, subject to collateral limitations. The line is available for overnight federal funds and with the collateral available on March 31, 2010, the Company believes the Bank could borrow up to approximately $65 million. FHLB borrowings in excess of $26.4 million would require the Company to purchase additional FHLB stock. The Bank also has access to additional liquidity through the Federal Reserve’s credit programs, subject to collateral limitations. Borrowing capacity from FHLB or FRB may fluctuate based upon the acceptability and risk rating of loan collateral, and counterparties could adjust discount rates applied to such collateral at their discretion. The FRB or FHLB could restrict or limit the Bank’s access to secured borrowings.

At March 31, 2010, the Bank had one overnight federal funds borrowing line with a correspondent bank that provided access to an additional $7.3 million for short-term liquidity needs, subject to collateral requirements. As with many community banks, correspondent banks have withdrawn unsecured lines of credit or now require collateralization for their purchase of federal funds on a short-term basis due to the present adverse economic environment.

As disclosed in the accompanying Consolidated Statements of Cash Flows, net cash flows used by operations in the first three months of 2010 and 2009 were $2.1 million and $1.2 million, respectively. The net cash used by operations in the first three months of 2010 and 2009 was primarily due to the net operating loss. Net cash flows from investing activities of $6.4 million in the first three months of 2010 related primarily to the decrease in loan balances, and mortgage-backed securities repayments, net of securities purchased. Net cash flows from investing activities of $12.6 million in the first quarter of 2009 was primarily from proceeds of maturities of investment securities, loan reductions and sales of foreclosed assets and an interest rate swap. Cash used by financing activities in the first three months of 2010 was primarily due to a net decrease in deposits. Net deposit increases provided most of the cash from financing activities in the first three months of 2009.

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Capital Resources

Management is committed to maintaining capital at a level sufficient to protect shareholders and depositors, provide for reasonable growth and fully comply with regulatory requirements. The Company and the Bank are required to maintain minimum amounts of capital to “risk-weighted” assets, as defined by banking regulators. As of March 31, 2010, the Bank’s risk based capital ratios were categorized as “critically under-capitalized” under the regulatory framework for Prompt Corrective Action due to the Tier 1 leverage capital ratio falling below two percent. See the “Recent Developments” section of this Item 2, Management’s Discussion and Analysis of Financial Condition and Results of Operations, for a discussion of the Company’s regulatory status.

	Actual					For Capital Adequacy Purposes					To Be Well-Capitalized Under Prompt Corrective Action Provisions
(dollars in thousands)	Amount			Ratio		Amount		Ratio			Amount		Ratio
March 31, 2010
Total risk-based capital:
Consolidated	$	(1,411	)	(0.42	)%	$	27,093	³	8.00	%		N/A		N/A
Bank	$	14,746		4.36	%	$	27,062	³	8.00	%	$	33,828	³	10.00	%
Tier 1 risk-based capital:
Consolidated	$	(1,411	)	(0.42	)%	$	13,546	³	4.00	%		N/A		N/A
Bank	$	10,421		3.08	%	$	13,531	³	4.00	%	$	20,297	³	6.00	%
Tier 1 (leverage) capital:
Consolidated	$	(1,411	)	(0.26	)%	$	22,007	³	4.00	%		N/A		N/A
Bank	$	10,421		1.89	%	$	22,015	³	4.00	%	$	27,519	³	5.00	%
December 31, 2009
Total risk-based capital:
Consolidated	$	27,538		7.40	%	$	29,759	³	8.00	%		N/A		N/A
Bank	$	27,291		7.34	%	$	29,739	³	8.00	%	$	37,174	³	10.00	%
Tier 1 risk-based capital:
Consolidated	$	14,424		3.88	%	$	14,880	³	4.00	%		N/A		N/A
Bank	$	22,571		6.07	%	$	14,870	³	4.00	%	$	22,304	³	6.00	%
Tier 1 (leverage) capital:
Consolidated	$	14,424		2.50	%	$	23,087	³	4.00	%		N/A		N/A
Bank	$	22,571		3.91	%	$	23,087	³	4.00	%	$	28,859	³	5.00	%

The Bank level capital ratios set forth above are substantially higher than the capital ratios at the Consolidated level. This is mainly because regulatory calculations give different treatment to the $12.4 million in Trust Preferred debt proceeds. At the Company level, Trust Preferred debt is excluded from regulatory capital, while it is fully included at the Bank level at December 31, 2009. At March 31, 2010, the entire amount of Trust Preferred debt is excluded from regulatory capital.

The holding company had approximately $378,000 of available cash at March 31, 2010, and continues to analyze all of its capital management options. The Company will face additional restrictions from the Board of Governors of the Federal Reserve based on the Bank’s capitalization, other conditions giving rise to the Consent Order and the decline in the consolidated regulatory capital ratios that fell below capital adequacy minimums as of December 31, 2009.

The Company is continuing its efforts to raise additional capital from a variety of sources, which would be contributed as common equity to the Bank. Any potential investment would be subject to due diligence and may require the approval of the Company’s shareholders. Certain prospective investors have engaged in various stages of due diligence as to the condition of the Company including discussions with management as well as a review of historical financial information and financial analyses of future performance, including loan portfolio credit quality. There can be no assurance that the Company’s efforts to raise additional capital will be successful. If capital is available, the costs of such capital may be very high and extremely dilutive to existing shareholders. If the Company cannot raise additional capital the Bank may be subject to additional adverse regulatory action. If capital levels continue to deteriorate, it is likely that the Company will need to seek to merge with another institution or raise capital through new investors in an extremely dilutive transaction on terms that could be considered unfavorable by current shareholders, or face the prospect of being placed into receivership, resulting in a complete loss of an investment in the Company.

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Stock Repurchase Program

In September 2007, the Company announced a stock repurchase program for up to 50,000 shares (restated for the reverse stock split (one-for-ten) effective March 1, 2010). Under the program, the Company intended to use existing funds to finance any repurchases. When evaluating timing and amount of common stock repurchases, management considers a number of factors including, but not limited to, projected earnings generation, risk weighted asset growth, capital ratios relative to regulatory capital guidelines, availability and cost of other capital resources and the market valuation of its stock price. No shares were purchased as of March 31, 2010 and none are expected to be purchased in 2010. The Company is currently restricted from repurchasing its common stock without approval of the Federal Reserve Bank and becoming current with respect to interest payments on its trust preferred securities.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

The Bank’s earnings are largely derived from net interest income, which is interest income and fees earned on loans and investment income, less interest expense paid on deposits and other borrowings. Interest rates are highly sensitive to many factors that are beyond the control of the Bank’s management, including general economic conditions, and the policies of various governmental and regulatory authorities. As interest rates change, net interest income is affected. With fixed rate assets (such as fixed rate loans) and liabilities (such as certificates of deposit), the effect on net interest income is dependent upon on the maturities of the assets and liabilities. The Bank’s primary objective in managing interest rate risk is to minimize the adverse impact of changes in interest rates on the Bank’s net interest income and capital, while structuring the Bank’s asset/liability position to obtain the maximum yield-cost spread on that structure. Such structuring includes the use of interest rate derivative contracts. Interest rate risk is managed through the monitoring of the Bank’s gap position and sensitivity to interest rate risk by subjecting the Bank’s balance sheet to hypothetical interest rate shocks using a computer based model. In a falling rate environment, the spread between interest yields earned and interest rates paid may narrow, depending on the relative level of fixed and variable rate assets and liabilities. In a stable or increasing rate environment the Bank’s variable rate loans will remain steady or increase immediately with changes in interest rates, while fixed rate liabilities, particularly certificates of deposit, will only re-price as the liability matures. The Company’s assessment of market risk as of March 31, 2010 indicates there were no material changes in the quantitative and qualitative disclosures from those made in “Quantitative and Qualitative Disclosures About Market Risk” in Part II, Item 7A of the Annual Report on Form 10-K for the year ended December 31, 2009.

Item 4T. Controls and Procedures

We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in the reports that we file or submit under the Securities and Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosures. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

As previously reported in our Form 10-K for the year ended December 31, 2009, there was a material weakness in our internal control over financial reporting related to the valuation of impaired assets, including the timely charge-off of collateral dependent loans and write-downs of other real estate owned. This section of Item 4T, “Controls and Procedures,” should be read in conjunction with Item 4T, “Controls and Procedures,” included in the Company’s Form 10-K for the year ended December 31, 2009 for additional information on Management’s Report on Internal Controls Over Financial Reporting.

As of the end of the period covered by this Quarterly Report on Form 10-Q, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Securities and Exchange Act Rule 13a-15. Based upon this evaluation, our management, including our Chief Executive Officer and Chief Financial Officer, determined that there was insufficient evidence to conclude that the material weakness had been remediated. Additional time is required to collect evidence for testing and evaluating the control deficiencies noted below. To address the control deficiencies, we performed additional analysis and other procedures in order to prepare this Quarterly Report on Form 10-Q, including the unaudited quarterly consolidated financial statements in accordance with generally accepted accounting principles in the United States. Accordingly, management believes that the condensed consolidated financial statements included in this Quarterly Report on Form 10-Q fairly present, in all material respects, our financial condition, results of operations and cash flows for the periods presented.

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As of March 31, 2010, the unremediated material weakness was ineffective controls over the valuation of impaired assets. The material weakness resulted from the aggregation of the following deficiencies:

• Ineffective controls related to valuation of impaired loans, including timely charge-off of collateral dependent loans; and

• Personnel involved in other real estate owned valuation did not communicate updated appraisal results in a timely fashion to accounting personnel for accounting and disclosure consideration.

Remediation

Remediation efforts surrounding ineffective controls over valuation of impaired assets are ongoing and include strengthening corporate oversight of impaired asset valuation methodologies and processes, and improving the timeliness of communications between the Special Assets Group and accounting personnel for accounting and disclosure consideration. Additional changes will be implemented as determined necessary.

There have been no changes in our internal controls or in other factors that have materially affected or are likely to materially affect our internal controls over financial reporting subsequent to the date of the evaluation.

Part II. OTHER INFORMATION

Item 1. Legal Proceedings

The Company from time to time enters into routine litigation resulting from the collection of secured and unsecured indebtedness as part of its business of providing financial services. In some cases, such litigation will involve counterclaims or other claims against the Company. Such proceedings against financial institutions sometimes also involve claims for punitive damages in addition to other specific relief. The Company is not a party to any litigation other than in the ordinary course of business. In the opinion of management, the ultimate outcome of all pending legal proceedings will not individually or in the aggregate have a material adverse effect on the financial condition or the results of operations of the Company.

Item 1A. Risk Factors

Except as noted below, there were no material changes to the risk factors set forth in the Company’s Form 10-K for the year ended December 31, 2009.

Capital necessary to absorb losses and return the Bank to compliance with regulatory standards may not be available.

The Company and the Bank are required by federal regulatory authorities to maintain adequate levels of capital to support operations. The Company is exploring alternatives to raise additional capital to support operations and absorb loan losses, but the Company’s ability to raise additional capital will depend on conditions in the capital markets, which are outside the Company’s control, and on the Company’s financial performance and prospects. Accordingly, the Company cannot be certain of its ability to raise additional capital. The Bank’s regulatory capital ratios are currently categorized as “critically under-capitalized,” which places further regulatory restrictions on the Company and the Bank, and will result in further FDIC action designed to improve the Bank’s condition and increase capital levels by June 30, 2010. The FDIC may appoint a receiver for a critically undercapitalized bank after 90 days at such capital levels. In addition, we entered into a Consent Order with the FDIC and Washington Department of Financial Institutions that requires the Bank to increase capital ratios above the “well-capitalized” level and if the Company and the Bank cannot raise capital to such levels the Bank could face additional adverse regulatory action. If we cannot raise additional capital when needed, our financial condition and our ability to maintain or improve our capital position to support our operations and to continue as a going concern could be materially impaired.

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

Not applicable

Item 3. Defaults upon Senior Securities

Not applicable

Item 4. (Removed and Reserved)

Item 5. Other Information

None

Item 6. Exhibits

(a) Exhibits. The following constitutes the exhibit index.

3.1	Restated Articles of Incorporation (incorporated by reference to Exhibit 3.1 to the Company’s Form 10-K filed March 31, 2010)
3.2	Amended and Restated Bylaws (incorporated by reference to Exhibit 3.2 to the Form 10-K filed March 31, 2009)
31.1	Certification of Chief Executive Officer
31.2	Certification of Chief Financial Officer
32	Certification of Chief Executive Officer and Chief Financial Officer
99.1	Stipulation and Consent Order with FDIC and Washington Department of Financial institutions (incorporated by reference to Exhibit 99.1 to Form 8-K filed February 2, 2010)

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SIGNATURES

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

Date: May 17, 2010

Cowlitz Bancorporation (Registrant)
By:
	/s/ Richard J. Fitzpatrick
	Richard J. Fitzpatrick, President and Chief Executive Officer
	/s/ Gerald L. Brickey
	Gerald L. Brickey, Vice-President and Chief Financial Officer

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