Edgar Filing: PACIFIC FINANCIAL CORP

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2012

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from ____________ to ____________

Commission File Number 000-29829

PACIFIC FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

Washington	91-1815009
(State or other jurisdiction of	(IRS Employer Identification No.)
incorporation or organization)

1101 S. Boone Street

Aberdeen, Washington 98520-5244

(360) 533-8870

(Address, including zip code, and telephone number,

including area code, of Registrant's principal executive offices)

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 website, if any, every Interactive Data File required to be submitted and posted to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes x No ¨

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

¨ Large Accelerated Filer ¨ Accelerated Filer ¨ Non-accelerated Filer x Smaller Reporting Company

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

The number of shares of the issuer's common stock, par value $1.00 per share, outstanding as of July 31, 2012, was 10,121,853 shares.

TABLE OF CONTENTS

PART I	FINANCIAL INFORMATION	3

ITEM 1.	FINANCIAL STATEMENTS (UNAUDITED)	3

	CONDENSED CONSOLIDATED BALANCE SHEETS JUNE 30, 2012 AND DECEMBER 31, 2011	3

	CONDENSED CONSOLIDATED STATEMENTS OF INCOME THREE AND SIX MONTHS ENDED JUNE 30, 2012 AND 2011	4

	CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME THREE AND SIX MONTHS ENDED JUNE 30, 2012 AND 2011	5

	CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS SIX MONTHS ENDED JUNE 30, 2012 AND 2011	6

	CONDENSED CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY SIX MONTHS ENDED JUNE 30, 2012 AND 2011	8

	NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS	9

ITEM 2.	MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	32

ITEM 3.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	44

ITEM 4.	CONTROLS AND PROCEDURES	45

PART II	OTHER INFORMATION	45

ITEM 1.	LEGAL PROCEEDINGS	45

ITEM 1A.	RISK FACTORS	45

ITEM 2.	UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS	45

ITEM 3.	DEFAULTS UPON SENIOR SECURITIES	45

ITEM 4.	MINE SAFETY DISCLOSURES	45

ITEM 5.	OTHER INFORMATION	45

ITEM 6.	EXHIBITS	46

	SIGNATURES	46

PART I – FINANCIAL INFORMATION

ITEM 1 – FINANCIAL STATEMENTS

PACIFIC FINANCIAL CORPORATION

Condensed Consolidated Balance Sheets

June 30, 2012 and December 31, 2011

(Dollars in thousands) (Unaudited)

	June 30, 2012			December 31, 2011
Assets
Cash and due from banks	$	11,865		$	12,607
Interest bearing deposits in banks		26,457			28,525
Investment securities available-for-sale (amortized cost of $52,471 and $47,015)		53,157			47,652
Investment securities held-to-maturity (fair value of $6,931 and $7,118)		6,871			7,025
Federal Home Loan Bank stock, at cost		3,182			3,182
Loans held for sale		19,771			14,541

Loans		459,715			474,893
Allowance for credit losses		11,064			11,127
Loans, net		448,651			463,766

Premises and equipment		14,765			14,884
Other real estate owned		6,195			7,725
Accrued interest receivable		2,365			2,156
Cash surrender value of life insurance		17,533			17,275
Goodwill		11,282			11,282
Other intangible assets		1,268			1,268
Other assets		9,822			9,366

Total assets	$	633,184		$	641,254

Liabilities and Shareholders' Equity
Deposits:
Demand, non-interest bearing	$	105,368		$	108,899
Savings and interest-bearing demand		287,862			286,642
Time, interest-bearing		145,479			152,509
Total deposits		538,709			548,050

Accrued interest payable		773			1,490
Secured borrowings		222			741
Short-term borrowings		3,000			—
Long-term borrowings		7,500			10,500
Junior subordinated debentures		13,403			13,403
Other liabilities		4,114			3,800
Total liabilities		567,721			577,984

Commitments and Contingencies (Note 7)		—			—

Shareholders' Equity
Common Stock (par value $1); 25,000,000 shares authorized; 10,121,853 shares issued and outstanding at June 30, 2012 and December 31, 2011		10,122			10,122
Additional paid-in capital		41,353			41,342
Retained earnings		14,142			12,051
Accumulated other comprehensive income (loss)		(154	)		(245	)
Total shareholders' equity		65,463			63,270

Total liabilities and shareholders' equity	$	633,184		$	641,254

See notes to condensed consolidated financial statements.

PACIFIC FINANCIAL CORPORATION

Condensed Consolidated Statements of Income

Three and six months ended June 30, 2012 and 2011

(Dollars in thousands, except per share data) (Unaudited)

	Three Months Ended June 30,						Six Months Ended June 30,
	2012			2011			2012			2011
Interest and dividend income
Loans	$	6,551		$	6,773		$	13,098		$	13,598
Investment securities and FHLB dividends		468			516			938			1,032
Deposits with banks and federal funds sold		18			24			36			48
Total interest and dividend income		7,037			7,313			14,072			14,678

Interest Expense
Deposits		748			1,254			1,573			2,619
Other borrowings		159			294			319			609
Total interest expense		907			1,548			1,892			3,228

Net Interest Income		6,130			5,765			12,180			11,450
Provision for credit losses		300			—			400			500
Net interest income after provision for credit losses		5,830			5,765			11,780			10,950

Non-interest Income
Service charges on deposits		437			466			850			880
Net gain (loss) on sales of other real estate owned		139			(146	)		311			(143	)
Gain on sales of loans		1,201			546			2,000			1,099
Gain on sales of investments available-for-sale, net		89			74			99			184
Net other-than-temporary impairment losses ( net of $2, $62, $190 and $367, respectively, recognized in other comprehensive income before taxes)		(35	)		(50	)		(105	)		(243	)
Earnings on bank owned life insurance		127			134			258			263
Other operating income		451			350			844			664
Total non-interest income		2,409			1,374			4,257			2,704

Non-interest Expense
Salaries and employee benefits		3,964			3,397			7,722			6,825
Occupancy and equipment		638			641			1,251			1,285
Other real estate owned write-downs		227			422			334			537
Other real estate owned operating costs		178			112			300			204
Professional services		179			225			336			400
FDIC and State assessments		139			183			333			496
Data processing		350			302			693			584
Other		1,235			1,312			2,540			2,402
Total non-interest expense		6,910			6,594			13,509			12,733

Income before income taxes		1,329			545			2,528			921
Income taxes (benefit)		256			(58	)		437			(114	)

Net Income	$	1,073		$	603		$	2,091		$	1,035

Earnings per common share:
Basic	$	0.11		$	0.06		$	0.21		$	0.10
Diluted		0.11			0.06			0.21			0.10
Weighted Average shares outstanding:
Basic		10,121,853			10,121,853			10,121,853			10,121,853
Diluted		10,122,350			10,121,853			10,122,106			10,121,853

See notes to condensed consolidated financial statements.

PACIFIC FINANCIAL CORPORATION

Condensed Consolidated Statements of Comprehensive Income

Three and six months ended June 30, 2012 and 2011

(Dollars in thousands) (Unaudited)

	Three Months Ended June 30,				Six Months Ended June 30,
	2012		2011		2012		2011

Net Income	$	1,073	$	603	$	2,091	$	1,035

Other comprehensive income, net of tax:
Net unrealized gains on investment securities (net of tax of $36, $98, $16 and $231, respectively)		69		191		32		449
Defined benefit plans (net of tax of $15, $12, $30 and $24, respectively)		30		23		59		46

Other Comprehensive Income		99		214		91		495

Comprehensive Income	$	1,172	$	817	$	2,182	$	1,530

See notes to condensed consolidated financial statements.

PACIFIC FINANCIAL CORPORATION

Condensed Consolidated Statements of Cash Flows

Six months ended June 30, 2012 and 2011

(Dollars in thousands)

(Unaudited)

	2012			2011
OPERATING ACTIVITIES
Net income	$	2,091		$	1,035
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Provision for credit losses		400			500
Depreciation and amortization		844			753
Origination of loans held for sale		(109,051	)		(60,088	)
Proceeds of loans held for sale		105,821			61,713
Gain on sales of loans		(2,000	)		(1,099	)
Gain on sale of investments available-for-sale		(99	)		(184	)
Net OTTI losses recognized in earnings		105			243
Net (gain) loss on sale of other real estate owned		(311	)		143
Net gain on sale of premises and equipment		(1	)		—
Increase in accrued interest receivable		(209	)		(37	)
Increase (decrease) in accrued interest payable		(717	)		95
Other real estate owned write-downs		334			537
Other, net		(493	)		2,582
Net cash provided by (used in) operating activities		(3,286	)		6,193

INVESTING ACTIVITIES
Net decrease in interest bearing balances with banks		2,068			19,936
Purchase of securities held-to-maturity		—			(828	)
Purchase of securities available-for-sale		(12,414	)		(13,169	)
Proceeds from maturities of investments held-to-maturity		153			130
Proceeds from sales of securities available-for-sale		4,064			5,089
Proceeds from maturities of securities available-for-sale		2,678			2,473
Net (increase) decrease in loans		13,013			(13,413	)
Proceeds from sales of other real estate owned		3,462			859
Additions to other real estate owned		(180	)		(183	)
Purchase of premises and equipment		(440	)		(416	)
Net cash provided by investing activities		12,404			478

FINANCING ACTIVITIES
Net decrease in deposits		(9,341	)		(1,011	)
Net decrease in short-term borrowings		—			(1,500	)
Proceeds from issuance of long-term borrowings		2,500			5,000
Repayment of long-term borrowings		(2,500	)		(5,000	)
Net decrease in secured borrowings		(519	)		(157	)
Net cash used in financing activities		(9,860	)		(2,668	)

Net increase (decrease) in cash and due from banks		(742	)		4,003

Cash and due from banks
Beginning of period		12,607			7,428

End of period	$	11,865		$	11,431

(continued)

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash payments for:
Interest	$	2,609		$	3,133
Income taxes		1,316			20

SUPPLEMENTAL SCHEDULE OF NONCASH INVESTING AND FINANCING ACTIVITIES
Change in fair value of securities available-for-sale, net of tax	$	32		$	449
Other real estate owned acquired in settlement of loans		(1,941	)		(2,383	)
Financed sale of other real estate owned		166			822
Reclass of long-term borrowings to short-term borrowings		3,000			—

See notes to condensed consolidated financial statements.

PACIFIC FINANCIAL CORPORATION

Condensed Consolidated Statements of Shareholders' Equity

Six months ended June 30, 2012 and 2011

(Dollars in thousands)

(Unaudited)

	Shares of Common Stock		Common Stock		Additional Paid-in Capital		Retained Earnings		Accumulated Other Comprehensive Loss			Total

Balance January 1, 2011		10,121,853	$	10,122	$	41,316	$	9,233	($	902	)	$	59,769

Other comprehensive income:
Net income								1,035					1,035
Unrealized holding gain on securities less reclassification adjustment for net gains included in net income										449			449
Amortization of unrecognized prior service costs and net (gains)/losses										46			46
Comprehensive income													1,530

Stock compensation expense						12							12

Balance June 30, 2011		10,121,853	$	10,122	$	41,328	$	10,268	($	407	)	$	61,311

Balance January 1, 2012		10,121,853	$	10,122	$	41,342	$	12,051	($	245	)	$	63,270

Other comprehensive income:
Net income								2,091					2,091
Unrealized holding gain on securities less reclassification adjustment for net gains included in net income										32			32
Amortization of unrecognized prior service costs and net (gains)/losses										59			59
Comprehensive income													2,182

Stock compensation expense						11							11

Balance June 30, 2012		10,121,853	$	10,122	$	41,353	$	14,142	$	(154	)	$	65,463

See notes to condensed consolidated financial statements.

PACIFIC FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

(Dollars in thousands, except per share amounts)

Note 1 – Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared by Pacific Financial Corporation ("Pacific" or the "Company") in accordance with accounting principles generally accepted in the United States of America ("GAAP") for interim financial information and with instructions to Form 10-Q. Accordingly, these financial statements do not include all of the information and footnotes required by GAAP for complete financial statements. In the opinion of management, adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the six months ended June 30, 2012, are not necessarily indicative of the results anticipated for the year ending December 31, 2012. Certain information and footnote disclosures included in the Company's consolidated financial statements for the year ended December 31, 2011, have been condensed or omitted from this report. Accordingly, these statements should be read in conjunction with the financial statements and notes thereto included in the Company's Annual Report on Form 10-K for the year ended December 31, 2011.

The preparation of financial statements in conformity with GAAP requires management to make 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 periods. Actual results could differ from those estimates.

Note 2 – Earnings per Share

The following table illustrates the computation of basic and diluted earnings per share.

	Three Months Ended June 30,				Six Months Ended June 30,
	2012		2011		2012		2011
Basic:
Net income	$	1,073	$	603	$	2,091	$	1,035
Weighted average shares outstanding		10,121,853		10,121,853		10,121,853		10,121,853
Basic earnings per share	$	0.11	$	0.06	$	0.21	$	0.10

Diluted:
Net income	$	1,073	$	603	$	2,091	$	1,035
Weighted average shares outstanding		10,121,853		10,121,853		10,121,853		10,121,853
Effect of dilutive stock options		497		—		253		—
Weighted average shares outstanding assuming dilution		10,122,350		10,121,853		10,122,106		10,121,853
Diluted earnings per share	$	0.11	$	0.06	$	0.21	$	0.10

As of June 30, 2012 and 2011, there were 534,607 and 608,608 shares, respectively, subject to outstanding options and 699,642 and 699,642 shares, respectively, subject to outstanding warrants with exercise prices in excess of the current market value. All of these shares are not included in the table above, as exercise of these options and warrants would not be dilutive to shareholders.

Note 3 – Investment Securities

Investment securities consist principally of short and intermediate term debt instruments issued by the U.S. Treasury, other U.S. government agencies, state and local government units, and other corporations, and mortgage backed securities (“MBS”).

Securities Held-to-Maturity	Amortized Cost		Unrealized Gains		Unrealized Losses		Fair Value

June 30, 2012
State and municipal securities	$	6,616	$	39	$	—	$	6,655
Agency MBS		255		21		—		276
Total	$	6,871	$	60	$	—	$	6,931

December 31, 2011
State and municipal securities	$	6,732	$	68	$	—	$	6,800
Agency MBS		293		25		—		318
Total	$	7,025	$	93	$	—	$	7,118

Securities Available-for-Sale	Amortized Cost		Unrealized Gains		Unrealized Losses		Fair Value

June 30, 2012
U.S. Government securities	$	1,205	$	10	$	5	$	1,210
State and municipal securities		24,222		1,321		19		25,524
Agency MBS		17,161		227		58		17,330
Non-agency MBS		6,012		26		829		5,209
Corporate bonds		3,871		32		19		3,884
Total	$	52,471	$	1,616	$	930	$	53,157

December 31, 2011
U.S. Government securities	$	73	$	11	$	—	$	84
State and municipal securities		21,398		1,462		1		22,859
Agency MBS		16,709		255		49		16,915
Non-agency MBS		6,825		25		968		5,882
Corporate bonds		2,010		—		98		1,912
Total	$	47,015	$	1,753	$	1,116	$	47,652

Unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in continuous unrealized loss position, as of June 30, 2012 and December 31, 2011 are summarized as follows:

	Less than 12 Months				12 months or More				Total
Available-for-Sale	Fair Value		Gross Unrealized Losses		Fair Value		Gross Unrealized Losses		Fair Value		Gross Unrealized Losses

June 30, 2012
U.S. Government securities	$	1,129	$	5	$	—	$	—	$	1,129	$	5
State and municipal securities		2,278		19		—		—		2,278		19
Agency MBS		5,654		50		577		8		6,231		58
Non-agency MBS		577		51		3,651		778		4,228		829
Corporate bonds		1,566		19		—		—		1,566		19
Total	$	11,204	$	144	$	4,228	$	786	$	15,432	$	930

December 31, 2011
U.S. Government securities	$	—	$	—	$	—	$	—	$	—	$	—
State and municipal securities		77		1		—		—		77		1
Agency MBS		4,985		49		—		—		4,985		49
Non-agency MBS		590		90		4,223		878		4,813		968
Corporate bonds		1,912		98		—		—		1,912		98
Total	$	7,564	$	238	$	4,223	$	878	$	11,787	$	1,116

At June 30, 2012, there were 25 investment securities in an unrealized loss position, of which seven were in a continuous loss position for 12 months or more. The unrealized losses on these securities were caused by changes in interest rates, widening pricing spreads and market illiquidity, leading to a decline in the fair value subsequent to their purchase. The Company has evaluated the securities shown above and anticipates full recovery of amortized cost with respect to these securities at maturity or sooner in the event of a more favorable market environment. Based on management’s evaluation, and because the Company does not have the intent to sell these securities and it is not more likely than not that it will have to sell the securities before recovery of cost basis, the Company does not consider these investments to be other-than-temporarily impaired at June 30, 2012, except as described below with respect to one non-agency MBS.

For non-agency MBS the Company estimates expected future cash flows of the underlying collateral, together with any credit enhancements. The expected future cash flows of the underlying collateral are determined using the remaining contractual cash flows adjusted for future expected credit losses (which considers current delinquencies, future expected default rates and collateral value by vintage) and prepayments. The expected cash flows of the security are then discounted to arrive at a present value amount. For the six months ended June 30, 2012, one non-agency MBS was determined to be other-than-temporarily-impaired resulting in the Company recording $190 in impairments not related to credit losses through other comprehensive income and $105 in impairments related to credit losses through earnings.

Gross gains realized on sales of securities were $105 and $184 and gross losses realized were $6 and $0 during the six months ended June 30, 2012 and 2011, respectively.

The Company did not engage in originating subprime mortgage loans and it does not believe that it has material exposure to subprime mortgage loans or subprime mortgage backed securities. Additionally, the Company does not have any investment in, or exposure to, collateralized debt obligations, structured investment vehicles or Euro zone sovereign debt.

Note 4 – Loans

Loans and Leases

Loans (including loans held for sale) at June 30, 2012 and December 31, 2011 are as follows:

	June 30, 2012			December 31, 2011

Commercial	$	93,006		$	90,731
Residential real estate:
Residential 1-4 family		96,787			90,552
Multi-family		7,968			7,682
Commercial real estate:
Construction and land development		37,271			47,156
Commercial real estate – owner occupied		113,869			118,469
Commercial real estate – non owner occupied		99,795			103,005
Farmland		23,696			23,752
Consumer		7,862			8,928
Less unearned income		(768	)		(841	)

Total Loans	$	479,486		$	489,434

Allowance for Credit Losses

Changes in the allowance for credit losses for the three and six months ended June 30, 2012 and 2011, and the year ended December 31, 2011 are as follows:

Allowance for Credit Losses	Commercial			Commercial Real Estate (“CRE”)			Residential Real Estate			Consumer			Unallocated			Total

Three months ended June 30, 2012

Beginning balance	$	936		$	6,339		$	858		$	637		$	2,093		$	10,863
Charge-offs		—			(449	)		(49	)		(110	)		—			(608	)
Recoveries		—			345			162			2			—			509
Provision for (recapture of) credit losses		169			623			(152	)		71			(411	)		300

Ending balance	$	1,105		$	6,858		$	819		$	600		$	1,682		$	11,064

Six months ended June 30, 2012

Beginning balance	$	1,012		$	6,803		$	1,046		$	642		$	1,624		$	11,127
Charge-offs		(57	)		(694	)		(120	)		(133	)		—			(1,004	)
Recoveries		23			353			162			3			—			541
Provision for (recapture of) credit losses		127			396			(269	)		88			58			400

Ending balance	$	1,105		$	6,858		$	819		$	600		$	1,682		$	11,064

	Commercial			Commercial Real Estate (“CRE”)			Residential Real Estate			Consumer			Unallocated			Total

Three months ended June 30, 2011

Beginning balance	$	843		$	5,610		$	1,885		$	673		$	1,763		$	10,774
Charge-offs		(52	)		(252	)		(58	)		(17	)		—			(379	)
Recoveries		59			511			—			1			—			571
Provision for (recapture of) credit losses		(21	)		541			(229	)		(254	)		(37	)		—

Ending balance	$	829		$	6,410		$	1,598		$	403		$	1,726		$	10,966

Six months ended June 30, 2011

Beginning balance	$	816		$	5,385		$	1,754		$	690		$	1,972		$	10,617
Charge-offs		(98	)		(550	)		(90	)		(25	)		—			(763	)
Recoveries		68			514			25			5			—			612
Provision for (recapture of) credit losses		43			1,061			(91	)		(267	)		(246	)		500

Ending balance	$	829		$	6,410		$	1,598		$	403		$	1,726		$	10,966

Twelve months ended December 31, 2011

Beginning balance	$	816		$	5,385		$	1,754		$	690		$	1,972		$	10,617
Charge-offs		(161	)		(2,005	)		(665	)		(93	)		—			(2,924	)
Recoveries		69			750			107			8			—			934
Provision for (recapture of) credit losses		288			2,673			(150	)		37			(348	)		2,500

Ending balance	$	1,012		$	6,803		$	1,046		$	642		$	1,624		$	11,127

Recorded investment in loans as of June 30, 2012 and December 31, 2011 are as follows:

June 30, 2012	Commercial		Commercial Real Estate (“CRE”)		Residential Real Estate		Consumer		Unallocated		Total

Allowance for credit losses:
Ending balance: individually evaluated for impairment		—		1,782		66		—		—		1,848

Ending balance: collectively evaluated for impairment		1,105		5,076		753		600		1,682		9,216

Loans:
Ending balance: individually evaluated for impairment	$	607	$	7,912	$	700	$	225	$	—	$	9,444

Ending balance: collectively evaluated for impairment		92,399		266,719		84,284		7,637		—		451,039

Loans held for sale		—		—		19,771		—		—		19,771

Ending balance	$	93,006	$	274,631	$	104,755	$	7,862	$	—	$	480,254

Less unearned income												(768	)

Ending balance total loans											$	479,486

December 31, 2011

Allowance for credit losses:
Ending balance: individually evaluated for impairment		—		1,987		45		—		—		2,032

Ending balance: collectively evaluated for impairment		1,012		4,816		1,001		642		1,624		9,095

Loans:
Ending balance: individually evaluated for impairment	$	529	$	13,076	$	827	$	—	$	—	$	14,432

Ending balance: collectively evaluated for impairment		90,202		279,306		82,866		8,928		—		461,302

Loans held for sale		—		—		14,541		—		—		14,541

Ending balance	$	90,731	$	292,382	$	98,234	$	8,928	$	—	$	490,275

Less unearned income												(841	)

Ending balance total loans											$	489,434

Credit Quality Indicators

Federal regulations require that the Bank periodically evaluate the risks inherent in its loan portfolios. In addition, the Washington Division of Banks and the Federal Deposit Insurance Corporation (“FDIC”) have authority to identify problem loans and, if appropriate, require them to be reclassified. There are three classifications for problem loans: Substandard, Doubtful, and Loss. These terms are used as follows:

“Substandard” loans have one or more defined weaknesses and are characterized by the distinct possibility some loss will be sustained if the deficiencies are not corrected.

“Doubtful” loans have the weaknesses of loans classified as "Substandard," with additional characteristics that suggest the weaknesses make collection or recovery in full after liquidation of collateral questionable on the basis of currently existing facts, conditions, and values. There is a high possibility of loss in loans classified as "Doubtful."

“Loss” loans are considered uncollectible and of such little value that continued classification of the credit as a loan is not warranted. If a loan or a portion thereof is classified as "Loss," it must be charged-off; meaning the amount of the loss is charged against the allowance for credit losses, thereby reducing that reserve.

The Bank also classifies some loans as “Pass” or Other Loans Especially Mentioned (“OLEM”). Within the Pass classification certain loans are “Watch” rated because they have elements of risk that require more monitoring than other performing loans. Pass grade loans include a range of loans from very high credit quality to acceptable credit quality. These borrowers generally have strong to acceptable capital levels and consistent earnings and debt service capacity. Loans with higher grades within the Pass category may include borrowers who are experiencing unusual operating difficulties, but have acceptable payment performance to date. Overall, loans with a Pass grade show no immediate loss exposure. Loans classified as OLEM continue to perform but have shown deterioration in credit quality and require close monitoring.

Loans by credit quality risk rating at June 30, 2012 are as follows:

	Pass		Other Loans Especially Mentioned		Substandard		Doubtful		Total

Commercial	$	87,838	$	801	$	4,332	$	35	$	93,006

Real estate:
Construction and development		27,145		772		9,354		—		37,271
Residential 1-4 family		91,309		1,326		4,152		—		96,787
Multi-family		7,968		—		—		—		7,968
CRE – owner occupied		107,304		1,769		4,796		—		113,869
CRE – non owner occupied		75,932		15,111		8,752		—		99,795
Farmland		22,530		110		1,056		—		23,696
Total real estate		332,188		19,088		28,110		—		379,386

Consumer		7,547		6		309		—		7,862

Subtotal	$	427,573	$	19,895	$	32,751	$	35	$	480,254
Less unearned income										(768	)

Total loans									$	479,486

Loans by credit quality risk rating at December 31, 2011 are as follows:

	Pass		Other Loans Especially Mentioned		Substandard		Doubtful		Total

Commercial	$	83,920	$	2,232	$	4,579	$	—	$	90,731

Real estate:
Construction and development		37,804		1,394		7,958		—		47,156
Residential 1-4 family		86,239		741		3,572		—		90,552
Multi-family		7,682		—		—		—		7,682
CRE – owner occupied		111,028		1,856		5,585		—		118,469
CRE – non owner occupied		77,414		13,877		11,714		—		103,005
Farmland		22,543		110		1,099		—		23,752
Total real estate		342,710		17,978		29,928		—		390,616

Consumer		8,804		53		63		8		8,928

Subtotal	$	435,434	$	20,263	$	34,570	$	8	$	490,275
Less unearned income										(841	)

Total loans									$	489,434

Impaired Loans

Following is a summary of information pertaining to impaired loans at June 30, 2012:

	Recorded Investment		Unpaid Principal Balance		Related Allowance		3 Month Average Recorded Investment		6 Month Average Recorded Investment		3 Months Interest Income Recognized		6 Months Interest Income Recognized
With no related allowance recorded:
Commercial	$	607	$	607	$	—	$	653	$	612	$	6	$	15
Consumer		225		325		—		113		75		—		—
Residential real estate		700		819		—		809		715		4		6
Commercial real estate:
CRE – owner occupied		134		233		—		224		359		1		2
CRE – non-owner occupied		2,405		2,498		—		2,664		2,746		16		16
Construction and development		1,704		3,836		—		2,416		3,389		14		35

With an allowance recorded:
Residential real estate		—		—		—		93		161		—		—
Commercial real estate:
CRE – non-owner occupied		3,485		3,997		1,782		3,556		3,580		—		—
Construction and development		184		382		66		92		252		9		12

Total:
Commercial		607		607		—		653		612		6		15
Consumer		225		325		—		113		75		—		—
Residential real estate		700		819		—		902		876		4		6
Commercial real estate:
CRE – owner occupied		134		233		—		224		359		1		1
CRE – non-owner occupied		5,890		6,495		1,782		6,220		6,326		16		16
Construction and development		1,888		4,218		66		2,508		3,641		23		47

Following is a summary of information pertaining to impaired loans at June 30, 2011:

	Recorded Investment		Unpaid Principal Balance		Related Allowance		3 Month Average Recorded Investment		6 Month Average Recorded Investment		3 Months Interest Income Recognized		6 Months Interest Income Recognized
With no related allowance recorded:
Commercial	$	193	$	206	$	—	$	154	$	355	$	3	$	11
Residential real estate		695		879		—		1,215		1,878		8		11
Commercial real estate:
CRE – owner occupied		1,564		1,607		—		1,535		1,265		—		2
CRE – non-owner occupied		4,133		4,133		—		2,135		2,337		21		21
Construction and development		4,858		5,512		—		6,011		6,252		5		72

With an allowance recorded:
Commercial		—		—		—		251		337		—		5
Residential real estate		71		71		16		36		24		—		—
Construction and development		1,844		3,266		64		922		615		—		52

Total:
Commercial		193		206		—		405		692		3		16
Residential real estate		766		950		16		1,251		1,902		8		11
Commercial real estate:
CRE – owner occupied		1,564		1,607		—		1,535		1,265		—		2
CRE – non-owner occupied		4,133		4,133		—		2,135		2,337		21		21
Construction and development		6,702		8,778		64		6,933		6,867		5		124

Following is a summary of information pertaining to impaired loans at December 31, 2011:

	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
With no related allowance recorded:
Commercial	$	530	$	556	$	—	$	355	$	15
Residential real estate		528		620		—		1,314		16
Commercial real estate:
CRE – owner occupied		629		719		—		971		7
CRE – non-owner occupied		2,912		2,912		—		3,181		21
Construction and development		5,335		7,501		—		5,868		188

With an allowance recorded:
Commercial		—		—		—		202		5
Residential real estate		298		298		45		74		—
Commercial real estate:
CRE - non-owner occupied		3,627		3,997		1,782		725		—
Construction and development		573		573		205		716		3

Total:
Commercial		530		556		—		557		20
Residential real estate		826		918		45		1,388		16
Commercial real estate:
CRE – owner occupied		629		719		—		971		7
CRE – non-owner occupied		6,539		6,909		1,782		3,906		21
Construction and development		5,908		8,074		205		6,584		191

Aging Analysis

The following table provides an age analysis of past due loans at June 30, 2012.

	Current			30-59 Days Past Due		60-89 Days Past Due		Greater Than 90 Days Past Due and Still Accruing		Total Past Due		Non- accrual Loans		Total Loans

Commercial	$	92,228		$	169	$	—	$	—	$	169	$	609	$	93,006

Real estate:
Construction & development		32,684			2,699		—		—		2,699		1,888		37,271
Residential 1-4 family		95,126			938		23		—		961		700		96,787
Multi-family		7,968			—		—		—		—		—		7,968
CRE owner occupied		110,658			2,307		—		770		3,077		134		113,869
CRE non-owner occupied		93,905			—		—		—		—		5,890		99,795
Farmland		23,696			—		—		—		—		—		23,696
Total real estate		364,037			5,944		23		770		6,737		8,612		379,386

Consumer		7,624			13		—		—		13		225		7,862

Less unearned income		(768	)		—		—		—		—		—		(768	)

Total	$	463,121		$	6,126	$	23	$	770	$	6,919	$	9,446	$	479,486

The following table provides an age analysis of past due loans at December 31, 2011.

	Current			30-59 Days Past Due		60-89 Days Past Due		Greater Than 90 Days Past Due and Still Accruing		Total Past Due		Non- accrual Loans		Total Loans

Commercial	$	89,981		$	220	$	—	$	—	$	220	$	530	$	90,731

Real estate:
Construction & development		41,570			76		—		—		76		5,510		47,156
Residential 1-4 family		88,661			880		184		299		1,363		528		90,552
Multi-family		7,682			—		—		—		—		—		7,682
CRE owner occupied		116,979			508		353		—		861		629		118,469
CRE non-owner occupied		96,332			134		—		—		134		6,539		103,005
Farmland		23,752			—		—		—		—		—		23,752
Total real estate		374,976			1,598		537		299		2,434		13,206		390,616

Consumer		8,869			59		—		—		59		—		8,928

Less unearned income		(841	)		—		—		—		—		—		(841	)

Total	$	472,985		$	1,877	$	537	$	299	$	2,713	$	13,736	$	489,434

Modifications

A modification of a loan constitutes a troubled debt restructuring (“TDR”) when a borrower is experiencing financial difficulty and the modification constitutes a concession. There are various types of concessions when modifying a loan, however, forgiveness of principal is rarely granted by the Company. Commercial and industrial loans modified in a TDR may involve term extensions, below market interest rates and/or interest-only payments wherein the delay in the repayment of principal is determined to be significant when all elements of the loan and circumstances are considered. Additional collateral, a co-borrower, or a guarantor is often required. Commercial mortgage and construction loans modified in a TDR often involve reducing the interest rate for the remaining term of the loan, extending the maturity date at an interest rate lower than the current market rate for new debt with similar risk, or substituting or adding a new borrower or guarantor. Construction loans modified in a TDR may also involve extending the interest-only payment period. Residential mortgage loans modified in a TDR are primarily comprised of loans where monthly payments are lowered to accommodate the borrowers’ financial needs. Land loans are typically structured as interest-only monthly payments with a balloon payment due at maturity. Land loans modified in a TDR typically involve extending the balloon payment by one to three years, and providing an interest rate concession. Home equity modifications are made infrequently and are uniquely designed to meet the specific needs of each borrower.

Loans modified in a TDR are typically already on non-accrual status and partial charge-offs have in some cases already been taken against the outstanding loan balance. As a result, loans modified in a TDR for the Company may have the financial effect of increasing the specific allowance associated with the loan. An allowance for impaired loans that have been modified in a TDR is measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s observable market price, or the estimated fair value of the collateral, less any selling costs, if the loan is collateral dependent. The Company’s practice is to re-appraise collateral dependent loans semi-annually. During the six months ended June 30, 2012, there was no impact on the allowance from TDRs during the period, as the loans classified as TDRs during the period did not have a specific reserve and were already considered impaired loans at the time of modification.

The Company closely monitors the performance of modified loans for delinquency, as delinquency is considered an early indicator of possible future default. The allowance may be increased, adjustments may be made in the allocation of the allowance, or partial charge-offs may be taken to further write-down the carrying value of the loan.

The following tables present TDRs for the three and six months ended June 30, 2012, all of which were modified due to financial stress of the borrower.

	Current TDRs						Subsequently Defaulted TDRs
Six months ended June 30, 2012	Number of Contracts		Pre-TDR Outstanding Recorded Investment		Post-TDR Outstanding Recorded Investment		Number of Contracts		Pre-TDR Outstanding Recorded Investment		Post-TDR Outstanding Recorded Investment

Commercial		1	$	335	$	327
Residential real estate		3		342		302		—	$	—	$	—
CRE owner occupied		1		59		58		—		—		—
CRE non-owner occupied		1		2,180		2,178		—		—		—
Construction & development		3		2,972		1,552		2		2,561		2,465

Ending balance (1)		9	$	5,888	$	4,417		2	$	2,561	$	2,465

	Current TDRs						Subsequently Defaulted TDRs
Three months ended June 30, 2012	Number of Contracts		Pre-TDR Outstanding Recorded Investment		Post-TDR Outstanding Recorded Investment		Number of Contracts		Pre-TDR Outstanding Recorded Investment		Post-TDR Outstanding Recorded Investment

Residential real estate		1	$	78	$	78		—	$	—	$	—

Ending balance (1)		1	$	78	$	78		—	$	—	$	—

(1)

The period end balances are inclusive of all partial pay downs and charge-offs since the modification date.

The construction and development loan TDRs that subsequently defaulted were modified by extending the maturity date. Both loans were on non-accrual status prior to and after the TDR. The subsequent defaults reported above occurred during the last twelve months and the loans were subsequently transferred to other real estate owned during the three months ended March 31, 2012. There were no other loans modified as a TDR within the previous 12 months that subsequently defaulted during the three and six months ended June 30, 2012.

Loans classified as TDRs are considered impaired loans. The Company had no commitments to lend additional funds for loans classified as troubled debt restructured at June 30, 2012.

Note 5 – Stock Based Compensation

Stock Options

The Company’s 2000 Stock Incentive Plan provided for incentive and non-qualified stock options and other types of stock based awards to key personnel. Under the plan, the Company was authorized to issue up to 1,100,000 shares; however the plan expired January 1, 2011. On April 27, 2011, the shareholders of the Company approved the 2011 Equity Incentive Plan, pursuant to which the Company is authorized to issue up to 900,000 shares of common stock in connection with awards under the plan.

The fair value of stock options granted is determined using the Black-Scholes option pricing model based on assumptions noted in the following table. Expected volatility is based on historical volatility of the Company’s common stock. The expected term of stock options granted is based on the simplified method, which is the simple average between contractual term and vesting period. The risk-free rate is based on the expected term of stock options and the applicable U.S. Treasury yield in effect at the time of grant.

Grant period ended	Expected Life	Risk Free Interest Rate			Expected Volatility			Dividend Yield			Average Fair Value

June 30, 2012	6.5 years		1.34	%		22.43	%		—	%	$	0.77

There were no options granted during the six months ended June 30, 2011.

A summary of stock option activity under the stock option plans as of June 30, 2012 and 2011, and changes during the six months then ended are presented below:

	Shares			Weighted Average Exercise Price		Weighted Average Remaining Contractual Term ( Years)		Aggregate Intrinsic Value
June 30, 2012

Outstanding beginning of period		586,448		$	11.32
Granted		10,500			5.00
Exercised		—			—
Forfeited		(10,050	)		11.30
Expired		(47,291	)		10.57

Outstanding end of period		539,607		$	11.26		4.5	$	—

Exercisable end of period		366,647		$	13.26		3.1	$	—

June 30, 2011

Outstanding beginning of period		818,612		$	11.07
Granted		—			—
Exercised		—			—
Forfeited		(32,225	)		10.40
Expired		(177,779	)		10.10

Outstanding end of period		608,608		$	11.39		4.8	$	—

Exercisable end of period		426,358		$	12.93		3.6	$	—

A summary of the status of the Company’s non-vested options as of June 30, 2012 and 2011 and changes during the six months then ended are presented below:

	2012					2011
	Shares			Weighted Average Fair Value		Shares			Weighted Average Fair Value
Non-vested beginning of period		174,740		$	0.37		218,885		$	0.51
Granted		10,500			0.77		—			—
Vested		(8,470	)		1.82		(17,765	)		1.77
Forfeited		(3,810	)		0.29		(18,870	)		0.49

Non-vested end of period		172,960		$	0.33		182,250		$	0.38

The Company accounts for stock based compensation in accordance with GAAP, which requires measurement of compensation cost for all stock-based awards based on grant date fair value and recognition of compensation cost over the service period of each award. Stock-based compensation expense during the six months ended June 30, 2012 and 2011 was $8 and $12 ($5 and $8 net of tax), respectively. Future compensation expense for unvested awards outstanding as of June 30, 2012 is estimated to be $32 recognized over a weighted average period of 1.8 years. There were no options exercised during the six months ended June 30, 2012 and 2011.

Restricted Stock Units

In March 2012, the Company granted restricted stock units (“RSU”) to certain employees receiving awards under the Company’s Annual Incentive Compensation Plan. Recipients of RSUs will be issued a specified number of shares of the Company’s common stock upon the lapse of their applicable restrictions. Restrictions require the employee to continue in employment for a period of three years from the date the RSU is awarded.

The following table summarizes RSU activity during 2012. There was no RSU activity prior to 2012.

	Shares		Weighted average grant price		Weighted average remaining contractual terms (in years)

Outstanding, January 1, 2012		—	$	—		—
Granted		7,274		4.15		3.0

Outstanding, June 30, 2012		7,274	$	4.15		3.0

For the six months ended June 30, 2012, the Company recognized compensation expense related to RSUs of $3 ($2 net of tax). As of June 30, 2012, there was $27 of total unrecognized compensation expense related to non-vested RSUs.

Note 6 – Commitments and Contingencies

The Bank is party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit, and involve, to varying degrees, elements of credit risk in excess of the amount recognized on the consolidated balance sheets.

The Bank’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amount of those instruments. The Bank uses the same credit policies in making commitments and conditional obligations as they do for on-balance-sheet instruments. A summary of the Bank’s off-balance sheet commitments at June 30, 2012 and December 31, 2011 is as follows:

	June 30,		December 31,
	2012		2011

Commitments to extend credit	$	80,624	$	91,596
Standby letters of credit		2,104		1,310

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Many of the commitments expire without being drawn upon; therefore total commitment amounts do not necessarily represent future cash requirements. The Bank evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary upon extension of credit, is based on management’s credit evaluation of the customer. Collateral held varies, but may include accounts receivable, inventory, property and equipment, residential real estate, and income-producing commercial properties.

Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers.

In connection with certain loans held for sale, the Bank typically makes representations and warranties that the underlying loans conform to specified guidelines. If the underlying loans do not conform to the specifications, the Bank may have an obligation to repurchase the loans or indemnify the purchaser against loss. The Bank believes that the potential for loss under these arrangements is remote. Accordingly, no contingent liability is recorded in the condensed consolidated financial statements.

The Company is currently not party to any material pending litigation. However, because of the nature of its activities, the Company may be subject to or threatened with legal actions in the ordinary course of business. In the opinion of management, liabilities arising from these claims, if any, will not have a material effect on the results of operations or financial condition of the Company.

Note 7 – Recent Accounting Pronouncements

In May 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2011-04, “Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS.” This ASU is the result of joint efforts by the FASB and International Accounting Standards Board to develop a single, converged fair value framework on how (not when) to measure fair value and what disclosures to provide about fair value measurements. The ASU is largely consistent with existing fair value measurement principles in U.S. GAAP (Topic 820), with many of the amendments made to eliminate unnecessary wording differences between U.S. GAAP and International Financial Reporting Standards. The amendments are effective for interim and annual periods beginning after December 15, 2011 with prospective application required. The Company adopted the provisions of ASU No. 2011-04 effective January 1, 2012. The fair value measurement provisions had no impact on the Company’s consolidated financial statements. See Note 8 for the enhanced disclosures required by ASU No. 2011-04.

In June 2011, FASB issued ASU No. 2011-05, “Comprehensive Income (Topic 220): Presentation of Comprehensive Income”. This ASU will require companies to present the components of net income and other comprehensive income either as one continuous statement or as two consecutive statements. It eliminates the option to present components of other comprehensive income as part of the statement of changes in shareholders’ equity. The standard does not change the items which must be reported in other comprehensive income, how such items are measured or when they must be reclassified to net income. This standard is effective for interim and annual periods beginning after December 15, 2011. The FASB subsequently deferred the effective date of certain provisions of this standard pertaining to the reclassification of items out of accumulated other comprehensive income. A Consolidated Statement of Comprehensive Income has been included as part of the Company’s unaudited financial statements, for the six months ended June 30, 2012 and 2011. The adoption of ASU No. 2011-05 had no impact on the Company’s financial condition, results of operations or cash flows.

Note 8 – Fair Value Measurements

Fair Value Hierarchy

The Company uses an established hierarchy for measuring fair value that is intended to maximize the use of observable inputs and minimize the use of unobservable inputs. This hierarchy uses three levels of inputs to measure the fair value of assets and liabilities as follows:

Level 1 – Valuations based on quoted prices in active exchange markets for identical assets or liabilities; also includes certain corporate debt securities actively traded in over-the-counter markets.

Level 2 – Valuations of assets and liabilities traded in less active dealer or broker markets. Valuations include quoted prices for similar assets and liabilities traded in the same market; quoted prices for identical or similar instruments in markets that are not active; and model–derived valuations whose inputs are observable or whose significant value drivers are observable. Valuations may be obtained from, or corroborated by, third-party pricing services. This category generally includes certain U.S. Government, agency and non-agency securities, state and municipal securities, mortgage-backed securities, corporate securities, and residential mortgage loans held for sale.

Level 3 – Valuation based on unobservable inputs supported by little or no market activity for financial instruments whose value is determined using pricing models, discounted cash flow methodologies, yield curves and similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation. Level 3 valuations incorporate certain assumptions and projections in determining the fair value assigned to such assets or liabilities, but in all cases are corroborated by external data, which may include third-party pricing services.

Investment Securities available-for-sale

The Company uses an independent pricing service to assist management in determining fair values of investment securities available-for-sale. This service provides pricing information by utilizing evaluated pricing models supported with observable market data. Standard inputs include benchmark yields, reported trades, broker/dealer quotes, credit ratings, bids and offers, relative credit information and reference data from market research publications. Investment securities that are deemed to have been trading in illiquid or inactive markets may require the use of significant unobservable inputs.

The pricing service provides quoted market prices when available. Quoted prices are not always available due to bond market inactivity. For securities where quoted prices or market prices of similar securities are not available, fair values are calculated using discounted cash flows. Discounted cash flows are calculated using spread to swap and LIBOR curves that are updated to incorporate loss severities, volatility, credit spread and optionality. Additionally, the pricing service may obtain a broker quote when sufficient information is not available to produce a valuation. Valuations and broker quotes are non-binding and do not represent quotes on which one may execute the disposition of the assets.

The Company generally obtains one value from its primary external third-party pricing service. The Company’s third-party pricing service has established processes for us to submit inquiries regarding quoted prices. The Company’s third-party pricing service will review the inputs to the evaluation in light of any new market data presented by us. The Company’s third-party pricing service may then affirm the original quoted price or may update the evaluation on a going forward basis.

On a quarterly basis, management reviews the pricing information received from the third party-pricing service through a combination of procedures that include an evaluation of methodologies used by the pricing service, analytical reviews and performance analysis of the prices against statistics and trends and maintenance of an investment watch list. Based on this review, management determines whether the current placement of the security in the fair value hierarchy is appropriate or whether transfers may be warranted. As necessary, the Company compares prices received from the pricing service to discounted cash flow models or through performing independent valuations of inputs and assumptions similar to those used by the pricing service in order to ensure prices represent a reasonable estimate of fair value. Although the Company does identify differences from time to time as a result of these validation procedures, the Company did not make any significant adjustments as of June 30, 2012 or December 31, 2011.

The following table presents the balances of assets measured at fair value on a recurring basis at June 30, 2012 and December 31, 2011.

June 30, 2012	Readily Available Market Inputs Level 1		Observable Market Inputs Level 2		Significant Unobservable Inputs Level 3		Total

Securities available-for-sale
U.S. Government securities	$	—	$	1,210	$	—	$	1,210
State and municipal securities		—		24,455		1,069		25,524
Agency MBS		—		17,330		—		17,330
Non-agency MBS		—		5,209		—		5,209
Corporate bonds		1,309		2,575		—		3,884

Total	$	1,309	$	50,779	$	1,069	$	53,157

December 31, 2011	Readily Available Market Inputs Level 1		Observable Market Inputs Level 2		Significant Unobservable Inputs Level 3		Total

Securities available-for-sale
U.S. Government securities	$	—	$	84	$	—	$	84
State and municipal securities		—		21,719		1,140		22,859
Agency MBS		—		16,915		—		16,915
Non-agency MBS		—		5,882		—		5,882
Corporate bonds		918		994		—		1,912

Total	$	918	$	45,594	$	1,140	$	47,652

As of June 30, 2012 and December 31, 2011 the Company had two investments classified as Level 3 investments which consist of local non-rated municipal bonds for which the Company is the sole owner of the entire bond issue. The valuation of these securities is supported by analysis prepared by an independent third party. Their approach to determining fair value involves using recently executed transactions and market quotations for similar securities. As these securities are not rated by the rating agencies and there is no trading volume, management determined that these securities should be classified as Level 3 inputs. Additionally, these securities are considered sensitive to changes in credit given the unobserved assumed credit ratings.

The following table presents a reconciliation of assets that are measured at fair value on a recurring basis using significant unobservable inputs (Level 3) during the six months ended June 30, 2012 and 2011, respectively. There were no transfers of assets into or out of Level 1, 2 or 3 for the six months ended June 30, 2012.

	Three months ended June 30,						Six months ended June 30,
	2012			2011			2012			2011

Balance beginning of period	$	1,078		$	1,152		$	1,140		$	1,157
Included in other comprehensive income (loss)		(9	)		(17	)		(71	)		(22	)

Balance end of period	$	1,069		$	1,135		$	1,069		$	1,135

Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis

Certain assets and liabilities are measured at fair value on a nonrecurring basis after initial recognition such as loans measured for impairment and other real estate owned (“OREO”). The following methods were used to estimate the fair value of each such class of financial instrument:

Impaired loans – A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due (both interest and principal) according to the contractual terms of the loan agreement. Impaired loans are classified as Level 3 in the fair value hierarchy and are measured based on the present value of expected future cash flows or by the net realizable value of the collateral if the loan is collateral dependent. In determining the net realizable value of the underlying collateral, we primarily rely on third party appraisals by qualified licensed appraisers, less costs to sell. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach.

Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available and include consideration for variations in location, size, and income production capacity of the property. The income approach commonly utilizes a discount or cap rate to determine the present value of expected future cash flows. Additionally, the appraisals are periodically further adjusted by the Company in consideration of charges that may be incurred in the event of foreclosure and are based on management’s historical knowledge, changes in business factors and changes in market conditions. Such discounts are typically significant, and may range from 10% to 30% resulting in a Level 3 classification.

Impaired loans are reviewed and evaluated quarterly for additional impairment and adjusted accordingly, based on the same factors identified above. Because of the high degree of judgment required in estimating the fair value of collateral underlying impaired loans and because of the relationship between fair value and general economic conditions, we consider the fair value of impaired loans to be highly sensitive to changes in market conditions.

Other real estate owned – OREO is initially recorded at the lower of the carrying amount of the loan or fair value of the property less estimated costs to sell. This amount becomes the property’s new basis. Management considers third party appraisals in determining the fair value of particular properties. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach.

Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available and include consideration for variations in location, size, and income production capacity of the property. Additionally, the appraisals are periodically further adjusted by the Company based on management’s historical knowledge, changes in business factors and changes in market conditions. Such discounts are typically significant, and may range from 10% to 25% resulting in a Level 3 classification.

Any write-downs based on the property fair value less estimated costs to sell at the date of acquisition are charged to the allowance for credit losses. Management periodically reviews OREO to ensure the property is carried at the lower of its new basis or fair value, net of estimated costs to sell. Any additional write-downs based on re-evaluation of the property fair value are charged to non-interest expense. Because of the high degree of judgment required in estimating the fair value of OREO and because of the relationship between fair value and general economic conditions, we consider the fair value of OREO to be highly sensitive to changes in market conditions.

The following table presents the Company’s assets that were held at the end of each period that were accounted for at fair value on a nonrecurring basis at June 30, 2012 and December 31, 2011.

	Readily Available Market Inputs Level 1		Observable Market Inputs Level 2		Significant Unobservable Inputs Level 3		Total
June 30, 2012
Impaired loans	$	—	$	—	$	5,485	$	5,485
OREO	$	—	$	—	$	2,652	$	2,652

December 31, 2011
Impaired loans	$	—	$	—	$	7,183	$	7,183
OREO	$	—	$	—	$	6,455	$	6,455

Other real estate owned with a pre-foreclosure loan balance of $2,031 was acquired during the six months ended June 30, 2012. Upon foreclosure, certain of these assets were written down a total of $90 to their fair value, less estimated costs to sell, which was charged to the allowance for credit losses during the period.

The following table presents quantitative information about Level 3 inputs for financial instruments measured at fair value on a nonrecurring basis at June 30, 2012:

	Fair Value		Valuation Technique	Significant Unobservable Inputs	Range (Weighted Average)

Impaired loans	$	2,000	Appraised value - Sales comparison approach	Adjustment for market conditions		0-29% (5%)

	$	3,485	Income approach	Discount rate		10.5%

OREO	$	2,652	Appraised value - Sales comparison approach	Adjustment for market conditions		0-10% (6%)

Fair Value of Financial Instruments

The following methods and assumptions were used by the Company in estimating the fair values of financial instruments disclosed in these consolidated financial statements:

Cash and due from banks, Interest bearing deposits in banks, and Federal funds sold

The carrying amounts of cash, interest bearing deposits at other financial institutions, and federal funds sold approximate their fair value.

Investment Securities Available-for-Sale and Held-to-Maturity

The fair value of all investment securities are based upon the assumptions market participants would use in pricing the security. Such assumptions include observable and unobservable inputs such as quoted market prices, dealer quotes and analysis of discounted cash flows.

Federal Home Loan Bank stock

FHLB stock is carried at cost which approximates fair value and equals its par value because the shares can only be redeemed with the FHLB at par.

Loans, net and Loans held for sale

The fair value of loans is estimated based on comparable market statistics for loans with similar credit ratings. An additional liquidity discount is also incorporated to more closely align the fair value with observed market prices. Fair values of loans held for sale are based on a discounted cash flow calculation using interest rates currently available on similar loans. The fair value was determined on an aggregate loan basis.

Deposits

The fair value of deposits with no stated maturity date is included at the amount payable on demand. Fair values for fixed rate certificates of deposit are estimated using a discounted cash flow calculation based on interest rates currently offered on similar certificates.

Short-term borrowings

The fair values of the Company’s short-term borrowings are estimated using discounted cash flow analysis based on the Company’s incremental borrowing rates for similar types of borrowing arrangements.

Long-term borrowings

The fair values of the Company’s long-term borrowings are estimated using discounted cash flow analysis based on the Company’s incremental borrowing rates for similar types of borrowing arrangements.

Secured borrowings

For variable rate secured borrowings that reprice frequently and have no significant change in credit risk, fair values are based on carrying values.

Junior subordinated debentures

The fair value of the junior subordinated debentures and trust preferred securities is estimated using discounted cash flow analysis based on interest rates currently available for junior subordinated debentures.

Off-Balance-Sheet Instruments

The fair value of commitments to extend credit and standby letters of credit was estimated using the rates currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the customers. Since the majority of the Company’s off-balance-sheet instruments consist of non-fee producing, variable-rate commitments, the Company has determined they do not have a material fair value.

The estimated fair values of the Company’s financial instruments at June 30, 2012 and December 31, 2011 are as follows:

June 30, 2012	Carrying Amount		Level 1		Level 2		Level 3		Total Fair Value

Financial Assets
Cash and cash equivalents	$	38,322	$	38,322	$	—	$	—	$	38,322
Securities available-for sale		53,157		1,309		50,779		1,069		53,157
Securities held-to-maturity		6,871		—		6,931		—		6,931
Federal Home Loan Bank stock		3,182		—		3,182		—		3,182
Loans held for sale		19,771		—		20,061		—		20,061
Loans, net		448,651		—		—		406,423		406,423

Financial Liabilities
Deposits	$	538,709	$	—	$	540,265	$	—	$	540,265
Short-term borrowings		3,000		—		3,059		—		3,059
Long-term borrowings		7,500		—		7,767		—		7,767
Secured borrowings		222		—		222		—		222
Junior subordinated debentures		13,403		—		—		6,969		6,969

December 31, 2011	Carrying Amount		Level 1		Level 2		Level 3		Total Fair Value

Financial Assets
Cash and cash equivalents	$	41,132	$	41,132	$	—	$	—	$	41,132
Securities available-for sale		47,652		918		45,594		1,140		47,652
Securities held-to-maturity		7,025		—		7,118		—		7,118
Loans held for sale		14,541		—		14,808		—		14,808
Loans, net		463,766		—		—		419,059		419,059

Financial Liabilities
Deposits	$	548,050	$	—	$	549,472	$	—	$	549,472
Short-term borrowings		—		—		—		—		—
Long-term borrowings		10,500		—		10,867		—		10,867
Secured borrowings		741		—		741		—		741
Junior subordinated debentures		13,403		—		—		6,691		6,691

Note 9 – Goodwill

The majority of goodwill and intangibles generally arise from business combinations accounted for under the purchase method. Goodwill and other intangibles deemed to have indefinite lives generated from purchase business combinations are not subject to amortization and are instead tested for impairment no less than annually.

During the second quarter of 2012, the Company initiated its annual goodwill impairment test to determine whether an impairment of its goodwill asset exists. The test was completed during the current quarter. The goodwill impairment test involves a two-step process. The first step is a comparison of the reporting unit’s fair value to its carrying value. If the reporting unit’s fair value is less than its carrying value, the Company is required to progress to the second step. In the second step the Company calculates the implied fair value of its reporting unit and, in accordance with applicable GAAP standards, compares the implied fair value of goodwill to the carrying amount of goodwill on the Company’s balance sheet. If the carrying amount of the goodwill is greater than the implied fair value of that goodwill, an impairment loss must be recognized in an amount equal to that excess. The implied fair value of goodwill is determined in the same manner as goodwill recognized in a business combination. The estimated fair value of the Company is allocated to all of the Company’s individual assets and liabilities, including any unrecognized identifiable intangible assets, as if the Company had been acquired in a business combination and the estimated fair value of the Company is the price paid to acquire it. The allocation process is performed only for purposes of determining whether a goodwill impairment exists and the amount of any such impairment. No assets or liabilities are written up or down, nor are any additional unrecognized identifiable intangible assets recorded as a part of this process.

The Company estimates fair value using the best information available, including market information and a discounted cash flow analysis, which is also referred to as the income approach. The income approach uses a reporting unit’s projection of estimated operating results and cash flows that is discounted using a rate that reflects current market conditions. The projection uses management’s best estimates of economic and market conditions over the projected period including growth rates in loans and deposits, estimates of future expected changes in net interest margins and cash expenditures. The market approach estimates fair value by applying cash flow multiples to the reporting unit’s operating performance. The multiples are derived from comparable publicly traded companies with similar operating and investment characteristics of the reporting unit. We validate our estimated fair value by comparing the fair value estimates using the income approach to the fair value estimates using the market approach.

As part of our process for performing the step one impairment test of goodwill, the Company estimated the fair value of the reporting unit utilizing the income approach and the market approach in order to derive an enterprise value of the Company. In determining the discount rate for the discounted cash flow model, the Company used a modified capital asset pricing model that develops a rate of return utilizing a risk-free rate and equity risk premium resulting in a discount rate of 14.0%. This approach also includes adjustments for the industry the Company operates in and size of the Company. In addition, assumptions used by the Company in its discounted cash flow model (income approach) included an average annual revenue growth rate that approximated 2%; an asset growth of 2% in year one, 3% in year two, 3.5% annually in years three through five and 4% in year six; net interest margin ranging from 4.38% in the base year to 4.26% in year five; and a return on assets that ranged from 0.4% to 1.1%.

In applying the market approach method, the Company considered all acquired banks between January 1, 2011 and June 30, 2012 with total assets between $100 million and $2 billion and non-performing assets to total assets between 1% and 6%. This resulted in selecting 28 comparable institutions which were analyzed based on a variety of financial metrics (tangible equity, return on assets, return on equity, net interest margin, efficiency ratio, nonperforming assets, and reserves for loan losses). After selecting comparable institutions, the Company derived the fair value of the reporting unit by completing a comparative analysis of the relationship between their financial metrics listed above and their market values utilizing various market multiples. Focus was placed on the price to tangible book value of equity multiple as this multiple generally reflects returns on the capital employed within the industry and is generally correlated with the profitability of each individual company.

The Company concluded a fair value of its reporting unit of $68.0 million, by giving similar consideration to the values derived from 1) the income approach of $68.1 million weighted at 65%, and 2) the market approach of $66.8 million weighted at 35%; compared to a carrying value of its reporting unit of $65.5 million. The results of the Company’s step one test indicated that the reporting unit’s fair value exceeded its carrying value and no goodwill impairment existed.

Even though the Company determined that there was no goodwill impairment, continued declines in the value of our stock price as well as values of others in the financial industry, declines in revenue for the Bank and significant adverse changes in the operating environment for the financial industry may result in a future impairment charge. It is possible that changes in circumstances existing at the measurement date or at other times in the future, or in the numerous estimates associated with management’s judgments, assumptions and estimates made in assessing the fair value of our goodwill, could result in an impairment charge of a portion or all of our goodwill. If the Company recorded an impairment charge, its financial position and results of operations would be adversely affected, however, such an impairment charge would have no impact on our liquidity, operations or regulatory capital.

ITEM 2 – MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

A Warning About Forward-Looking Information

This document contains forward-looking statements that are subject to risks and uncertainties. These statements are based on the present beliefs and assumptions of our management, and on information currently available to them. Forward-looking statements include the information concerning our possible future results of operations set forth under "Management's Discussion and Analysis of Financial Condition and Results of Operations" and statements preceded by, followed by or that include the words "believes," "expects," "anticipates," "intends," "plans," "estimates" or similar expressions.

Any forward-looking statements in this document are subject to the risks of our business, including risk factors described in our Annual Report on Form 10-K for the year ended December 31, 2011 (the “2011 10-K”), as well as risks relating to, among other things, the following:

1. changing laws, regulations, standards, and government programs that may limit our revenue sources, significantly increase our costs, including compliance and insurance costs, limit our opportunities to generate noninterest income, and place additional burdens on our limited management resources;

2. poor economic or business conditions, nationally and in the regions in which we do business, that have resulted in, and may continue to result in, among other things, a deterioration in credit quality and/or reduced demand for credit and other banking services, and additional workout and other real estate owned (“OREO”) expenses;

3. decreases in real estate and other asset prices, whether or not due to economic conditions, that may reduce the value of the assets that serve as collateral for many of our loans;

4 competitive pressures among depository and other financial institutions that may impede our ability to attract and retain depositors, borrowers and other customers, maintain and improve our net interest income and margin and non-interest income, such as fee income, and/or retain our key employees; and

5. a lack of liquidity in the market for our common stock that may make it difficult or impossible for you to liquidate your investment in our stock or lead to distortions in the market price of our stock.

Our management believes the forward-looking statements in this report are reasonable; however, you should not place undue reliance on them. Forward-looking statements are not guarantees of performance. They involve risks, uncertainties and assumptions. Many of the factors that will determine our future results and share value are beyond our ability to control or predict. We undertake no obligation to update forward-looking statements.

Overview

The Company is a bank holding company headquartered in Aberdeen, Washington. The Company's wholly-owned subsidiary, The Bank of the Pacific (the “Bank”), is a state chartered bank, also located in Washington. The Company has two wholly-owned subsidiary trusts known as PFC Statutory Trust I and II (the “Trusts”) that were formed December 2005 and May 2006, respectively, in connection with the issuance of trust preferred securities. The Company was incorporated in the state of Washington on February 12, 1997, pursuant to a holding company reorganization of the Bank.

The Company conducts its banking business through the Bank, which operates 16 branches located in communities in Grays Harbor, Pacific, Whatcom, Skagit and Wahkiakum counties in the state of Washington and one in Clatsop County, Oregon. During 2012, the Company opened a loan production office in Burlington, Washington. Additionally, subsequent to quarter-end, the Company received regulatory approval to establish a full service branch in Warrenton, Oregon with an estimated opening date in 2013.

The Bank provides loan and deposit services to customers who are predominantly small and middle-market businesses and middle-income individuals.

Critical Accounting Policies

Critical accounting policies are discussed in the 2011 10-K under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operation – Critical Accounting Policies.” There have been no material changes in our critical accounting policies from the 2011 10-K.

Recent Accounting Pronouncements

Please see Note 8 of the Company's Notes to Condensed Consolidated Financial Statements above for a discussion of recent accounting pronouncements and the likely effect on the Company.

Financial Summary

The following are significant trends reflected in the Company’s results of operations for the three and six months ended June 30, 2012 and financial condition as of that date:

Net income for the three months ended June 30, 2012 was $1,073,000, an increase of $470,000, or 77.9%, compared to the same period of the prior year, and represents the tenth consecutive quarter of profitability. The increase in net income for the current quarter primarily related to increases in net interest income and gain on sale of loans and other real estate owned (OREO). Net income for the six months ended June 30, 2012 was $2,091,000, an increase of $1,056,000 compared to net income of $1,035,000 for the first half of 2011.

Return on average assets and return on average equity were 0.66% and 6.47%, respectively, for the six months ended June 30, 2012, compared to 0.32% and 3.41%, respectively, for the same period in 2011.

Net interest income of $6,130,000 for the three months ended June 30, 2012 increased $365,000 compared to the same period of the prior year. Net interest income of $12,180,000 for the six months ended June 30, 2012 increased $730,000 compared to the same period of the prior year. The increase is primarily the result of decreased funding costs. Net interest margin improved to 4.27% and 4.30% for the three and six months ended June 30, 2012, compared to 3.99% and 3.97%, respectively, in the same periods one year ago.

The Bank’s tier 1 leverage ratio was 10.63% and total risk-based capital ratio was 15.83% at June 30, 2012, an increase from 10.35% and 15.05%, respectively, at year-end. During the 2012 second quarter the Bank paid a $1,400,000 dividend to the Company to pay accrued interest on junior subordinated debentures. Approximately $835,000 was paid during June 2012, with another $569,000 paid subsequent to quarter-end, bringing all interest payments on the junior subordinated debentures current. The Company had previously elected to exercise the right to defer interest payments as allowed in the debenture agreement.

Total assets were $633,184,000 at June 30, 2012, a decrease of $8,070,000, or 1.26%, over year-end 2011. Decreases in loans, OREO and interest bearing deposits with banks were the primary contributors to overall asset decline, which were partially offset by an increase in investments. Total loans, including loans held for sale, of $479,486,000 at June 30, 2012, decreased $9,948,000, or 2.03%, compared to year-end 2011.

Non-performing assets (“NPAs”) totaled $16,411,000 at June 30, 2012, which represents 2.59% of total assets, and is a decrease from $21,760,000 at December 31, 2011. The decrease is largely due to a decline in non-performing loans from $14,035,000 at year-end 2011 to $10,216,000 as of June 30, 2012. The largest reduction was in the construction and land development non-performing loan category which decreased by $3,622,000, or 65.74%, due to pay-offs.

Provision for credit losses was $300,000 and $400,000 for the three and six months ended June 30, 2012 compared to zero and $500,000 for the same periods one year ago. The increase in the 2012 second quarter over the prior year is due partly to net charge-offs of $99,000 for the three months ended June 30, 2012 compared to net recoveries of $192,000 one year ago. Provision expense for the first six months of 2012, however, is down from the prior year due to improving credit quality as evidenced by decreases in non-performing loans. The allowance for credit losses increased to 2.31% of total loans (including loans held for sale) compared to 2.27% at year-end 2011.

Total deposits of $538,709,000 at June 30, 2012 decreased $9,341,000, or 1.70%, for the six months ended June 30, 2012, compared to December 31, 2011, primarily in demand accounts and certificates of deposit, which were partially offset by an increase in money market accounts. Additionally, funding costs for interest-bearing deposits decreased to 0.68% for the current quarter, compared to 1.11% for the same period a year ago.

The Company’s liquidity ratio of approximately 42% at June 30, 2012 remains strong and translates into over $266 million in available funding to meet loan and deposit needs.

Results of Operations

Net income. For the three and six months ended June 30, 2012, net income was $1,073,000 and $2,091,000, respectively, compared to $603,000 and $1,035,000 for the same periods in 2011. The increase in net income for both the three and six month periods was primarily related to increases in net interest income and gain on sale of loans and OREO coupled with a decrease in FDIC assessments, which were partially offset by an increase in salaries and benefits, OREO operating costs, and data processing expenses.

Net interest income. Net interest income for the three and six months ended June 30, 2012 increased $365,000 and $730,000 or 6.33% and 6.38%, respectively, compared to the same periods in 2011. See the table below and the accompanying discussion for further information on interest income and expense. The net interest margin (net interest income divided by average earning assets and adjusted for tax on tax-exempt securities and loans) increased to 4.30% for the three months ended June 30, 2012 from 3.99% for the same period of the prior year. Net interest margin increased to 4.27% for the six months ended June 30, 2012 from 3.97% for the same period last year. The increase in the current three and six month periods is due to an improvement in the average cost of funds to 0.81% for the six months ended June 30, 2012 from 1.32% one year ago, that was only partially offset by a decline in the Company’s average yield earned on assets from 5.23% to 5.08%. The following tables set forth information with regard to average balances of interest earning assets and interest bearing liabilities and the resultant yields or cost, net interest income, and the net interest margin on a tax equivalent basis. Loans held for sale and non-accrual loans are included in total loans.

Three Months Ended June 30,

	2012									2011
				Interest									Interest
(dollars in thousands)	Average			Income			Avg			Average			Income			Avg
	Balance			(Expense)			Rate			Balance			(Expense)			Rate
Interest Earning Assets
Loans (1)	$	478,454		$	6,628	*		5.54	%	$	480,874		$	6,850	*		5.70	%
Taxable securities		31,311			217			2.77			29,799			270			3.62
Tax-exempt securities		27,336			380	*		5.56			23,719			373	*		6.29
Federal Home Loan Bank Stock		3,183			—			—			3,183			—			—
Interest earning balances with banks		29,704			18			0.24			39,882			24			0.24

Total interest earning assets	$	569,988		$	7,243			5.08	%	$	577,457		$	7,517			5.21	%

Cash and due from banks		10,090									10,100
Bank premises and equipment (net)		14,816									15,129
Other real estate owned		7,629									7,221
Other assets		42,276									41,730
Allowance for credit losses		(10,909	)								(11,099	)

Total assets	$	633,890								$	640,538

Interest Bearing Liabilities
Savings and interest bearing demand	$	293,272		$	(281	)		0.38	%	$	268,164		$	(424	)		0.63	%
Time deposits		147,621			(467	)		1.27			183,779			(830	)		1.81
Total deposits		440,893			(748	)		0.68			451,943			(1,254	)		1.11

Short-term borrowings		3,000			(22	)		2.93			9,940			(95	)		3.82
Long-term borrowings		7,500			(53	)		2.83			10,500			(89	)		3.39
Secured borrowings		475			(8	)		6.74			770			(10	)		5.19
Junior subordinated debentures		13,403			(76	)		2.27			13,403			(100	)		2.98
Total borrowings		24,378			(159	)		2.61			34,613			(294	)		3.40

Total interest-bearing liabilities	$	465,271		$	(907	)		0.78	%	$	486,556		$	(1,548	)		1.27	%

Demand deposits		98,236									88,293
Other liabilities		5,221									4,564
Shareholders’ equity		65,162									61,125

Total liabilities and shareholders’ equity	$	633,890								$	640,538

Net interest income				$	6,336	*							$	5,969	*
Net interest spread								4.45	%								4.13	%
Net interest margin								4.30	%								3.99	%
Tax equivalent adjustment				$	206	*							$	204	*

* Tax equivalent basis – 34% tax rate used

(1) Interest income on loans includes loan fees of $166 and $75 in 2012 and 2011, respectively.

Six Months Ended June 30,

	2012									2011
				Interest									Interest
(dollars in thousands)	Average			Income			Avg			Average			Income			Avg
	Balance			(Expense)			Rate			Balance			(Expense)			Rate
Interest Earning Assets
Loans (1)	$	479,465		$	13,251	*		5.53	%	$	480,463		$	13,749	*		5.72	%
Taxable securities		30,698			447			2.91			29,745			549			3.69
Tax-exempt securities		26,391			744	*		5.64			23,375			732	*		6.26
Federal Home Loan Bank Stock		3,183			—			—			3,183			—			—
Interest earning balances with banks		30,488			36			0.24			39,712			48			0.24

Total interest earning assets	$	570,225		$	14,478			5.08	%	$	576,478		$	15,078			5.23	%

Cash and due from banks		9,917									9,834
Bank premises and equipment (net)		14,834									15,148
Other real estate owned		7,873									6,997
Other assets		42,076									41,771
Allowance for credit losses		(11,001	)								(10,984	)

Total assets	$	633,924								$	639,244

Interest Bearing Liabilities
Savings and interest bearing demand	$	291,579		$	(604	)		0.41	%	$	265,662		$	(867	)		0.65	%
Time deposits		149,090			(969	)		1.30			187,491			(1,752	)		1.87
Total deposits		440,669			(1,573	)		0.71			453,153			(2,619	)		1.16

Short-term borrowings		2,390			(35	)		2.93			10,218			(195	)		3.82
Long-term borrowings		8,111			(115	)		2.84			10,500			(178	)		3.39
Secured borrowings		729			(17	)		4.66			838			(23	)		5.49
Junior subordinated debentures		13,403			(152	)		2.27			13,403			(213	)		3.18
Total borrowings		24,632			(319	)		2.59			34,959			(609	)		3.48

Total interest-bearing liabilities	$	465,301		$	(1,892	)		0.81	%	$	488,112		$	(3,228	)		1.32	%

Demand deposits		98,730									85,940
Other liabilities		5,267									4,515
Shareholders’ equity		64,626									60,677

Total liabilities and shareholders’ equity	$	633,924								$	639,244

Net interest income				$	12,586	*							$	11,850	*
Net interest spread								4.41	%								4.11	%
Net interest margin								4.27	%								3.97	%
Tax equivalent adjustment				$	406	*							$	400	*

* Tax equivalent basis – 34% tax rate used

(1) Interest income on loans includes loan fees of $303 and $241 in 2012 and 2011, respectively.

Interest and dividend income on a tax equivalent basis for the three and six months ended June 30, 2012 decreased $274,000 and $600,000, or 3.65% and 3.98%, respectively, compared to the same periods in 2011. The decrease was primarily due to the decline in income earned on our loan portfolio as a result of the continued low interest rate environment. Loans averaged $479,465,000 with an average yield of 5.53% for the six months ended June 30, 2012, compared to average loans of $480,463,000 with an average yield of 5.72% for the same period in 2011. Interest and dividend income on investment securities on a tax equivalent basis for the three and six months ended June 30, 2012 decreased $46,000 and $90,000, or 7.15% and 7.03%, respectively, compared to the same periods in 2012. The decrease was attributable to the reduction in rates earned on adjustable rate mortgage-backed securities and the maturity and sale of higher yielding securities that cannot be replaced in the current low rate environment.

Average interest earning balances with banks for the three and six months ended June 30, 2012 were $29,704,000 and $30,488,000, respectively, compared to $39,882,000 and $39,712,000 for the same periods in 2011. The average yield was unchanged in all periods at 0.24% and is comparable to the federal funds target rate of 0.25% set by the Federal Open Market Committee.

Interest expense for the three and six months ended June 30, 2012 decreased $641,000 and $1,336,000, or 41.34% and 41.39%, respectively, compared to the same periods in 2011. The decrease is primarily attributable to a decrease in rates paid on deposits and junior subordinated debentures, coupled with lower average balances outstanding on time deposits. Average interest-bearing deposit balances for the six months ended June 30, 2012 and 2011 were $440,669,000 and $453,153,000, respectively, with an average cost of 0.71% and 1.16%, respectively.

Average borrowings for the six months ended June 30, 2012 were $24,632,000 with an average cost of 2.59% compared to $34,959,000 with an average cost of 3.48% for the same period in 2011. The decrease in average borrowing balances outstanding is primarily due to the maturity of $10,500,000 in FHLB advances in the latter part of 2011. The pay down in borrowings was funded by growth in lower cost demand, money market and savings deposits, further improving net interest margin.

Provision and allowance for credit losses. The allowance for credit losses reflects management's current estimate of the amount required to absorb probable losses on loans in its loan portfolio based on factors present as of the end of the period. Loans deemed uncollectible are charged against and reduce the allowance.

Periodic provisions for credit losses are charged to current expense to replenish the allowance for credit losses in order to maintain the allowance at a level management considers adequate. The amount of provision is based on an analysis of various factors including historical loss experience based on volumes and types of loans, volumes and trends in delinquencies and non-accrual loans, trends in portfolio volume, results of internal and independent external credit reviews, and anticipated economic conditions. Estimated loss factors used in the allowance for credit loss analysis are established based in part on historic charge-off data by loan category and economic conditions. During the three months ended June 30, 2012, the loss factors used in the allowance for credit losses were updated specifically on pass rated commercial loans from 0.60% to 0.55%, on farmland loans from 0.25% to 0.20%, and on residential real estate loans from 0.75% to 0.65%, based upon charge-off experience and other factors. For additional information, please see the discussion under the heading “Critical Accounting Policies” in Item 7 of our 2011 10-K.

During the three and six months ended June 30, 2012, provision for credit losses totaled $300,000 and $400,000 compared to $0 and $500,000 for the same periods in 2011. The decrease in provision for credit losses in the current six-month period is due to improving credit quality as evidenced by decreases in non-performing loans and non-performing assets and a decrease in loans classified substandard. Non-performing loans decreased from $14,035,000 at December 31, 2011, to $10,216,000 at June 30, 2012. Loans classified as substandard decreased $1,819,000 from year-end 2011 to $32,751,000 at the close of the second quarter.

For the three and six months ended June 30, 2012, net charge-offs (recoveries) were $99,000 and $463,000 compared to $(192,000) and $151,000 for the same periods in 2011. Net charge-offs for the twelve months ended December 31, 2011 were $1,990,000. The ratio of net charge-offs to average loans outstanding for the six months ended June 30, 2012 and 2011 was 0.10% and 0.03%, respectively.

At June 30, 2012, the allowance for credit losses was $11,064,000 compared to $11,127,000 at December 31, 2011, and $10,966,000 at June 30, 2011. The decrease compared to year-end 2011 is due to continued improvement in credit quality and a decline in non-performing loans as discussed above. The ratio of the allowance for credit losses to total loans outstanding (including loans held for sale) was 2.31%, 2.34% and 2.25%, at June 30, 2012, December 31, 2011 and June 30, 2011, respectively. While the allowance for credit losses as a percentage of total loans has come down, it still remains elevated compared to historical standards and is reflective of management’s review since year-end 2011 of qualitative factors including the continued uncertainty in the economy, pervasive high unemployment rates in our geographic markets, and deterioration in real estate values, albeit at a slower pace than in the last three years.

The Company’s loan portfolio includes a significant portion of government guaranteed loans which are fully guaranteed by the United States Government. Government guaranteed loans were $51,390,000, $52,928,000, and $53,866,000 at June 30, 2012, December 31, 2011 and June 30, 2011, respectively. The ratio of allowance for credit losses to total loans outstanding excluding the government guaranteed loans was 2.58%, 2.64%, and 2.53%, respectively.

There is no precise method of predicting specific credit losses or amounts that ultimately may be charged off. The determination that a loan may become uncollectible, in whole or in part, is a matter of significant management judgment. Similarly, the adequacy of the allowance for credit losses is a matter of judgment that requires consideration of many factors, including (a) economic conditions and the effect on particular industries and specific borrowers; (b) a review of borrowers' financial data, together with industry data, the competitive situation, the borrowers' management capabilities and other factors; (c) a continuing evaluation of the loan portfolio, including monitoring by lending officers and staff credit personnel of all loans which are identified as being of less than acceptable quality; (d) an in-depth review, at a minimum quarterly or more frequently as considered necessary, of all loans judged to present a possibility of loss (if, as a result of such quarterly analysis, the loan is judged to be not fully collectible, the carrying value of the loan is reduced to that portion considered collectible); and (e) an evaluation of the underlying collateral for secured lending, including the use of independent appraisals of real estate properties securing loans. An analysis of the adequacy of the allowance is conducted by management quarterly and is reviewed by the board of directors. Based on this analysis and applicable accounting standards, management considers the allowance for credit losses to be adequate at June 30, 2012.

Non-performing assets and other real estate owned. Non-performing assets totaled $16,411,000 at June 30, 2012. This represents 2.59% of total assets, compared to $21,760,000, or 3.39%, at December 31, 2011, and $19,756,000, or 3.07%, at June 30, 2011. Construction and land development loans and commercial real estate loans are the primary components of non-performing assets, representing $7,912,000, or 48.21%, of non-performing assets.

The following table presents information related to the Company’s non-performing assets:

SUMMARY OF NON-PERFORMING ASSETS (dollars in thousands)	June 30, 2012			December 31, 2011			June 30, 2011

Accruing loans past due 90 days or more	$	770		$	299		$	—
Non-accrual loans:
Construction, land development and other land loans		1,888			5,510			6,304
Residential real estate 1-4 family		700			528			764
Commercial real estate		6,024			7,168			5,697
Consumer		225			—			—
Commercial		609			530			193
Total non-accrual loans (1)		9,446			13,736			12,958

Total non-performing loans		10,216			14,035			12,958

OREO		6,195			7,725			6,798
Total Non-Performing Assets (2)	$	16,411		$	21,760		$	19,756

Troubled debt restructured loans on accrual status	$	127		$	398		$	398
Allowance for credit losses	$	11,064		$	11,127		$	10,966
Allowance for credit losses to non-performing loans		108.30	%		79.28	%		84.63	%
Allowance for credit losses to non-performing assets		67.42	%		51.14	%		55.51	%
Non-performing loans to total loans (3)		2.22	%		2.96	%		2.71	%
Non-performing assets to total assets		2.59	%		3.39	%		3.07	%

(1)

Includes $4,289,000, $7,734,000 and $5,555,000 in non-accrual troubled debt restructured loans (“TDRs”) as of June 30, 2012, December 31, 2011 and June 30, 2011, respectively, which are also considered impaired loans.

(2)

Does not include TDRs on accrual status.

(3)

Excludes loans held for sale.

Non-performing loans decreased $3,819,000, or 27.21%, from the balance at December 31, 2011 due mostly to a decrease in non-accrual construction, land development and other land loans. The level of non-performing assets is still considered elevated by historical standards and reflects the continued weakness in the real estate market and economy. The Company continues to aggressively monitor and identify non-performing assets and take action based upon available information. In addition to the decrease in non-performing loans, OREO decreased by $1,530,000, or 19.81%, from the balance at December 31, 2011 due mostly to the sale of a 13-lot subdivision with a book value of $1,079,000 during the current quarter.

Currently, it is our practice to obtain new appraisals on non-performing collateral dependent loans and/or OREO semi-annually. Based upon the appraisal review for non-performing loans, the Company will record the loan at the lower of carrying value or fair value of collateral (less estimated costs to sell) by recording a charge-off to the allowance for credit losses or by designating a specific reserve per GAAP. Generally, the Company will record the charge-off rather than designate a specific reserve. As a result, the carrying amount of non-performing loans will not exceed the estimated value of the underlying collateral. During the six months ended June 30, 2012 and 2011, as a result of these appraisals and other factors, the Company recorded OREO write-downs of $334,000 and $537,000, respectively, and net charge-offs of $463,000 and $151,000, respectively.

OREO at June 30, 2012 totaled $6,195,000 and consists of properties as follows: eleven land or land development properties totaling $2,534,000, three residential construction properties totaling $887,000, eight commercial real estate properties totaling $2,406,000, and two single family residences collectively valued at $368,000. The balances are recorded at the lower of the original carrying amount of the loan or estimated net realizable value of the real estate less selling costs.

A troubled debt restructuring (“TDR”) is a loan for which the terms have been modified in order to grant a concession to a borrower that is experiencing financial difficulty. Troubled debt restructurings are considered impaired loans and reported as such. For more information regarding TDRs, see Note 4-“Loans” of the condensed consolidated financial statements. The Company had troubled debt restructures totaling $4,417,000 and $8,132,000 at June 30, 2012 and December 31, 2011, respectively. The decrease in the current period is largely due to the transfer of $2,465,000 in previously restructured construction and land loans to OREO.

Non-interest income and expense. Non-interest income for the three and six months ended June 30, 2012 increased by $1,035,000 and $1,553,000, or 75.33% and 57.43%, respectively, compared to the same periods in 2011. The increase was the result of an increase in gain on sale of loans of $655,000 for the three month period and $901,000 for the six month period due to increased mortgage refinancing activity driven by the low rate environment. Additionally, gain on sale of OREO increased $285,000 and $454,000 for the current three and six month periods, respectively, as the Company continues to have success in liquidating properties. Gain on sales of loans, the largest component of non-interest income, totaled $1,201,000 and $2,000,000 for the three and six months ended June 30, 2012 compared to $546,000 and $1,099,000 for the same periods in 2012. Originations of loans held for sale were $109,051,000 for the six months ended June 30, 2012, compared to $60,088,000 for the same period in 2011. Management expects gain on sale of loans to continue at a robust pace for the remainder of 2012.

Service charges on deposits for the three and six months ended June 30, 2012 decreased $29,000 and $30,000, or 6.22% and 3.41%, respectively. The decrease is due to declining overdraft revenue.

The Bank recorded net gains on sale of securities available-for-sale of $89,000 and $99,000 during the three and six months ended June 30, 2012, compared to $74,000 and $184,000 for the same periods in the prior year. The decrease in gain on sale for the six month period was more than offset by a decline in other-than-temporary-impairment (“OTTI”) losses. For the three and six months ended June 30, 2012 one non-agency mortgage-backed security was determined to be other-than-temporarily-impaired resulting in the Company recording $35,000 and $105,000 in impairment charges related to credit losses through earnings compared to $50,000 and $243,000 for the same periods a year ago. As of June 30, 2012, an additional $190,000 in impairments, not related to credit losses, have been recorded through other comprehensive income. There were no additional OTTI securities at June 30, 2012 or December 31, 2011.

Total non-interest expense for the three and six months ended June 30, 2012 increased $316,000 and $776,000, or 4.79% and 6.09%, respectively, compared to the same periods in 2011. The increases are attributable to increases in salaries and employee benefits related to annual performance and merit increases, coupled with higher commissions paid on the sale of loans held for sale. These expense increases were partially offset by reductions in FDIC assessments and OREO write-downs. Salaries and employee benefits for the three and six months ended June 30, 2012 and 2011, increased $567,000 and $897,000, or 16.69% and 13.14%, respectively. Full time equivalent employees at June 30, 2012 were 227 compared to 213 at June 30, 2011.

Income taxes. The federal income tax expense (benefit) for the three and six months ended June 30, 2012 was $256,000 and $437,000, respectively, as compared to ($58,000) and ($114,000), respectively, for the three and six months ended June 30, 2011. The effective tax rate for the six months ended June 30, 2012 was 17.3%. The effective tax rate differs from the statutory rate of 34.4% due to tax exempt income representing an increasing share of income as investments in municipal securities and loans, income earned on BOLI, and tax credits received on investments in low income housing partnerships remained at historical levels, while other earnings declined.

Financial Condition

Assets. Total assets were $633,184,000 at June 30, 2012, a decrease of $8,070,000, or 1.26%, over year-end 2011. Decreases in loans, OREO and interest bearing cash were the primary contributors to overall asset decline, which were partially offset by an increase in investments.

Investments. The investment portfolio provides the Company with an income alternative to loans. The Company’s investment portfolio at June 30, 2012 was $60,028,000 compared to $54,677,000 at the end of 2011, an increase of $5,351,000, or 9.79%, due to investments in municipal and corporate bond securities as an alternative to cash. For additional information on investments, see Note 3 of the Notes to Condensed Consolidated Financial Statements contained in "Item 1, Financial Statements."

Loans. Total loans, including loans held for sale, decreased $9,948,000, or 2.03%, to $479,486,000 at June 30, 2012, compared to $489,434,000 at December 31, 2011. The decrease in loans was primarily due to a decline of $9,885,000 in construction and land development loans and $7,810,000 in commercial real estate loans which were largely a result of continued loan payoffs prior to maturity, which the Company believes are reflective of the current low interest rate environment and economic conditions. These declines were partially offset by a modest increase in commercial and industrial loans and residential real estate loans. Loan detail by category, including loans held for sale, as of June 30, 2012 and December 31, 2011 follows (in thousands):

	June 30, 2012			December 31, 2011

Commercial	$	93,006		$	90,731
Residential real estate:
Residential 1-4 family		96,787			90,552
Multi-family		7,968			7,682
Commercial real estate:
Construction and land development		37,271			47,156
Commercial real estate – owner occupied		113,869			118,469
Commercial real estate – non owner occupied		99,795			103,005
Farmland		23,696			23,752
Consumer		7,862			8,928
Less unearned income		(768	)		(841	)
Total Loans		479,486			489,434
Allowance for credit losses		(11,064	)		(11,127	)

Net Loans	$	468,422		$	478,307

Interest and fees earned on our loan portfolio is our primary source of revenue. Gross loans represented 75.7% of total assets as of June 30, 2012, compared to 76.3% at December 31, 2011. The majority of the Company’s loan portfolio is comprised of commercial and industrial loans and real estate loans. The commercial and industrial loans are a diverse group of loans to small, medium, and larger businesses for purposes ranging from working capital needs to term financing of equipment.

The commercial real estate loan category constitutes 45% of our loan portfolio and generally consists of a wide cross-section of retail, small office, warehouse, and industrial type properties. Loan to value ratios for the Company’s commercial real estate loans at origination generally do not exceed 75% and debt service ratios are generally 125% or better. While we have significant balances within this lending category, we believe that our lending policies and underwriting standards are sufficient to reduce risk even in a downturn in the commercial real estate market. Additionally, this is a sector in which we have significant long-term management experience. It is our strategic plan to seek growth in commercial and small business loans where available and owner occupied commercial real estate loans.

We remain aggressive in managing our construction loan and land development portfolios. While these segments have historically played a significant role in our loan portfolio, balances have declined over the last three years. Construction and land development loans represented 7.8% and 9.6% of our loan portfolio at June 30, 2012 and at December 31, 2011, respectively. We believe this segment will remain challenged through 2012, although to a lesser extent than the previous three years.

It is the Company’s strategic objective to keep concentrations in land and residential construction and total commercial real estate below the regulatory guidelines of 100% and 300% of risk based capital, respectively. As of June 30, 2012, concentration in land and residential construction as a percentage of risk-based capital was 38% and concentration in commercial real estate as a percentage of risk based capital stood at 202%.

Deposits. Total deposits were $538,709,000 at June 30, 2012, a decrease of $9,341,000, or 1.70%, compared to December 31, 2011. Deposit detail by category as of June 30, 2012 and December 31, 2011 follows (in thousands):

	June 30, 2012		December 31, 2011

Demand, non-interest bearing	$	105,368	$	108,899
Interest bearing demand		119,600		122,160
Money market		102,832		99,031
Savings		65,430		65,451
Time, interest bearing		145,479		152,509

Total deposits	$	538,709	$	548,050

A decrease in non-interest bearing demand deposits of $3,531,000, or 3.24%, was offset by a similar increase in money market accounts due to the transfer of excess balances for commercial customers into higher yielding money market accounts. Interest bearing demand deposits decreased $2,560,000, or 2.10%, due to decreases in deposits from Indian nation customers.

Time deposits decreased $7,030,000, or 4.61%, due to our commitment to maintain a disciplined pricing strategy, focusing on enhancing long-term customer relationships rather than on rate sensitive customers. As a result, the percentage of time certificates of deposit to total deposits decreased to 27.0% at June 30, 2012, from 27.8% at December 31, 2011, which favorably impacted net interest margin.

It is our strategic goal to grow core deposits through the quality and breadth of our branch network, increased brand awareness, superior sales practices and competitive rates. In the long-term we anticipate continued growth in our core deposits through both the addition of new customers and our current client base. In addition, management’s strategy for funding asset growth as opportunities arise may include use of brokered and other wholesale deposits on an as-needed basis.

Liquidity. We believe adequate liquidity continues to be available to accommodate fluctuations in deposit levels, fund operations, provide for customer credit needs, and meet obligations and commitments on a timely basis. The Bank’s primary sources of funds are customer deposits, maturities of investment securities, loan sales, loan repayments, net income, and other borrowings which are used to make loans, acquire investment securities and other assets, and fund continuing operations. While maturities and scheduled amortization of loans are a predictable source of funds, deposit flows and prepayments are greatly influenced by the level of interest rates, economic conditions, and competition. In addition to customer deposits, when necessary, liquidity can be increased by taking advances from credit available to the Bank.

The Bank’s liquidity position at June 30, 2012, includes $38.3 million in cash and interest bearing deposits with banks and $53.2 million in investments classified as available-for-sale. We generally maintain sufficient cash and short-term investments to meet short-term liquidity needs. In addition, the Bank maintains credit facilities with correspondent banks totaling $16,000,000, of which none was used as of June 30, 2012. The Bank also has a credit line with the Federal Home Loan Bank (“FHLB”) of Seattle for up to 20% of assets, of which $10,500,000 was used at June 30, 2012. Based on current pledged collateral, the Bank had $108.7 million of available borrowing capacity on its line at the FHLB, although each advance is subject to prior consent. The Bank also has a borrowing facility of $44.8 million at the Federal Reserve Bank subject to pledged collateral, of which none was used at June 30, 2012. Borrowings may be used on a short-term basis to compensate for reductions in deposits, but are generally not considered a long-term solution to liquidity needs.

The holding company relies on dividends from the Bank, proceeds from the exercise of stock options, and proceeds from the issuance of shares of common stock for its funds, which are used for various corporate purposes. Dividends from the Bank are the holding company's most important source of funds, and are subject to regulatory restrictions and the capital needs of the Bank, which are always primary. Sales of trust preferred securities (“TRUPs”) historically were a source of liquidity for the holding company and capital for both the holding company and the Bank; however, we have not issued TRUPs since 2006 and do not anticipate TRUPs will be a source of liquidity in 2012 or beyond.

At June 30, 2012, two wholly-owned subsidiary grantor trusts established by the Company had issued and outstanding $13,403,000 of TRUPs. During 2009, the Company elected to exercise the right to defer interest payments on trust preferred debentures. Under the terms of the indenture, the Company has the right to defer interest payments for up to twenty consecutive quarterly periods without going into default. During the period of deferral, the principal balance and unpaid interest will continue to bear interest as set forth in the indenture. In addition, the Company will not be permitted to pay any dividends or distributions on, or redeem or make a liquidation payment with respect to, any of the Company’s common stock during the deferral period. During the three months ended June 30, 2012, the Company paid all accrued interest, including deferred interest, of approximately $835,000 on PFC Trust I. As of June 30, 2012, deferred interest on PFC Trust II totaled $569,000 and is included in accrued interest payable on the balance sheet. However, subsequent to quarter-end, the Company paid all accrued interest, including deferred interest, of approximately $569,000 on PFC Trust II, bringing the deferred interest to zero.

For additional information regarding trust preferred securities, see the 2011 10-K under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity”.

Capital. The Federal Reserve and the FDIC have established minimum guidelines that mandate risk-based capital requirements for bank holding companies and member banks. Under the guidelines, risk percentages are assigned to various categories of assets and off-balance sheet items to calculate a risk-adjusted capital ratio. Regulatory minimum risk-based capital guidelines under the Federal Reserve require Tier 1 capital to risk-weighted assets of 4% and total capital to risk-weighted assets of 8% to be considered adequately capitalized. To qualify as well capitalized under the FDIC guidelines, banks must have a Tier 1 leverage ratio of 5%, a Tier 1 risk-based capital ratio of 6%, and a Total risk-based capital ratio of 10%. Failure to qualify as well capitalized can negatively impact a bank’s ability to expand and to engage in certain activities.

The capital ratios for the Company and the Bank at June 30, 2012 and December 31, 2011, were as follows:

	Company						Bank						Requirements
	June 30, 2012			December 31, 2011			June 30, 2012			December 31, 2011			Adequately Capitalized			Well Capitalized

Tier 1 leverage ratio		10.64	%		10.18	%		10.63	%		10.35	%		4	%		5	%
Tier 1 risk-based capital ratio		14.58	%		13.56	%		14.56	%		13.79	%		4	%		6	%
Total risk-based capital ratio		15.84	%		14.82	%		15.83	%		15.05	%		8	%		10	%

Total shareholders' equity was $65,463,000 at June 30, 2012, an increase of $2,193,000, or 3.47%, compared to December 31, 2011.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Interest rate, credit, and operations risks are the most significant market risks that affect the Company's performance. The Company relies on loan review, prudent loan underwriting standards, and an adequate allowance for possible credit losses to mitigate credit risk.

An asset/liability management simulation model is used to measure interest rate risk. The model produces regulatory oriented measurements of interest rate risk exposure. The model quantifies interest rate risk by simulating forecasted net interest income over a 12-month time period under various interest rate scenarios, as well as monitoring the change in the present value of equity under the same rate scenarios. The present value of equity is defined as the difference between the market value of assets less current liabilities. By measuring the change in the present value of equity under various rate scenarios, management is able to identify interest rate risk that may not be evident from changes in forecasted net interest income.

The Company is currently asset sensitive, meaning that interest earning assets mature or re-price more quickly than interest-bearing liabilities in a given period. Therefore, a significant increase in market rates of interest could improve net interest income. Conversely, a decreasing rate environment may adversely affect net interest income.

It should be noted that the simulation model does not take into account future management actions that could be undertaken should actual market rates change during the year. Also, the simulation model results are not exact measures of the Company's actual interest rate risk. They are only indicators of rate risk exposure based on assumptions produced in a simplified modeling environment designed to heighten sensitivity to changes in interest rates. The rate risk exposure results of the simulation model typically are greater than the Company's actual rate risk. That is due to the modeling environment, which generally depicts a worst-case situation. Management has assessed the results of the simulation reports as of June 30, 2012 and believes that there has been no material change since December 31, 2011.

ITEM 4. CONTROLS AND PROCEDURES

The Company's disclosure controls and procedures are designed to ensure that information the Company must disclose in its reports filed or submitted under the Securities Exchange Act of 1934 ("Exchange Act") is recorded, processed, summarized, and reported on a timely basis. Our management has evaluated, with the participation and under the supervision of our chief executive officer (“CEO”) and chief financial officer (“CFO”), the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Exchange Act) as of the end of the period covered by this report. Based on this evaluation, our CEO and CFO have concluded that, as of such date, the Company's disclosure controls and procedures are effective in ensuring that information relating to the Company, including its consolidated subsidiaries, required to be disclosed in reports that it files under the Exchange Act is (1) recorded, processed, summarized, and reported within the time periods specified in the SEC's rules and forms, and (2) accumulated and communicated to our management, including our CEO and CFO, as appropriate to allow timely decisions regarding required disclosures.

No change in the Company's internal control over financial reporting occurred during our last fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting.

PART II – OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

Not applicable.

ITEM 1A. RISK FACTORS

There has been no material change from the risk factors previously reported in the 2011 10-K.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

None.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None.

ITEM 4. MINE SAFETY DISCLOSURES

None.

ITEM 5. OTHER INFORMATION

None.

ITEM 6. EXHIBITS

See Exhibit Index immediately following signatures below.

SIGNATURES

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

	PACIFIC FINANCIAL CORPORATION

DATED: August 14, 2012	By:	/s/ Dennis A. Long
		Dennis A. Long
		Chief Executive Officer

	By:	/s/ Denise Portmann
		Denise Portmann
		Chief Financial Officer

EXHIBIT INDEX

EXHIBIT NO.		EXHIBIT

31.1		Certification of CEO under Rule 13a – 14(a) of the Exchange Act.
31.2		Certification of CFO under Rule 13a – 14(a) of the Exchange Act.
32		Certification of CEO and CFO under 18 U.S.C. Section 1350.
101.		INS XBRL Instance Document *
101.		SCH XBRL Taxonomy Extension Schema Document *
101.		CAL XBRL Taxonomy Extension Calculation Linkbase Document *
101.		DEF XBRL Taxonomy Extension Definition Linkbase Document *
101.		LAB XBRL Taxonomy Extension Label Linkbase Document *
101.		PRE XBRL Taxonomy Extension Presentation Linkbase Document *

* Pursuant to Rule 406T of Regulation S-T, these interactive data files are deemed not filed or part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933, as amended, or Section 18 of the Securities Exchange Act of 1934, as amended and otherwise are not subject to liability under those sections.