PACIFIC FINANCIAL CORP - Annual Report: 2007 (Form 10-K)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

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

For the fiscal year ended December 31, 2007; or

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

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

(Address of Principal Executive Offices) (Zip Code)

Registrant’s telephone number, including area code: (360) 533-8870

Securities Registered Pursuant to Section 12(b) of the Exchange Act: None

Securities Registered Pursuant to Section 12(g) of the Exchange Act:

Common Stock, par value $1.00 per share

Indicate by check mark whether the registrant is a well known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o No x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 14(d) of the Exchange Act.

Yes o No x

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 periods that the Registrant was required to file such reports), and (2) has been subject to such requirements for the past 90 days. Yes x No o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o

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

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

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes o No x

The aggregate market value of the common stock held by non-affiliates of the registrant at June 30, 2007, was $94,791,092.

The number of shares outstanding of the registrant’s common stock, $1.00 par value as of February 29, 2008, was 6,645,908 shares.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrant's Proxy Statement filed in connection with its annual meeting of shareholders to be held April 23, 2008 are incorporated by reference into Part III of this Form 10-K.

PACIFIC FINANCIAL CORPORATION

ANNUAL REPORT ON FORM 10-K FOR THE FISCAL YEAR

ENDED DECEMBER 31, 2007

TABLE OF CONTENTS

		Page
PART I
Forward Looking Information		3
Item 1.	Business	4
Item 1A.	Risk Factors	10
Item 1B.	Unresolved Staff Comments	13
Item 2.	Properties	13
Item 3.	Legal Proceedings	14
Item 4.	Submission of Matters to a Vote of Security Holders	14
PART II
Item 5.	Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities	15
Item 6.	Selected Financial Data	17
Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	18
Item 7A.	Quantitative and Qualitative Disclosures About Market Risk	36
Item 8.	Financial Statements and Supplementary Data	38
Item 9.	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure	38
Item 9A.	Controls and Procedures	38
Item 9B.	Other Information	40
PART III
Item 10.	Directors, Executive Officers and Corporate Governance	40
Item 11.	Executive Compensation	40
Item 12.	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters	40
Item 13.	Certain Relationships and Related Transactions and Director Independence	41
Item 14.	Principal Accountant Fees and Services	41
PART IV
Item 15.	Exhibits and Financial Statement Schedules	41
SIGNATURES		42

PART I

Forward Looking Information

This document contains forward-looking statements that are subject to risks and uncertainties. These statements are based on the 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 risks relating to, among other things, the factors described under the heading "Risk Factors" below, as well as the following:

1. competitive pressures among depository and other financial institutions that may impede our ability to attract and retain borrowers, depositors and other customers, retain our key employees, and/or maintain our interest margins and fee income;

2. our growth strategy, particularly if accomplished through acquisitions, which may not be successful if we fail to accurately assess market opportunities, asset quality, anticipated cost savings, and transaction costs, or experience significant difficulty integrating acquired businesses or assets or opening new branches or lending offices;

3. expenses and dedication of management resources in connection with our efforts to comply with changing laws, regulations, and standards, that may significantly increase our costs and ongoing compliance expenditures and place additional burdens on our limited management resources, or may lead to revisions to our strategic focus;

4. general economic or business conditions, either nationally or in the state or regions in which we do business, that may be less favorable than expected, resulting in, among other things, a deterioration in credit quality and/or a reduced demand for credit;

5. any failure to comply with developing and changing standards of corporate governance and disclosure and internal control that could result in negative publicity, leading to declines in our stock price;

6. decreases in real estate prices, whether or not due to changes in economic conditions, that may reduce the value of our security for many of our loans; and

7. 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 our forward-looking statements 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.

ITEM 1. Business

Pacific Financial Corporation (the Company or Pacific) is a bank holding company headquartered in Aberdeen, Washington. The Company owns one bank, Bank of the Pacific (sometimes referred to as the "Bank"), which is also located in Washington. 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 18 branches located in communities throughout Grays Harbor, Pacific, and Wahkiakum Counties in Southwest Washington, and Whatcom and Skagit Counties in Northwest Washington. The Company also operates a branch in Gearhart, Oregon. There were no new branches opened during 2007. Two branches were opened during 2006 and one loan production office was converted to a full-service branch. Five locations in Whatcom County were acquired as part of Pacific’s acquisition of BNW Bancorp, Inc. (BNW) completed on February 27, 2004.

Pacific Financial Corporation is a reporting company with the Securities and Exchange Commission (SEC), and the Company’s common stock is listed on the OTC Bulletin Board™ under the symbol PFLC.OB. At December 31, 2007, the Company had total consolidated assets of $565.6 million, total loans, including loans held for sale, of $456.1 million, total deposits of $467.3 million, and total shareholders’ equity of $50.1 million.

Pacific’s filings with the SEC, including its annual report on Form 10-K, quarterly reports on Form 10-Q, periodic current reports on Form 8-K and amendments to these reports, are available free of charge through links from our website at http://www.thebankofpacific.com to the SEC’s site at http://www.sec.gov, as soon as reasonably practicable after filing with the SEC. You may also access our filings with the SEC directly from the EDGAR database found on the SEC’s website. By making reference to our website above and elsewhere in this report, we do not intend to incorporate any information from our site into this report.

The Bank

Bank of the Pacific was organized in 1978 and opened for business in 1979 to meet the need for a regional community bank with local interests to serve the small to medium-sized businesses and professionals in the coastal region of Western Washington. Services offered by the Bank include commercial loans, agriculture loans, installment loans, real estate loans, residential mortgage loans and personal and business deposit products.

The Bank originates loans primarily in its local markets. Its underwriting policies focus on assessment of each borrower’s ability to service and repay the debt, and the availability of collateral that can be used to secure the loan. Depending on the nature of the borrower and the purpose and amount of the loan, the Bank’s loans may be secured by a variety of collateral, including business assets, real estate, and personal assets.

The Bank’s commercial and agricultural loans consist primarily of secured revolving operating lines of credit and business term loans, some of which may be partially guaranteed by the Small Business Administration or the U.S. Department of Agriculture. Consumer installment loans and other loans represent a small percentage of total outstanding loans and include home equity loans, auto loans, boat loans, and personal lines of credit.

The Bank’s primary sources of deposits are from individuals and businesses in its local markets. A concerted effort has been made to attract deposits in the local market areas through competitive pricing and delivery of quality products. These products include demand accounts, negotiable order of withdrawal accounts, money market investment accounts, savings accounts and time deposits. The Bank may also utilize brokered deposits from time to time.

The Bank provides 24 hour online banking to its customers with access to account balances and transaction histories, plus an electronic check register to make account management and reconciliation simple. The online banking system is compatible with budgeting software like Intuit’s Quicken® or Microsoft’s Money®. In addition, the online banking system includes the ability to transfer funds, make loan payments, reorder checks, and request statement reprints, provides loan calculators and allows for e-mail exchanges with representatives of the Bank. Also for a nominal fee, customers can request stop payments and pay an unlimited number of bills online. These services along with rate information and other information can be accessed through the Bank’s website at http://www.thebankofpacific.com.

The Bank’s deposits are insured by the Federal Deposit Insurance Corporation (FDIC) up to applicable legal limits under the Bank Insurance Fund. The Bank is a member of the Federal Home Loan Bank (FHLB) and is regulated by the Washington Department of Financial Institutions, Division of Banks (Division), and the FDIC.

PFC Statutory Trusts I and II

PFC Statutory Trust I and II are wholly-owned subsidiary trusts of the Company formed to facilitate the issuance of pooled trust preferred securities (“trust preferred securities”). The trusts were organized in December 2005 and June 2006 in connection with two offerings of trust preferred securities. For more information regarding the Company’s issuance of trust preferred securities, see note 8 “Junior Subordinated Debentures” to Pacific’s audited consolidated financial statements included in Item 8 of this report.

Competition

Competition in the banking industry is significant and has intensified as the regulatory environment has grown more permissive. Banks face a growing number of competitors and greater degree of competition with respect to the provision of banking services and the attracting of deposits. Non-bank and non-depository institutions can be expected to increase competition further as they offer bank-type products in the more permissive regulatory climate of today.

The Bank competes in Grays Harbor County with well-established thrifts which are headquartered in the area along with branches of large banks with headquarters outside the area. The Bank also competes with well-established small community banks, branches of large banks, thrifts and credit unions in Pacific and Wahkiakum Counties in the state of Washington and Clatsop County in the state of Oregon. In Whatcom County and Skagit County, Washington, the Bank also competes with large regional and super-regional financial institutions that do not have a significant presence in the Company’s historical market areas. The Company believes Whatcom County provides opportunities for expansion, but in pursuing that expansion it faces greater competitive challenges than it faces in its historical market areas.

The adoption of the Gramm-Leach-Bliley Act of 1999 (the Financial Services Modernization Act) eliminated many of the barriers to affiliation among providers of financial services and further opened the door to business combinations involving banks, insurance companies, securities or brokerage firms, and others. This regulatory change has led to further consolidation in the financial services industry and the creation of financial conglomerates which frequently offer multiple financial services, including deposit services, brokerage and others. When combined with technological developments such as the Internet that have reduced barriers to entry faced by companies physically located outside the Company’s market area, changes in the market have resulted in increased competition and can be expected to result in further increases in competition in the future. Competition in the market for deposits has increased significantly.

Although it cannot guarantee that it will continue to do so, the Company has been able to maintain a competitive advantage in its historical markets as a result of its status as a local institution, offering products and services tailored to the needs of the community. Further, because of the extensive experience of management in its market area and the business contacts of management and the Company’s directors, management believes the Company can continue to compete effectively.

According to the Market Share Report compiled by the FDIC, as of June 30, 2007, the Company held a deposit market share of 30.0% in Pacific County, 45.1% in Wahkiakum County, 21.3% in Grays Harbor County, 3.4% in Whatcom County, 0.4% in Skagit County and 0.1% in Clatsop County.

Employees

As of December 31, 2007, the Bank employed 212 full time equivalent employees. Management believes relations with its employees are good.

Supervision and Regulation

The following is a general description of certain significant statutes and regulations affecting the banking industry. The following discussion is intended to provide a brief summary and, therefore, is not complete and is qualified by the statutes and regulations referenced.

The laws and regulations applicable to the Company and its subsidiary are primarily intended to protect depositors of the Bank and not stockholders of the Company. Proposals to change the laws and regulations governing the banking industry are frequently introduced in Congress, in state legislatures and before the various bank regulatory agencies. The likelihood and timing of any such proposals or legislation and the impact they might have on the Company cannot be determined. Changes in applicable laws or regulations or in the policies of banking and other government regulators may have a material effect on our business and prospects. Violation of the laws and regulations applicable to the Company may result in assessment of substantial civil monetary penalties, the imposition of a cease and desist order, and other regulatory sanctions, as well as private litigation.

General

As a bank holding company, the Company is subject to the Bank Holding Company Act of 1956, as amended (BHCA), which places the Company under the supervision of the Board of Governors of the Federal Reserve System (the Federal Reserve). The Company must file annual reports with the Federal Reserve and must provide it with such additional information as it may require. In addition, the Federal Reserve periodically examines the Company and the Bank.

Bank Holding Company Regulation

In general, the BHCA limits a bank holding company to owning or controlling banks and engaging in other banking-related activities. Bank holding companies must obtain approval of the Federal Reserve before they: (1) acquire direct or indirect ownership or control of any voting shares of any bank that results in total ownership or control, directly or indirectly, of more than 5% of the voting shares of such bank; (2) merge or consolidate with another bank holding company; or (3) acquire substantially all of the assets of another bank or bank holding company. In acting on applications for such prior approval, the Federal Reserve considers various factors, including, without limitation, the effect of the proposed transaction on competition in relevant geographic and product markets, and each transaction party's financial condition, managerial resources and performance record under the Community Reinvestment Act.

Control of Nonbanks. With certain exceptions, the BHCA prohibits bank holding companies from acquiring direct or indirect ownership or control of more than 5% of the voting shares in any company that is not a bank or a bank holding company unless the Federal Reserve determines that the activities of such company are incidental or closely related to the business of banking. If a bank holding company is well-capitalized and meets certain criteria specified by the Federal Reserve, it may engage de novo in certain permissible nonbanking activities without prior Federal Reserve approval.

Control Transactions. The Change in Bank Control Act of 1978, as amended, requires a person (or group of persons acting in concert) acquiring control of a bank holding company to provide the Federal Reserve with 60 days’ prior written notice of the proposed acquisition. Following receipt of this notice, the Federal Reserve has 60 days within which to issue a notice disapproving the proposed acquisition, but the Federal Reserve may extend this time period for up to another 30 days. An acquisition may be completed before expiration of the disapproval period if the Federal Reserve issues written notice of its intent not to disapprove the transaction. In addition, any company must obtain approval of the Federal Reserve before acquiring 25% (5% if the company is a bank holding company) or more of the outstanding shares or otherwise obtaining control over the Company.

Source of Strength Requirements. Under Federal Reserve policy, the Company is expected to act as a source of financial and managerial strength to the Bank. This means that the Company is required to commit, as necessary, resources to support the Bank. Any capital loans made by the Company to the Bank would be subordinate in priority to deposits and to certain other indebtedness of the Bank.

Financial Services Modernization Act

On November 12, 1999, the Financial Services Modernization Act (the “FSMA”) was signed into law. The FSMA repeals the two affiliation provisions of the Glass-Steagall Act: Section 20, which restricted the affiliation of Federal Reserve member banks with firms “engaged principally” in specified securities activities; and Section 32, which restricts officer, director, or employee interlocks between a member bank and any company or person “primarily engaged” in specified securities activities. In addition, the FSMA contains provisions that expressly preempt any state law restricting the establishment of financial affiliations, primarily related to insurance. The general effect of the law is to establish a comprehensive framework to permit affiliations among commercial banks, insurance companies, securities firms, and other financial service providers by revising and expanding the bank holding company framework to permit a holding company system to engage in a full range of financial activities through a new entity known as a financial holding company.

Financial holding companies may affiliate with securities firms and insurance companies and engage in other activities that are financial in nature or are incidental or complementary to activities that are financial in nature. “Financial in nature” activities include securities underwriting, dealing, and market making, sponsoring mutual funds and investment companies, insurance underwriting and agency, merchant banking, and other activities approved by the Federal Reserve.

Tie-In Arrangements

The Company and the Bank cannot engage in certain tie-in arrangements in connection with any extension of credit, sale or lease of property or furnishing of services. For example, with certain exceptions, neither the Company nor the Bank may condition an extension of credit to a customer on either (1) a requirement that the customer obtain additional services provided by it or (2) an agreement by the customer to refrain from obtaining other services from a competitor.

USA Patriot Act of 2001

On October 26, 2001, President Bush signed the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism (USA Patriot Act) of 2001. Among other things, the USA Patriot Act (1) prohibits banks from providing correspondent accounts directly to foreign shell banks; (2) imposes due diligence requirements on banks opening or holding accounts for foreign financial institutions or wealthy foreign individuals; (3) requires financial institutions to establish an anti-money-laundering compliance program, and (4) eliminates civil liability for persons who file suspicious activity reports. The USA Patriot Act also increases governmental powers to investigate terrorism, including expanded government access to account records. The Department of the Treasury is empowered to administer and make rules to implement the act. We do not believe that compliance with the USA Patriot Act has had a material effect on our business and operations.

The Bank

General

The Bank, as an FDIC insured state-chartered bank, is subject to regulation and examination by the FDIC and the Department of Financial Institutions of the State of Washington. The federal laws that apply to the Bank regulate, among other things, the scope of its business, its investments, its reserves against deposits, the timing of the availability of deposited funds and the nature and amount of and collateral for loans.

CRA. The Community Reinvestment Act (the CRA) requires that, in connection with examinations of financial institutions within their jurisdiction, the FDIC evaluate the record of the financial institutions in meeting the credit needs of their local communities, including low and moderate income neighborhoods, consistent with the safe and sound operation of those banks. These factors are also considered in evaluating mergers, acquisitions, and applications to open a branch or facility. In connection with the FDIC’s assessment of the record of financial institutions under the CRA, it assigns a rating of either, “outstanding,” “satisfactory,” “needs to improve,” or “substantial noncompliance” following an examination. The Bank received a CRA rating of “satisfactory” during its most recent examination.

Insider Credit Transactions. Banks are also subject to certain restrictions imposed by the Federal Reserve Act on extensions of credit to executive officers, directors, principal shareholders, or any related interests of such persons. Extensions of credit (i) must be made on substantially the same terms, including interest rates and collateral, and follow credit underwriting procedures that are not less stringent than those prevailing at the time for comparable transactions with persons not covered above and who are not employees and (ii) must not involve more than the normal risk of repayment or present other unfavorable features. Banks are also subject to certain lending limits and restrictions on overdrafts to such persons. A violation of these restrictions may result in the assessment of substantial civil monetary penalties on the affected bank or any officer, director, employee, agent, or other person participating in the conduct of the affairs of that bank, the imposition of a cease and desist order, and other regulatory sanctions.

FDICIA. Under the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA), each federal banking agency has prescribed, by regulation, noncapital safety and soundness standards for institutions under its authority. These standards cover internal controls, information systems, and internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, compensation, fees and benefits, such other operational and managerial standards as the agency determines to be appropriate, and standards for asset quality, earnings and stock valuation. An institution which fails to meet these standards must develop a plan acceptable to the agency, specifying the steps that the institution will take to meet the standards. Failure to submit or implement such a plan may subject the institution to regulatory sanctions. Management believes that the Bank meets all such standards and, therefore, does not believe that these regulatory standards will materially affect the Company’s business or operations.

Interstate Banking and Branching

The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (the Interstate Act) permits nationwide interstate banking and branching under certain circumstances. This legislation generally authorizes interstate branching and relaxes federal law restrictions on interstate banking. Currently, bank holding companies may purchase banks in any state, and states may not prohibit such purchases. Additionally, banks are permitted to merge with banks in other states as long as the home state of neither merging bank has opted out. The Interstate Act requires regulators to consult with community organizations before permitting an interstate institution to close a branch in a low-income area.

With regard to interstate bank mergers, Washington has opted in to the Interstate Act and allows in-state banks to merge with out-of-state banks subject to certain aging requirements. Washington law generally authorizes the acquisition of an in-state bank by an out-of-state bank through merger with a Washington financial institution that has been in existence for at least 5 years prior to the acquisition. With regard to interstate bank branching, out-of-state banks that do not already operate a branch in Washington may not establish de novo branches in Washington or establish and operate a branch by acquiring a branch in Washington. Under FDIC regulations, banks are prohibited from using their interstate branches primarily for deposit production. The FDIC has accordingly implemented a loan-to-deposit ratio screen to ensure compliance with this prohibition.

Deposit Insurance

The deposits of the Bank are currently insured to a maximum of $100,000 per depositor, and certain self-directed retirement accounts up to $250,000 per depositor, through the Bank Insurance Fund administered by the FDIC. All insured banks are required to pay semi-annual deposit insurance premium assessments to the FDIC.

FDICIA included provisions to reform the Federal deposit insurance system, including the implementation of risk-based deposit insurance premiums. FDICIA also permits the FDIC to make special assessments on insured depository institutions in amounts determined by the FDIC to be necessary to give it adequate assessment income to repay amounts borrowed from the U.S. Treasury and other sources, or for any other purpose the FDIC deems necessary. The FDIC has implemented a risk-based insurance premium system under which banks are assessed insurance premiums based on how much risk they present to the insurance fund. Banks with higher levels of capital and a low degree of supervisory concern are assessed lower premiums than banks with lower levels of capital or a higher degree of supervisory concern. The Bank presently qualifies for the lowest premium level.

Dividends

The principal source of the Company’s cash revenues is dividends received from the Bank. The payment of dividends is subject to government regulation, in that regulatory authorities may prohibit banks and bank holding companies from paying dividends in a manner that would constitute an unsafe or unsound banking practice. In addition, a bank may not pay cash dividends if that payment could reduce the amount of its capital below that necessary to meet minimum applicable regulatory capital requirements. Other than the laws and regulations noted above, which apply to all banks and bank holding companies, neither the Company nor the Bank are currently subject to any regulatory restrictions on their dividends. Under applicable restrictions, as of December 31, 2007, the Bank could declare dividends totaling $6,031,000 without obtaining prior regulatory approval.

Capital Adequacy

Federal bank regulatory agencies use capital adequacy guidelines in the examination and regulation of bank holding companies and banks. If capital falls below minimum guideline levels, the holding company or bank may be denied approval to acquire or establish additional banks or non-bank businesses or to open new facilities.

The FDIC and Federal Reserve use risk-based capital guidelines for banks and bank holding companies. These are designed to make such capital requirements more sensitive to differences in risk profiles among banks and bank holding companies, to account for off-balance sheet exposure and to minimize disincentives for holding liquid assets. Assets and off-balance sheet items are assigned to broad risk categories, each with appropriate weights. The resulting capital ratios represent capital as a percentage of total risk-weighted assets and off-balance sheet items. The guidelines are minimums, and the Federal Reserve has noted that bank holding companies contemplating significant expansion programs should not allow expansion to diminish their capital ratios and should maintain ratios well in excess of the minimum. The current guidelines require all bank holding companies and federally-regulated banks to maintain a minimum risk-based total capital ratio equal to 8%, of which at least 4% must be Tier I capital. Tier I capital for bank holding companies includes common shareholders' equity, certain qualifying perpetual preferred stock and minority interests in equity accounts of consolidated subsidiaries, less intangibles except as described above and accumulated other comprehensive income (loss).

The Federal Reserve also employs a leverage ratio, which is Tier I capital as a percentage of total assets less intangibles, to be used as a supplement to risk-based guidelines. The principal objective of the leverage ratio is to constrain the maximum degree to which a bank holding company may leverage its equity capital base. The Federal Reserve requires a minimum leverage ratio of 3%. However, for all but the most highly rated bank holding companies and for bank holding companies seeking to expand, the Federal Reserve expects an additional cushion of at least 1% to 2%.

FDICIA created a statutory framework of supervisory actions indexed to the capital level of the individual institution. Under regulations adopted by the FDIC, an institution is assigned to one of five capital categories depending on its total risk-based capital ratio, Tier I risk-based capital ratio, and leverage ratio, together with certain subjective factors. Institutions which are deemed to be undercapitalized depending on the category to which they are assigned are subject to certain mandatory supervisory corrective actions. The Company does not believe that these regulations had a material effect on its operations.

Effects of Government Monetary Policy

The earnings and growth of the Company are affected not only by general economic conditions, but also by the fiscal and monetary policies of the federal government, particularly the Federal Reserve. The Federal Reserve can and does implement national monetary policy for such purposes as curbing inflation and combating recession, but its open market operations in U.S. government securities, control of the discount rate applicable to borrowings from the Federal Reserve, and establishment of reserve requirements against certain deposits, influence the growth of bank loans, investments and deposits, and also affect interest rates charged on loans or paid on deposits. The nature and impact of future changes in monetary policies and their impact on the Company and the Bank cannot be predicted with certainty.

ITEM 1A. Risk Factors

The following are the material risks that management believes are specific to our business. This should not be viewed as an all inclusive list or in any particular order.

Future loan losses may exceed our allowance for loan losses.

We are subject to credit risk, which is the risk of losing principal or interest due to borrowers’ failure to repay loans in accordance with their terms. A downturn in the economy or the real estate market in our market areas or a rapid change in interest rates could have a negative effect on collateral values and borrowers’ ability to repay. This deterioration in economic conditions could result in losses to the Company in excess of loan loss allowances. To the extent loans are not paid timely by borrowers, the loans are placed on non-accrual, thereby reducing interest income or even requiring reversals of previously recorded income. To the extent loan charge-offs exceed our financial models, increased amounts charged to the provision for loan losses would reduce income.

Rapidly changing interest rate environments could reduce our net interest margin, net interest income, fee income and net income.

Interest and fees on loans and securities, net of interest paid on deposits and borrowings, are a large part of our net income. Interest rates are key drivers of our net interest margin and subject to many factors beyond the control of management. As interest rates change, net interest income is affected. Rapid increases in interest rates in the future could result in interest expense increasing faster than interest income because of mismatches in financial instrument maturities. Further, substantially higher interest rates generally reduce loan demand and may result in slower loan growth, particularly in commercial real estate lending, an important factor in the Company’s revenue growth over the past two years. Decreases or increases in interest rates could reduce the spreads between the interest rates earned on assets and the rates of interest paid on liabilities, and therefore decrease net interest income. See “Quantitative and Qualitative Disclosures about Market Risk.”

Recent disruptions in the credit markets and expected weakness in real estate values in the markets in which we make loans may adversely affect our operations.

Companies have recently experienced higher than anticipated levels of borrower defaults and lender foreclosures on many loan products, but particularly on sub-prime mortgage obligations. These defaults and other factors have led to disruptions in the credit markets and dramatic declines in the market for real estate in many areas. The areas in which we operate have been less affected by the credit crisis and declines in real estate values than others, but there is a possibility that our local real estate markets will experience increased declines in real estate values. In addition, there is a possibility that economic conditions will deteriorate. If the real estate market declines it could decrease the value and salability of the collateral for many of our loans. If the local economy deteriorates, we may see an increase in loan defaults. If defaults increase, we would likely foreclose on and take title to the real estate serving as collateral for many loans. Property ownership increases our expenses due to the costs of managing and disposing of properties. Also, we would then become directly affected by any decrease in sale prices on real estate we own, which could lead to write-downs. There is also a risk that hazardous or toxic substances will be found on properties, in which case we may be liable for remediation costs and related personal injury and property damage and the value of the property may be materially reduced. In general, the costs and financial liabilities associated with property ownership could have a material adverse effect on our financial condition and results of operations.

Slower than anticipated growth in new branches and new product and service offerings could result in reduced net income.

We have placed a strategic emphasis on expanding our branch network and product offerings. Executing this strategy carries risks of slower than anticipated growth both in new branches and new products. New branches and products require a significant investment of both financial and personnel resources. Lower than expected loan and deposit growth from new investments can result in revenues and net income generated by those investments that are less than anticipated. Also, opening new branches and introducing new products could result in more additional expenses than anticipated and divert resources from current operations.

The financial services industry is very competitive.

We face competition in attracting and retaining deposits, making loans, and providing other financial services throughout our market area. Our competitors include other community banks, larger banking institutions, and a wide range of other financial institutions such as credit unions, government-sponsored enterprises, mutual fund companies, insurance companies and other non-bank businesses. Many of these competitors have substantially greater resources than us. For a more complete discussion of our competitive environment, see “Business-Competition” in Item 1 above. If we are unable to compete effectively, we will lose market share and face a reduction in our income from our lending activities.

Decreased volumes and lower gains on sales of mortgage loans sold could reduce net income.

We originate and sell mortgage loans. Changes in interest rates and other market conditions affect demand for our loan products and the revenue realized on the sale of loans. A decrease in the volume of loans sold can decrease our revenues and net income.

Significant legal or regulatory actions could subject us to uninsured liabilities and associated reputational risk.

From time to time, we are sued for damages or threatened with lawsuits relating to various aspects of our operations. We may also be subject to investigations and possibly civil money penalties assessed by federal or state regulators in connection with violations of applicable laws and regulations. We may incur substantial attorney fees and expenses in the process of defending against lawsuits or regulatory actions and our insurance policies may not cover, or cover adequately, the costs of adverse judgments, civil money penalties, and attorney fees and expenses. As a result, we may be exposed to substantial uninsured liabilities that could adversely affect our results of operations, capital, and financial condition. There is also a risk that legal or regulatory actions could harm our reputation, which, whether successfully defended or not, could cause a decline in our customer base, stock price, or general reputation in the markets in which we operate.

The Company is subject to extensive regulation.

The Company’s operations are subject to extensive regulation by federal and state banking authorities which impose requirements and restrictions on the Company’s operations. The impact of changes to laws and regulations or other actions by regulatory agencies could make regulatory compliance more difficult or expensive for the Company and could adversely affect the Company’s financial condition or results of operations.

Any regulatory response to the sub-prime mortgage crisis could have a negative effect on the way we conduct our business.

Federal and state banking regulators have expressed concern with the high level of write-downs being taken by many financial institutions and the increase in defaults by many borrowers. In response, federal and state legislators and regulators may pursue increased regulation of lenders, including the methods by which loans are originated, purchased, or sold. Any legislative or regulatory response may impact how the Bank originates, buys and sells loans in the future or how the Bank underwrites loans that it originates, any of which could have a negative affect on our operations, including by reducing the liquidity provided to us by the secondary loan markets.

Inability to hire or retain certain key professionals, management and staff could reduce our revenues and net income.

We rely on key personnel to manage and operate our business, including important functions such as deposit generation and loan production. The loss of key staff may adversely affect our ability to maintain and manage these functions effectively, which could negatively affect our revenues and net income. In addition, loss of key personnel could result in increased recruiting and hiring expenses, which could cause higher than expected expenses and a decrease in our net income.

Our information systems may experience an interruption or breach in security.

We rely heavily on communication and information systems to conduct our business. Any failure, interruption or breach in security of these systems could result in failures or disruptions in our customer relationship management, general ledger, deposit, loan and other systems. While we have policies and procedures designed to prevent or limit the effect of the possible failure, interruption or security breach of our information systems, there can be no assurance that any such failures, interruptions or security breaches will not occur or, if they do occur, that they will be adequately addressed. The occurrence of any failures, interruptions or security breaches of our information systems could damage our reputation, result in a loss of customer business, subject us to additional regulatory scrutiny, or expose us to civil litigation and possible financial liability, any of which could have a material adverse effect on our financial condition and results of operation.

The Company’s controls and procedures may fail or be circumvented.

Management regularly reviews and updates the Company’s internal controls, disclosure controls and procedures, and corporate governance policies and procedures. Any system of controls, however well designed and operated, is based in part on certain assumptions and can provide only reasonable, not absolute, assurance that the objectives of the system are met. Any failure or circumvention of the Company’s controls and procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect on the Company’s business, results of operations and financial condition.

ITEM 1.B. Unresolved Staff Comments

None

ITEM 2. Properties

The Company’s administrative offices are located in Aberdeen, Washington. The building located at 300 East Market Street is owned by the Bank and houses the main branch. The administrative offices of the Bank and the Company, which are leased from an unaffiliated third party, are located at 1101 S. Boone Street.

Pacific owns the land and buildings occupied by its thirteen branches in Grays Harbor, Pacific, Skagit, Whatcom and Wahkiakum Counties, as well as its data processing operations in Long Beach, Washington. The remaining locations operate in leased facilities, which are leased from unaffiliated third parties. The aggregate monthly lease payment for all leased space is approximately $33,000.

In addition to the land and buildings owned by Pacific, it also owns all of its furniture, fixtures and equipment, including data processing equipment, at December 31, 2007. The net book value of the Company’s premises and equipment was $15.4 million at that date.

Management believes that the facilities are of sound construction and in good operating condition, are appropriately insured and are adequately equipped for carrying on the business of the Bank.

ITEM 3. Legal Proceedings

The Company and the Bank from time to time are party to various legal proceedings arising in the ordinary course of business. Management believes that there are no threatened or pending proceedings against the Company or the Bank which, if determined adversely, would have a material effect on its business, financial condition, results of operations or cash flows.

ITEM 4. Submission of Matters to a Vote of Security Holders

No matters were submitted to a vote of security holders in the fourth quarter of 2007.

PART II

ITEM 5. Market for Registrant’s Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities

The Company's common stock is presently traded on the OTC Bulletin Board™ under the trading symbol PFLC.OB. Historically, trading in our stock has been very limited and the trades that have occurred cannot be characterized as amounting to an established public trading market. As a result, the trading prices of our common stock may not reflect the price that would result if our stock was actively traded at high volumes.

The following are high and low bid prices quoted on the OTC Bulletin Board during the periods indicated. The quotations reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not represent actual transactions:

	2007						2006
	Shares Traded		High		Low		Shares Traded		High		Low
First Quarter		112,200	$	17.25	$	16.10		233,500	$	16.00	$	14.55
Second Quarter		188,100	$	17.10	$	15.25		117,400	$	15.30	$	14.55
Third Quarter		48,600	$	16.20	$	14.50		138,000	$	18.25	$	14.60
Fourth Quarter		128,800	$	15.25	$	12.05		58,900	$	18.25	$	16.40

As of December 31, 2007, there were approximately 1,153 shareholders of record of the Company’s common stock. Mellon Investor Services LLC serves as the transfer agent for our common stock.

The Company’s Board of Directors declared dividends on its common stock in December 2007 and 2006 in the amount of $.75 per share. The Board of Directors has adopted a dividend policy which is reviewed annually. There can be no assurance the Company will continue its dividend or declare and pay dividends at historical rates. Payment of dividends is subject to regulatory limitations. Under federal banking law, the payment of dividends by the Company and the Bank is subject to capital adequacy requirements established by the Federal Reserve and the FDIC. Under Washington general corporate law as it applies to the Company, no cash dividend may be declared or paid if, after giving effect to the dividend, the Company would not be able to pay its liabilities as they become due or its liabilities exceed its assets. Payment of dividends on the Common Stock is also affected by statutory limitations, which restrict the ability of the Bank to pay upstream dividends to the Company. Under Washington banking law as it applies to the Bank, no dividend may be declared or paid in an amount greater than net profits then available, and after a portion of such net profits have been added to the surplus funds of the Bank. Under applicable restrictions, as of December 31, 2007, the Bank could declare dividends totaling $6,031,000 without obtaining prior regulatory approval.

Issuer Purchases of Equity Securities

The following table provides information about purchases of common stock by the Company during the quarter ended December 31, 2007:

Period	Total Number of Shares Purchased		Average Price Paid Per Share		Total Number of Shares Purchased as Part of Publicly Announced Plan
October 1, 2007 - October 31, 2007		—	$	—		—
November 1, 2007 - November 30, 2007		9,500		12.70		—
December 1, 2007 - December 31, 2007		7,400		13.50		—
Total		16,900				—

STOCK PERFORMANCE GRAPH

The following graph compares the cumulative total shareholder return on the Company's Common Stock with the cumulative total return on the S&P 500 and NASDAQ Bank Index. Total return assumes that the value of the investment in the Company's Common Stock and each index was $100 on December 31, 2002, and that all dividends were reinvested.

COMPARISON OF FIVE YEAR CUMULATIVE TOTAL RETURN*

	Period Ending
Index	12/31/02		12/31/03		12/31/04		12/31/05		12/31/06		12/31/07
Pacific Financial Corporation	$	100.00	$	93.05	$	95.36	$	122.79	$	130.83	$	104.95
S&P 500		100.00		128.69		140.27		147.16		170.40		179.76
NASDAQ Bank Index		100.00		133.04		145.97		143.15		162.94		130.50

ITEM 6. Selected Financial Data

The following selected consolidated five year financial data should be read in conjunction with the Company’s consolidated financial statements and the accompanying notes presented in this report.

	As of and For the Year ended December 31,
	2007			2006			2005			2004			2003
	($ in thousands, except per share data)
Operations Data
Net interest income	$	24,503		$	23,867		$	22,284		$	19,520		$	12,541
Provision for credit losses		482			625			1,100			970			—
Non-interest income		4,475			4,176			4,081			3,162			1,846
Non-interest expense		20,379			18,118			16,566			13,555			7,945
Provision for income taxes		2,086			2,749			2,653			2,450			1,863
Net income		6,031			6,551			6,046			5,707			4,579
Net income per share:
Basic		.92			1.01			.94			.93	(1)		.91	(1)
Diluted		.90			.99			.92			.91	(1)		.90	(1)

Dividends declared		4,955			4,893			4,719			4,624			3,530
Dividends declared per share		.75			.75			.73			.72	(1)		. 70	(1)
Dividends paid ratio		82	%		75	%		78	%		81	%		77	%

Performance Ratios
Interest rate spread		4.92	%		5.13	%		5.34	%		5.37	%		4.89	%
Net interest margin (2)		4.82	%		5.04	%		5.25	%		5.25	%		4.75	%
Efficiency ratio (3)		70.33	%		64.61	%		62.83	%		59.76	%		55.22	%
Return on average assets		1.08	%		1.26	%		1.31	%		1.41	%		1.61	%
Return on average equity		11.46	%		13.16	%		12.70	%		14.21	%		17.10	%

Balance Sheet Data
Total assets	$	565,587		$	562,384		$	489,409		$	441,791		$	306,715
Loans, net		433,904			420,768			393,574			341,671			197,500
Total deposits		467,336			466,841			399,726			363,501			260,800
Other borrowings		37,446			36,809			35,790			25,233			14,500
Shareholders’ equity		50,699			48,984			46,600			45,303			25,650
Book value per share (4)		7.67			7.51			7.21			7.06	(1)		5.09	(1)
Equity to assets ratio		8.96	%		8.71	%		9.52	%		10.25	%		8.36	%

Asset Quality Ratios
Nonperforming loans to total loans		1.41	%		1.76	%		1.67	%		.15	%		.27	%
Allowance for loan losses to total loans		1.14	%		.95	%		1.33	%		1.23	%		1.12	%
Allowance for loan losses to nonperforming loans		143.92	%		54.98	%		79.64	%		832.22	%		411.40	%
Nonperforming assets to total assets		.62	%		1.30	%		1.36	%		.12	%		.18	%

(1)	Retroactively adjusted for a two-for-one stock split effective April 4, 2005.

(2)	Net interest income divided by average earning assets.

(3)	Non-interest expense divided by the sum of net interest income and non-interest income.

(4)	Shareholder equity divided by shares outstanding.

ITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion should be read in conjunction with Pacific's audited consolidated financial statements and related notes appearing elsewhere in this report. In addition, please refer to Pacific's forward-looking statement disclosure included in Part I of this report.

EXECUTIVE OVERVIEW

Net income in 2007 was $6,031,000, or $0.90 per diluted share compared to $6,551,000, or $0.99 per diluted share in 2006. The following are major factors impacting the Company’s results of operations for 2007 as compared to 2006.

Net interest income increased by 2.7% or $636,000 to $24,503,000 as compared to 2006. The increase was primarily due to growth in earning assets which was partially offset by margin compression. Growth in earning assets was mainly driven by loan production and was funded from federal funds sold and interest bearing deposits.

The net interest margin for 2007 declined to 4.82% compared to 5.04% in 2006. The decrease in the net interest margin was mainly attributable to rate reductions in the Federal Funds rate by the Federal Open Market Committee (FOMC) in the third and fourth quarters of 2007 of a combined 100 basis points which caused an immediate reduction in the variable rate loan portfolio and a delayed reduction of the Bank’s costs of its portfolio of time deposits. To a lesser extent, a change in the loan portfolio mix contributed to the margin compression, as the majority of the loan growth in 2007 came from government guaranteed loans which generally have a lower yield than real estate or commercial loans. In addition, the slight decrease in demand deposits and increase in savings and interest-bearing demand deposits contributed to the decrease in net interest margin.

The loan loss provision decreased $143,000, or 22.9%, to $482,000 for 2007 due primarily to flat growth in the non-government guaranteed loan portfolio and a large single recovery of a credit during 2007 in the amount of $619,000. Management’s assessment of the credit risk inherent in the portfolio is based on a migration, quantitative and qualitative analysis, other historical factors and trends.

In 2007, return on average assets and return on average equity decreased to 1.08% and 11.46%, respectively, compared to 1.26% and 13.16% in 2006 as a result of the aforementioned net interest margin compression.

The following are important factors in understanding the Company financial condition and liquidity:

Total assets at December 31, 2007 increased by $3,203,000, or 0.6%, to $565,587,000 compared to $562,384,000 at the end of 2006. Net loans (including loans held for sale) grew $15,930,000, or 3.7%, to $451,066,000 compared to $435,136,000 at December 31, 2006. The growth in loans was comprised primarily of net increases in government guaranteed loans.

The Company purchased an additional $5,000,000 in bank owned life insurance during the fourth quarter of 2007.

Non-accrual loans decreased $3,856,000, or 52.5%, to $3,479,000 at December 31, 2007. This improvement is mainly attributable to the resolution of a single large problem loan at December 31, 2006 to a borrower in the forest products industry. We believe the ratio of nonperforming assets to total assets of 0.62% at December 31, 2007 reflects the Company’s conservative underwriting policies and continued efforts to monitor and address potential credit issues early and effectively.

RESULTS OF OPERATIONS

Years ended December 31, 2007, 2006, and 2005

General. The following table presents condensed consolidated statements of income for the Company for each of the years in the three-year period ended December 31, 2007.

(dollars in thousands)	2007		Increase (Decrease) Amount			%			2006		Increase (Decrease) Amount			%			2005
Interest income	$	40,136	$	3,692			10.1		$	36,444	$	6,813			23.0		$	29,631
Interest expense		15,633		3,056			24.3			12,577		5,230			71.2			7,347
Net interest income		24,503		636			2.7			23,867		1,583			7.1			22,284
Provision for credit losses		482		(143	)		(22.9	)		625		(475	)		(43.2	)		1,100
Net interest income after provision for credit losses		24,021		779			3.4			23,242		2,058			9.7			21,184
Other operating income		4,475		299			7.2			4,176		95			2.3			4,081
Other operating expense		20,379		2,261			12.5			18,118		1,552			9.4			16,566
Income before income taxes		8,117		(1,183	)		(12.7	)		9,300		601			6.9			8,699
Income taxes		2,086		(663	)		(24.1	)		2,749		96			3.6			2,653
Net income	$	6,031	$	(520	)		(7.9	)	$	6,551	$	505			8.4		$	6,046

Net Interest Income. The Company derives the majority of its earnings from net interest income, which is the difference between interest income earned on interest earning assets and interest expense incurred on interest bearing liabilities. The Company’s net interest income is affected by the change in the level and mix of interest-earning assets and interest-bearing liabilities, referred to as volume changes. The Company’s net interest income is also affected by changes in the yields earned on assets and rates paid on liabilities, referred to as rate changes. Interest rates charged on loans are affected principally by the demand for such loans, the supply of money available for lending purposes and competitive factors. Those factors are, in turn, affected by general economic conditions and other factors beyond the Company’s control, such as federal economic policies, legislative tax policies and actions by the FOMC. Interest rates on deposits are affected primarily by rates charged by competitors and actions by the FOMC. The following table sets forth information with regard to average balances of the interest earning assets and interest bearing liabilities and the resultant yields or cost, net interest income, and the net interest margin.

	Year Ended December 31,
	2007									2006									2005
(dollars in thousands)	Average Balance			Interest Income (Expense)			Avg Rate			Average Balance			Interest Income (Expense)			Avg Rate			Average Balance			Interest Income (Expense)			Avg Rate
Assets
Earning assets:
Loans (1)	$	453,940		$	37,823			8.33	%	$	415,695		$	34,002			8.18	%	$	371,609		$	27,652			7.44	%
Investment securities:
Taxable		26,522			1,336			5.04	%		22,395			1,021			4.56	%		23,231			1,004			4.32	%
Tax-Exempt (1)		17,514			1,074			6.13	%		16,120			983			6.10	%		16,313			1,018			6.24	%
Total investment securities		44,036			2,410			5.47	%		38,515			2,004			5.20	%		39,544			2,022			5.11	%
Federal Home Loan Bank Stock		1,858			7			0.38	%		1,858			—			—	%		1,855			—			—	%
Federal funds sold and deposits in banks		8,499			426			5.01	%		17,631			909			5.16	%		11,282			344			3.05	%
Total earning assets/interest income	$	508,333		$	40,666			8.00	%	$	473,699		$	36,915			7.79	%	$	424,290		$	30,018			7.07	%
Cash and due from banks		12,236									12,150									10,009
Bank premises and equipment (net)		13,249									11,103									8,180
Other assets		30,013									26,904									24,876
Allowance for credit losses		(4,618	)								(5,114	)								(4,818	)
Total assets	$	559,213								$	518,742								$	462,537

Liabilities and Shareholders’ Equity
Interest bearing liabilities:
Deposits:
Savings and interest-bearing demand	$	194,356		$	(4,947	)		2.55	%	$	195,921		$	(4,650	)		2.37	%	$	195,040		$	(3,089	)		1.58	%
Time		177,362			(8,513	)		4.80	%		148,055			(6,196	)		4.18	%		112,345			(3,323	)		2.96	%
Total deposits		371,718			(13,460	)		3.62	%		343,976			(10,846	)		3.15	%		307,385			(6,412	)		2.09	%
Short-term borrowings		5,961			(329	)		5.52	%		1,388			(75	)		5.40	%		69			(4	)		5.80	%
Long-term borrowings		21,286			(820	)		3.85	%		23,092			(868	)		3.76	%		22,982			(768	)		3.34	%
Secured borrowings		1,517			(110	)		7.25	%		1,981			(141	)		7.12	%		2,942			(163	)		5.54	%
Junior subordinated debentures		13,403			(914	)		6.82	%		9,539			(647	)		6.78	%		152			—			—
Total borrowings		42,167			(2,173	)		5.15	%		36,000			(1,731	)		4.81	%		26,145			(935	)		3.58	%
Total interest-bearing liabilities/Interest expense	$	413,885		$	(15,633	)		3.78	%	$	379,976		$	(12,577	)		3.31	%	$	333,530		$	(7,347	)		2.20	%
Demand deposits		87,467									84,846									78,787
Other liabilities		5,227									4,133									2,600
Shareholders’ equity		52,634									49,787									47,620

Total liabilities and shareholders’equity	$	559,213								$	518,742								$	462,537
Net interest income (1)				$	25,033								$	24,338								$	22,671

Net interest income as a percentage of average earning assets
Interest income								8.00	%								7.79	%								7.07	%
Interest expense								3.08	%								2.66	%								1.73	%
Net interest income								4.92	%								5.13	%								5.34	%
Net interest margin (2)								4.82	%								5.04	%								5.25	%
Tax equivalent adjustment (1)				$	530								$	471								$	387

(1)	Interest earned on tax-exempt loans and securities has been computed on a 34% tax equivalent basis.

(2)	Net interest income divided by average interest earning assets.

For purposes of computing the average rate, the Company used historical cost balances which do not give effect to changes in fair value that are reflected as a component of shareholders’ equity. Nonaccrual loans and loans held for sale are included in “loans.” Interest income on loans include loan fees of $1,828,000, $1,508,000, and $2,439,000 in 2007, 2006, and 2005, respectively.

Net interest income on a tax equivalent basis totaled $25,033,000 for the year ended December 31, 2007, an increase of $695,000, or 2.9%, compared to 2006. Net interest income increased 7.1% to $23,867,000 in 2006 compared to 2005. The Company’s tax equivalent interest income increased 10.2% to $40,666,000 from year end 2006 to year end 2007, and 23.0% to $36,915,000 in 2006 from $30,018,000 in 2005. The increase in 2007 is primarily the result of increased lending volumes, higher loan balances and higher interest rates earned on interest earning assets. The Company’s average earning assets increased $34,634,000, or 7.3%, in 2007 and was offset by compression of its net interest margin. The decrease in net interest margin was due to a 100 basis point decrease by the FOMC which caused an immediate reduction in the variable rate loan portfolio and a delayed reduction of the Company’s costs of time deposits. Additionally, the FOMC cut the Federal Funds rate another 125 basis points in January 2008. Approximately 75% of the Company’s loan portfolio is variable with pricing tied to indexes that are heavily influenced by short-term interest rates. Because of its focus on commercial lending, the Company will continue to have a high percentage of floating rate loans. We anticipate that the impact of lower yields on loans and competition for deposits will continue to put pressure on our net interest margin.

The Company’s average loan portfolio increased $38,245,000, or 9.2%, from year end 2006 to year end 2007, and increased $44,086,000, or 11.9%, from 2005 to 2006. The increase in the average portfolio in 2007 was a result of the purchase of $22 million in variable rate loans that are fully guaranteed by U.S. government agencies. Of this amount, approximately $16 million are real estate loans, with the remaining $6 million being commercial loans. Excluding the purchase of loans previously mentioned, loan balances are down in 2007 due to softer loan demand. Additionally, the Company experienced higher than expected prepayments on the government guaranteed loan portfolio in 2007 which contributed to a reduction in net interest income of $529,000 during the course of the year. The increase in loans in 2006 was a result of the Company’s expanded presence in Whatcom County, which enjoyed a very strong residential real estate construction market in 2006 and to some degree in 2007. Whatcom County is showing some signs of a slow down in the real estate market, however, we do not expect that geographic area to exhibit the price depreciation and market issues of the same magnitude realized in other parts of the country due in part to the strong Canadian dollar.

The Company’s average investment portfolio increased $5,521,000, or 14.3%, from 2006, and decreased $1,029,000, or 2.6%, from 2005 to 2006. The increase in 2007 was due to management’s decision to redistribute federal funds sold into investment securities to capture a higher return. The change in 2006 was due to maturing investments being utilized to fund loan production.

The Company’s average deposits increased $30,363,000, or 7.1%, from 2006, and increased $42,650,000 or 11.0% in 2006 from 2005. The Company attributes its growth to its experienced branch staff, a commitment to improving customer service throughout its branch delivery system, and continued success from branches opened in 2006. During 2007, average deposits from branches opened in recent years contributed $12,389,000 or 40.8%, to the overall increase. Actual deposit balances outstanding remained flat year over year 2007 to 2006 at $467,336,000 compared to $466,841,000. Even though the Company offers a wide variety of retail deposit products to both consumer and commercial customers, future deposit growth will be challenging as the Company anticipates heightened market competition.

The Company increased its average borrowings during 2007 by $6,167,000 or 17.1%, and by $9,855,000, or 37.7%, during 2006. The increase in both years is primarily the result of issuing $8,248,000 in trust preferred securities in June 2006. Total borrowings consist of advances from the Federal Home Loan Bank of Seattle, short-term borrowings with correspondent banks and secured borrowings. The Company’s overall cost of interest-bearing liabilities increased to 3.78% in 2007 from 3.31% and 2.20% in 2006 and 2005, respectively. The increase in cost of interest-bearing liabilities for 2007 was primarily due to competitive deposit pricing and higher interest rates paid during the first half of 2007. The increase from 2005 to 2006 was due to the funding of the Company’s loan growth with time deposits, which are more sensitive to market rate increases versus funding such growth with lower cost demand, money market, NOW or savings deposits.

Net interest margins were 4.82%, 5.04%, and 5.25%, for the years ended December 31, 2007, 2006, and 2005, respectively.

The following table presents changes in net interest income attributable to changes in volume or rate. Changes not solely due to volume or rate are allocated to volume and rate based on the absolute values of each.

	2007 compared to 2006									2006 compared to 2005
	Increase (decrease) due to									Increase (decrease) due to
(dollars in thousands)	Volume			Rate			Net			Volume			Rate			Net
Interest earned on:
Loans	$	3,177		$	644		$	3,821		$	3,458		$	2,892		$	6,350
Securities:
Taxable		201			114			315			(37	)		54			17
Tax-exempt		85			6			91			(12	)		(23	)		(35	)
Total securities		286			120			406			(49	)		31			(18	)
Federal Home Loan Bank Stock		—			7			7			—			—			—
Fed funds sold and interest
bearing deposits in other banks		(458	)		(25	)		(483	)		254			311			565
Total interest earning assets		3,005			746			3,751			3,663			3,234			6,897

Interest paid on:
Savings and interest bearing
demand deposits		37			(334	)		(297	)		(14	)		(1,547	)		(1,561	)
Time deposits		(1,330	)		(987	)		(2,317	)		(1,246	)		(1,627	)		(2,873	)
Total borrowings		(312	)		(130	)		(442	)		(416	)		(380	)		(7,96	)
Total interest bearing liabilities		(1,605	)		(1,451	)		(3,056	)		(1,676	)		(3,554	)		(5,230	)

Change in net interest income	$	1,400		$	(705	)	$	695		$	1,987		$	(320	)	$	1,667

Non-Interest Income. Non-interest income was $4,475,000 for 2007, an increase of $299,000 or 7.2% from 2006 when it totaled $4,176,000. The 2006 amount increased $95,000 or 2.3% compared to the 2005 total of $4,081,000.

The following table represents the principal categories of non-interest income for each of the years in the three-year period ended December 31, 2007.

				Increase								Increase
				(Decrease)								(Decrease)
(dollars in thousands)	2007			Amount			%			2006		Amount			%			2008
Service charges on
deposit accounts	$	1,494		$	42			2.9	%	$	1,452	$	(18	)		(1.2	%)	$	1,470
Income from and gains on sale of
foreclosed real estate		—			(5	)		(100.0	%)		5		5			—			—
Net gains from sales of loans		1,984			89			4.7	%		1,895		86			4.8	%		1,809
Net gain on sale of securities		(20	)		(20	)		(100.0	%)		—		(2	)		(100.0	%)		2
Earnings on bank owned life insurance		397			43			12.1	%		354		(39	)		(9.9	%)		393
Other operating income		620			150			31.9	%		470		63			15.5	%		407
Total non-interest income	$	4,475		$	299			7.2	%	$	4,176	$	95			2.3	%	$	4,081

Service charges on deposits increased 2.9% during 2007 and decreased 1.2% during 2006. The Company continues to emphasize the importance of exceptional customer service and believes this emphasis, together with the addition of three new full-service branches in 2006 contributed to the increase in service charge revenue in 2007. Flattening overdraft revenue in 2006 contributed to the decrease in service charges in 2006 as the Bank discontinued advertising of its overdraft protection product in mid-year.

Income from sources other than service charges on deposit accounts totaled $2,981,000 in 2007, an increase of $257,000 from 2006, or 9.4%. The largest component is gain on sales of loans. The market interest rate environment heavily influences revenue from mortgage banking activities. Refinance activity continued to be strong for most of 2007, as long-term interest rates remained stable, with a softening of demand in the fourth quarter which was partially due to issues surrounding the subprime mortgage crisis. The Company does not engage in or have any exposure to subprime loans or subprime mortgage backed securities. Management expects gains on sale of loans to remain flat in 2008 due to new home construction slowing and downward pressure on home values in our markets, which may be partially offset by increased refinancing activity from lower interest rates partially attributable to recent rate reductions by the FOMC. Other major components of non-interest income were bank owned life insurance income and other operating income. The increase in cash surrender value of life insurance was primarily the result of $5,000,000 in additional policies purchased in the fourth quarter of 2007. Other operating income increases for both 2007 and 2006 were attributable primarily to increased merchant card and loan document preparation fees.

Non-Interest Expense. Total non-interest expense in 2007 was $20,379,000, an increase of $2,261,000 or 12.5% compared to $18,118,000 in 2006. In 2006, non-interest expense increased $1,552,000 or 9.4% compared to $16,566,000 in 2005. Changes in non-interest expense are discussed in greater detail below. The Company expects that non-interest expense will increase approximately 5% during 2008 as it continues to make infrastructure improvements to support the future growth of the Company.

The following table represents the principal categories of non-interest expense for each of the years in the three-year period ended December 31, 2007.

			Increase								Increase
			(Decrease)								(Decrease)
(dollars in thousands)	2007		Amount			%			2006		Amount			%			2005
Salaries and employee benefits	$	12,280	$	1,671			15.8	%	$	10,609	$	536			5.3	%	$	10,073
Occupancy and equipment		2,528		110			4.5	%		2,418		381			18.7	%		2,037
Marketing and advertising		560		75			15.5	%		485		(10	)		(2.0	%)		495
State taxes		436		61			16.3	%		375		27			7.8	%		348
Data processing		393		(29	)		(6.9	%)		422		(57	)		(11.9	%)		479
Other expense		4,182		373			9.8	%		3,809		675			21.5	%		3,134
Total non-interest expense	$	20,379	$	2,261			12.5	%	$	18,118	$	1,552			9.4	%	$	16,566

Salary and employee benefits, the largest component of non-interest expense, increased by $1,671,000, or 15.8%, in 2007 to $12,280,000 and increased by $536,000, or 5.3%, in 2006 compared to 2005. The increase in 2007 was due in part to filling key management positions and normal salary increases. The number of full-time equivalent employees increased from 203 to 212 during 2007. In 2006, higher salaries, additional employees primarily from new branches and increased performance-based compensation were the key drivers of increased personnel expense. Also included in salaries and benefits for 2007 and 2006 was stock option expense of $97,000 and $36,000, respectively, in accordance with SFAS No. 123R.

Occupancy and equipment expenses increased $110,000 to $2,528,000 in 2007 compared with $2,418,000 for 2006 due primarily to equipment depreciation expense as a result of our continued investment in the technology infrastructure needed to support the future growth of the Company. Occupancy and equipment expenses increased $381,000, or 18.7%, for 2006 compared to 2005 due to increased operational costs resulting from a full year of expenses associated with the Raymond and Anacortes, Washington branches opened in early 2006.

Marketing and advertising expense increased 15.5% to $560,000 in 2007 compared with $485,000 for 2006. The increase in 2007 is due to the Company’s efforts to increase awareness of its brand in the markets we serve, which included a strategic brand initiative, an evaluation of marketing materials, and ongoing customer surveys. The 2006 decline was the result of increased promotional activity incurred in 2005 to expand the Company’s presence in the Whatcom County market following the acquisition of BNW and a name change for all BNW branches.

Data processing expense decreased 6.9% to $393,000 in 2007 compared with $422,000 for 2006. The decrease is attributable to a full year of savings in 2007 from the implementation of back counter image capture which reduced item processing costs and expedited funds availability with the Federal Reserve Bank as opposed to a partial year of benefits in 2006. Data processing expense decreased $57,000 or 11.9% in 2006 compared to 2005 due to costs savings associated with consolidating the BNW processing operations into the Company’s existing system.

Other operating expense increased 9.8% to $4,182,000 in 2007 compared with $3,809,000 for 2006 primarily due to increased software amortization, business travel, and training expenses, which were up $149,000, $65,000, and $42,000, respectively. Additionally, the Company recorded an expense of $115,000 in 2007 relating to the settlement of an employment contract dispute. Other operating expenses increased 21.5% to $3,809,000 in 2006 compared to 2005 primarily due to increases in accounting and consulting fees, legal fees, FDIC assessments, and loan collection expense, each of which were up $354,000, $67,000, $63,000 and $41,000, respectively.

Income Tax Expense. For the years ended December 31, 2007, 2006, and 2005, the provision for income taxes was $2,086,000, $2,749,000 and $2,653,000, respectively, representing effective tax rates of 25.7%, 29.6% and 30.5%, respectively. During 2007, the Company filed amended tax returns for the 2003 and 2004 tax years in order to capture a previously unrecognized net operating loss benefit from the BNW acquisition. This resulted in a $215,000 favorable tax adjustment recorded during 2007. The effective tax rates differ from the statutory federal tax rate of 35% largely due to tax exempt interest income earned on certain investment securities and loans, income earned from the increase in cash surrender value of bank owned life insurance and tax credits from investments in low-income housing projects.

Deferred income tax assets or liabilities reflect the estimated future tax effects attributable to differences as to when certain items of income or expense are reported in the financial statements versus when they are reported in the tax returns. As of December 31, 2007, the Company had a net deferred tax liability of $441,000.

FINANCIAL CONDITION

INVESTMENT PORTFOLIO

The Company’s investment securities portfolio increased $4,529,000, or 10.6%, during 2007 to $47,241,000, which was offset by a reduction in interest bearing deposits in banks and federal funds sold. The Company’s investment securities portfolio increased $6,460,000, or 17.8%, during 2006 to $42,712,000 at year end from $36,252,000 in 2005 funded by strong deposit growth in 2006.

The Company regularly reviews its investment portfolio to determine whether any of its securities are other than temporarily impaired. In addition to accounting and regulatory guidance, in determining whether a security is other than temporarily impaired, the Company considers duration and amount of each unrealized loss, the financial condition of the issuer, and the prospects for a change in market value and net asset value within a reasonable period of time. The securities that have been in a continuous unrealized loss position for twelve months or longer at December 31, 2007 had investment grade ratings upon purchase. The issuers of these securities have not, to the Company’s knowledge, established any cause for default and the various rating agencies have reaffirmed the securities’ long-term investment grade status at December 31, 2007. Because the Company has the ability and the intent to hold these investments until recovery of fair value, which may be at maturity, the Company does not have any other than temporarily impaired securities at December 31, 2007. Additionally, the Company does not hold any securities backed by subprime mortgages, collateralized debt obligations, or special investment vehicles at December 31, 2007.

The carrying values of investment securities at December 31 in each of the last three years are as follows:

HELD TO MATURITY

(dollars in thousands)	2007		2006		2005
Obligations of states and political subdivisions	$	3,562	$	5,155	$	5,315
Mortgage-backed securities		767		949		1,189
Total	$	4,329	$	6,104	$	6,504

AVAILABLE FOR SALE

(dollars in thousands)	2007		2006		2005
U.S. Agency securities	$	3,818	$	8,311	$	4,370
Obligations of states and political subdivisions		16,136		13,619		12,172
Mortgage-backed securities		18,540		10,232		8,257
Corporate bonds		1,512		1,512		2,024
Mutual funds		2,906		2,934		2,925
Total	$	42,912	$	36,608	$	29,748

The following table presents the maturities of investment securities at December 31, 2007. Taxable equivalent values are used in calculating yields assuming a tax rate of 34%.

HELD TO MATURITY

(dollars in thousands)	Due in one year or less			Due after one through five years			Due after five through ten years			Due after ten years			Total
Mortgage-backed securities	$	—		$	—		$	—		$	767		$	767
Weighted average yield		—			—			—			5.42	%
Obligations of states and political subdivisions		646			784			1,128			1,004			3,562
Weighted average yield		3.87	%		7.03	%		6.11	%		6.93	%
Total	$	646		$	784		$	1,128		$	1,771		$	4,329

AVAILABLE FOR SALE

(dollars in thousands)	Due in one year or less			Due after one through five years			Due after five through ten years			Due after ten years			Total
U.S. Agency securities	$	999		$	2,084		$	—		$	735		$	3,818
Weighted average yield		5.23	%		4.53	%		—			5.81	%
Mortgage-backed securities		—			239			1,598			16,703			18,540
Weighted average yield		—			4.37	%		4.75	%		5.10	%
Obligations of states and political subdivisions		501			5,577			3,564			6,494			16,136
Weighted average yield		6.64	%		5.48	%		5.35	%		5.74	%
Other securities		3,399			1,019			—			—			4,418
Weighted average yield		4.50	%		4.21	%		—			—
Total	$	4,899		$	8,919		$	5,162		$	23,932		$	42,912

LOAN PORTFOLIO

General. The Company’s policy is to originate loans primarily in its local markets. Depending on the purpose of the loan, the loans may be secured by a variety of collateral, including business assets, real estate, and personal assets. Loans, including loans held for sale, represented 81% of total assets as of December 31, 2007, compared to 78% at December 31, 2006. 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 large businesses for purposes ranging from working capital needs to term financing of equipment.

The Company emphasizes commercial real estate and construction and land development loans. Our commercial real estate portfolio generally consists of a wide cross-section of retail, small office, warehouse, and industrial type properties. A substantial number of these properties are owner-occupied. Loan to value ratios for the Company’s commercial real estate loans generally do not exceed 80% at origination 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 if there were to be a downturn in the commercial real estate market. Additionally, this is a sector in which we have significant and long-term management experience. During the third quarter of 2007, the Company tightened its underwriting criteria for advance rates on raw land loans, land development loans, residential lots, speculative construction for condominiums and all construction loans.

It is our strategic plan to continue to emphasize growth in commercial and small business loans. We believe this will be a key contributor to growing more low cost deposits. Additionally, we are currently in the process of automating our consumer loan approval procedures. We anticipate this system will expedite the loan approval process and reduce overhead, while increasing consumer loan balances, including installment and credit card categories.

The following table sets forth the composition of the Company’s loan portfolio (including loans held for sale) at December 31 in each of the past five years.

(dollars in thousands)	2007			2006			2005			2004			2003
Commercial	$	128,145		$	132,843		$	124,536		$	111,050		$	64,344
Real estate construction		93,249			87,063			87,621			49,347			11,894
Real estate mortgage		224,714			209,206			185,503			176,011			117,940
Installment		7,283			8,668			9,945			9,653			4,625
Credit cards and overdrafts		3,363			1,990			1,863			1,979			935
Less unearned income		(681	)		(601	)		(487	)		(281	)		—
Total	$	456,073		$	439,169		$	408,981		$	347,759		$	199,738

Loan Maturities and Sensitivity in Interest Rates. The following table presents information related to maturity distribution and interest rate sensitivity of commercial and real estate construction loans outstanding, based on scheduled repayments at December 31, 2007.

			Due after
	Due in one		one through		Due after
(dollars in thousands)	year or less		five years		five years		Total
Commercial	$	58,773	$	35,185	$	34,187	$	128,145
Real estate construction		75,823		13,050		4,376		93,249
Total	$	134,596	$	48,235	$	38,563	$	221,394

Total loans maturing after one year with
Predetermined interest rates (fixed)			$	26,969	$	45,620	$	72,589
Floating or adjustable rates (variable)				86,159		4,183		90,342
Total			$	113,128	$	49,803	$	162,931

At December 31, 2007, 33.9% of the total loan portfolio presented above was due in one year or less.

Nonperforming Assets. Nonperforming assets are defined as loans on non-accrual status, loans past due ninety days or more and still accruing interest, loans which have been restructured to provide reduction or deferral of interest or principal for reasons related to the debtor’s financial difficulties, and foreclosed real estate. The Company’s policy for placing loans on non-accrual status is based upon management’s evaluation of the ability of the borrower to meet both principal and interest payments as they become due. Generally, loans with interest or principal payments which are ninety or more days past due are placed on non-accrual (unless they are well-secured and in the process of collection), and previously accrued interest is reversed against income.

The following table presents information related to the Company’s non-accrual loans and other non-performing assets at December 31 in each of the last five years.

(dollars in thousands)	2007		2006		2005		2004		2003
Non-accrual loans	$	3,479	$	7,335	$	6,650	$	470	$	465
Accruing loans past due 90 days or more		2,932		376		82		—		—
Restructured loans		—		—		—		—		—
Foreclosed real estate		—		—		37		40		98

Non-accrual loans totaled $3,479,000 at December 31, 2007, a decrease of $3,856,000 as compared to $7,335,000 at December 31, 2006. The balance of non-accrual loans at year end is equal to 0.76% of total loans including loans held for sale, compared to 1.67% at December 31, 2006. The totals are net of charge-offs based on management’s estimate of fair market value or the result of appraisals. Of the non-accrual loans at year end 2006 and 2005, $5,603,000 and $5,817,000 related to one borrower involved in the forest products industry, of which $3,510,000 was guaranteed by the United States Department of Agriculture (USDA). The improvement in non-accrual loans in 2007 resulted from the resolution of this loan. Loans ninety days or more and still accruing interest of $2,932,000 at December 31, 2007 are made up entirely of two loans which are 100% guaranteed by the USDA. Subsequent to December 31, 2007, these loans were paid off in full. Sales of foreclosed real estate owned totaled $0, $42,000, and $0 during 2007, 2006 and 2005, respectively. We consider the current level of nonperforming assets to be manageable.

Interest income on non-accrual loans that would have been recorded had those loans performed in accordance with their initial terms, as of December 31, was $270,000 for 2007, $306,000 for 2006, $76,000 for 2005, $8,000 for 2004, and $37,000 for 2003. Interest income recognized on impaired loans for 2007 was $457,000, for 2006 was $272,000, for 2005 was $569,000, for 2004 was $16,000, and for 2003 was $19,000.

Loan Concentrations. The Company has credit risk exposure related to real estate loans. The Company makes loans for acquisition, construction and other purposes that are secured by real estate. At December 31, 2007, loans secured by real estate totaled $317,963,000, which represents 69.7% of the total loan portfolio. Real estate construction loans comprised $93,249,000 of that amount, while real estate loans secured by residential properties totaled $60,616,000. As a result of these concentrations of loans, the loan portfolio is susceptible to changes in economic and market conditions in the Company’s market areas. The Company generally requires collateral on all real estate exposures and typically maintains loan-to-value ratios of no greater than 80%.

Allowance and Provision for Credit Losses. The allowance for credit losses reflects management's current estimate of the amount required to absorb losses on existing loans and commitments to extend credit. Loans deemed uncollectible are charged against and reduce the allowance. Periodically, a provision for credit losses is charged to current expense. This provision acts to replenish the allowance for credit losses and to maintain the allowance at a level that management deems adequate. There is no precise method of predicting specific loan losses or amounts that ultimately may be charged off on segments of the loan portfolio. The determination that a loan may become uncollectible, in whole or in part, is a matter of judgment. Similarly, the adequacy of the allowance for credit losses can be determined only on a judgmental basis, after full review, including (a) consideration of 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 appraisal, on a monthly basis, of all loans judged to present a possibility of loss (if, as a result of such monthly appraisals, 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. A formal analysis of the adequacy of the allowance is conducted quarterly and is reviewed by the Board of Directors.

Periodic provisions for loan losses are made to maintain the allowance for credit losses at an appropriate level. The provisions are based on an analysis of various factors including historical loss experience by 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.

Transactions in the allowance for credit losses for the five years ended December 31, 2007 are as follows:

(dollars in thousands)	2007			2006			2005			2004			2003
Balance at beginning of year	$	4,033		$	5,296		$	4,236		$	2,238		$	2,473
Charge-offs:
Commercial		—			1,925			41			235			17
Real estate loans		40			—			—			18			239
Credit card		18			16			7			11			6
Installment		93			4			17			11			3
Total charge-offs		151			1,945			65			275			265

Recoveries:
Commercial		619			—			3			7			5
Real estate loans		21			51			19			123			23
Credit card		2			5			1			1			1
Installment		1			1			2			—			1
Total recoveries		643			57			25			131			30

Net charge-offs (recoveries)		(492	)		1,888			40			144			235
Provision for credit losses		482			625			1,100			970			—
BNW Bancorp, Inc. acquisition		—			—			—			1,172			—
Balance at end of year	$	5,007		$	4,033		$	5,296		$	4,236		$	2,238
Ratio of net charge-offs (recoveries)
to average loans outstanding		(.11	%)		.45	%		.01	%		.05	%		.12	%

The allowance for credit losses was $5,007,000 at year-end 2007, compared with $4,033,000 at year-end 2006, an increase of $974,000 or 24.2%. The increase in 2007 was due to increased recoveries and provision expense of $482,000 during 2007. Total recoveries in 2007 include a $619,000 recovery on the $1,925,000 charge-off in 2006 that was attributable to one commercial borrower. The Company continued to record loss provisions in 2007 to compensate for both growth in the Company’s loan portfolio and weakening economic trends in our markets. The increased level of allowance for credit losses in 2005 and 2006 was primarily due to the growth of the loan portfolio.

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 year ended December 31, 2007, the loss factors used in the allowance for credit losses were updated based on trends in historical charge-offs, portfolio migration analysis, and other qualitative factors. Management is committed to maintaining the allowance for credit losses at a level that is considered commensurate with estimated and known risks in the portfolio. Although the adequacy of the allowance is reviewed quarterly, management performs an ongoing assessment of the risks inherent in the portfolio. As of December 31, 2007, management deems the allowance for credit losses of $5,007,000 (1.14% of total loans outstanding and 143.92% of non-performing loans) adequate to provide for probable losses based on an evaluation of known and inherent risks in the loan portfolio at that date. See “Risk Factors” under Item 1A above for a discussion of certain risks faced by the Company that could affect the adequacy of the allowance.

The Financial Accounting Standards Board (FASB) has issued SFAS No. 114, "Accounting by Creditors for Impairment of a Loan" and SFAS No. 118, "Accounting by Creditors for Impairment of a Loan—Income Recognition Disclosures, an amendment to SFAS No. 114". The Company measures impaired loans based on the present value of expected future cash flows discounted at the loan's effective interest rate or, as a practical expedient, at the loan's observable market price or the fair market value of the collateral if the loan is collateral dependent. The Company excludes loans that are currently measured at fair value or at the lower of cost or fair value, and certain large groups of smaller balance homogeneous loans that are collectively measured for impairment.

The following table summarizes the Bank’s impaired loans at December 31:

(dollars in thousands)	2007		2006		2005		2004		2003
Total impaired loans	$	6,431	$	7,379	$	6,650	$	7,934	$	588
Total impaired loans with valuation allowance		3,052		51		4,917		7,464		123
Valuation allowance related to impaired loans		72		17		924		200		23

No valuation allowance for credit losses was considered necessary for the remaining impaired loans. The balance of the allowance for credit losses in excess of these specific reserves is available to absorb losses from all loans.

It is the Company's policy to charge-off any loan or portion of a loan that is deemed uncollectible in the ordinary course of business. The entire allowance for credit losses is available to absorb such charge-offs.

The Company allocates its allowance for credit losses among major loan categories primarily on the basis of historical data. Based on certain characteristics of the portfolio and management’s analysis, losses can be estimated for major loan categories. The following table presents the allocation of the allowance for credit losses among the major loan categories based primarily on their historical net charge-off experience and other business considerations at December 31 in each of the last five years.

				% of						% of					% of					% of					% of
	2007			Total			2006			Total			2005		Total			2004		Total			2003		Total
(dollars in thousands)	Reserve			Loans			Reserve			Loans			Reserve		Loans			Reserve		Loans			Reserve		Loans
Commercial loans	$	1,780			36	%	$	1,705			42	%	$	1,589		32	%	$	1,680		32	%	$	764		32	%
Real estate loans		3,016			60	%		2,167			54	%		3,548		65	%		2,432		65	%		1,399		65	%
Consumer loans		211			4	%		161			4	%		159		3	%		124		3	%		75		3	%

Total allowance	$	5,007			100	%	$	4,033			100	%	$	5,296		100	%	$	4,236		100	%	$	2,238		100	%

Ratio of allowance for credit losses to loans outstanding at end of year		1.14	%					.95	%							1.33	%				1.23	%				1.12	%

The table indicates an increase of $849,000 in the allowance related to real estate loans from December 31, 2006 to December 31, 2007. The primary reason for the increases and changes in percentage allocations are due to changes in portfolio mix and the growth trend in real estate and real estate construction loans. The Company had a specific reserve of $857,000 at December 31, 2005 relative to one borrower. This specific reserve was used to offset losses on that credit in 2006. The overall net reduction in the allowance for credit losses attributable to that borrower was $1,263,000 during 2006.

DEPOSITS

The Company’s primary source of funds has historically been customer deposits. A variety of deposit products are offered to attract customer deposits. These products include non-interest bearing demand accounts, negotiable order of withdrawal (NOW) accounts, savings accounts, and time deposits. Interest-bearing accounts earn interest at rates established by management, based on competitive market factors and the need to increase or decrease certain types of maturities of deposits. The Company has succeeded in growing its deposit base over the last three years despite increasing competition for deposits in our markets. The Company believes that it has benefited from its local identity and superior customer service. Attracting deposits remains integral to the Company’s business as it is the primary source of funds for loans and a major decline in deposits or failure to attract deposits in the future could have an adverse effect on operations. The Company relies primarily on its branch staff and current customer relationships to attract and retain deposits. The Company’s strategic plan contemplates and focuses on continued growth in non-interest bearing accounts which contribute to higher levels of non-interest income and net interest margin. We expect significant competition for deposits of this nature for the foreseeable future.

The following table sets forth the average balances for each major category of deposits and the weighted average interest rate paid for deposits for the periods indicated.

(dollars in thousands)	2007		Rate			2006		Rate			2005		Rate
Non-interest bearing demand deposits	$	87,467		0.00	%	$	84,846		0.00	%	$	79,866		0.00	%
Interest bearing demand deposits		42,803		0.48	%		48,140		0.57	%		56,615		0.58	%
Savings deposits		151,553		3.13	%		147,781		2.96	%		138,425		1.99	%
Time deposits		177,362		4.80	%		148,055		4.18	%		112,345		2.96	%
Total	$	459,185		2.93	%	$	428,822		2.53	%	$	387,251		1.66	%

Maturities of time certificates of deposit as of December 31, 2007 are summarized as follows:

(dollars in thousands)	Under $100,000		Over $100,000		Total
3 months or less	$	24,322	$	40,247	$	64,569
Over 3 through 6 months		27,275		33,100		60,375
Over 6 through 12 months		13,500		10,449		23,949
Over 12 months		11,041		15,744		26,785
Total	$	76,138	$	99,540	$	175,678

Total deposits slightly increased 0.1% to $467.3 million at December 31, 2007 compared to $466.8 million at December 31, 2006, primarily in money market accounts from a business investment sweep product launched in 2007, which were partially offset by decreases in non-interest bearing demand deposits. The ratio of non-interest bearing deposits to total deposits was 18.6% and 19.6% at December 31, 2007 and 2006, respectively. Total deposits increased 16.8% to $466.8 million at December 31, 2006 compared to $399.7 million at December 31, 2005 primarily as a result of growth in money market accounts and time certificates. Management attributes the growth in 2006 to aggressive rate specials offered to attract new customers at three new locations in 2006 as well as a shift of consumers towards higher rate products.

The Company obtains deposits from the communities it serves. In addition, management’s strategy for funding asset growth is to make use of brokered and other wholesale deposits on an as-needed basis. Brokered deposits are generally less desirable because of higher interest rates. Brokered deposits totaled $5,000,000 and $8,000,000 at December 31, 2007 and 2006, respectively.

SHORT-TERM BORROWINGS

The following is information regarding the Company’s short-term borrowings for the years ended December 31, 2007, 2006 and 2005.

(dollars in thousands)	2007			2006			2005
Amount outstanding at end of period	$	10,125		$	—		$	3,985
Weighted average interest rate thereon		4.26	%		—	%		5.13	%
Maximum month-end balance during the year		18,695		$	6,500			3,985
Average balance during the year		5,961			1,388			69
Average interest rate during the year		5.52	%		5.40	%		5.80	%

CONTRACTUAL OBLIGATIONS

The following is information regarding the Company’s long-term obligations, which consist of borrowings from the Federal Home Loan Bank of Seattle, Junior Subordinated Debentures and premises under operating leases for the year ended December 31, 2007.

	Payments due by Period
Contractual obligations	Less than 1 year		1 - 3 years		3 - 5 years		More than 5 years		Total
Federal Home Loan Bank borrowings	$	—	$	12,500	$	—	$	—	$	12,500
Operating leases		268		309		103		—		680
Secured borrowings		—		350		1,068		—		1,418
Junior subordinated debentures		—		—		—		13,403		13,403
Total long-term obligations	$	268	$	13,159	$	1,171	$	13,403	$	28,001

COMMITMENTS AND CONTINGENCIES AND OFF-BALANCE SHEET ARRANGEMENTS

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 commitments at December 31 is as follows:

	2007		2006
Commitments to extend credit	$	108,095	$	100,792
Standby letters of credit		3,489		2,650

KEY FINANCIAL RATIOS

Year ended December 31,	2007			2006			2005			2004			2003
Return on average assets		1.08	%		1.26	%		1.31	%		1.41	%		1.61	%
Return on average equity		11.46	%		13.16	%		12.70	%		14.21	%		17.10	%
Average equity to average assets ratio		9.41	%		9.60	%		10.30	%		9.91	%		9.44	%
Dividend payout ratio		82	%		75	%		78	%		81	%		77	%

LIQUIDITY AND CAPITAL RESOURCES

Liquidity. The primary concern of depositors, creditors and regulators is the Company’s ability to have sufficient funds readily available to repay liabilities as they mature. In order to ensure adequate funds are available at all times, the Company monitors and projects the amount of funds required on a daily basis. Through the Bank, the Company obtains funds from its customer base, which provides a stable source of “core” demand and consumer deposits.

Other sources are available with borrowings from the Federal Home Loan Bank of Seattle and correspondent banks. Liquidity requirements can also be met through disposition of short-term assets. In management’s opinion, the Company maintains an adequate level of liquid assets, consisting of cash and due from banks, interest bearing deposits with banks, and federal funds sold to support the daily cash flow requirements.

Management expects to continue to rely on customer deposits as the primary source of liquidity, but may also obtain liquidity from maturity of its investment securities, sale of securities currently available for sale, loan sales, loan repayments, net income, and other borrowings. Although deposit balances have shown historical growth, deposit habits of customers may be influenced by changes in the financial services industry, interest rates available on other investments, general economic conditions, consumer confidence, and competition. 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 issues. Therefore, reductions in deposits could adversely affect the Company’s results of operations.

The holding company specifically relies on dividends from the Bank, proceeds from the exercise of stock options, and proceeds from the issuance of trust preferred securities for its funds, which are used for various corporate purposes. On July 2, 2003, the Federal Reserve issued Supervisory Letter SR 03-13 clarifying that Bank Holding Companies should continue to report trust preferred securities in accordance with current Federal Reserve Bank instructions which allows trust preferred securities to be counted in Tier 1 capital subject to certain limitations. The Federal Reserve has indicated it will review the implications of any accounting treatment changes and, if necessary or warranted, will provide appropriate guidance. For additional information regarding trust preferred securities, this discussion and analysis should be read in conjunction with our consolidated financial statements and related notes included elsewhere in this report including Footnote 8 - “Junior Subordinated Debentures”.

Capital. The Company endeavors to maintain equity capital at an adequate level to support and promote investor confidence. The Company conducts its business through the Bank. Thus, the Company needs to be able to provide capital and financing to the Bank should the need arise. The primary sources for obtaining capital are additional stock sales and retained earnings. Total shareholders’ equity averaged $52,634,000 in 2007, which includes $11,282,000 of goodwill associated with the BNW acquisition. Shareholders’ equity averaged $49,787,000 in 2006, compared to $47,620,000 in 2005.

The Company’s Board of Directors considers financial results, growth plans, and anticipated capital needs in formulating its dividend policy. The payment of dividends is subject to adequate financial resources at the Bank, which depend in part on operating results, and limitations imposed by law and governmental regulations.

The Federal Reserve has established guidelines that mandate risk-based capital requirements for bank holding companies. Under the guidelines, one of four risk weights is applied to balance sheet assets, each with different capital requirements based on the credit risk of the asset. The Company’s capital ratios include the assets of the Bank on a consolidated basis in accordance with the requirements of the Federal Reserve. The Company’s capital ratios have exceeded the minimum required to be classified “well capitalized” for each of the past three year-end reporting dates.

The following table sets forth the minimum required capital ratios and actual ratios for December 31, 2007 and 2006.

	Actual					Capital Adequacy
(dollars in thousands)	Amount		Ratio			Amount		Ratio
December 31, 2007
Tier 1 capital (to average assets)
Consolidated	$	50,825		9.28	%	$	21,906		4.00	%
Bank		50,210		9.19	%		21,860		4.00	%
Tier 1 capital (to risk-weighted assets)
Consolidated		50,825		11.37	%		17,887		4.00	%
Bank		50,210		11.26	%		17,840		4.00	%
Total capital (to risk-weighted assets)
Consolidated		55,832		12.49	%		35,774		8.00	%
Bank		55,217		12.38	%		35,679		8.00	%

December 31, 2006
Tier 1 capital (to average assets)
Consolidated	$	49,042		9.27	%	$	21,173		4.00	%
Bank		48,162		9.11	%		21,147		4.00	%
Tier 1 capital (to risk-weighted assets)
Consolidated		49,042		11.03	%		17,784		4.00	%
Bank		48,162		10.91	%		17,662		4.00	%
Total capital (to risk-weighted assets)
Consolidated		53,075		11.94	%		35,567		8.00	%
Bank		52,195		11.82	%		35,324		8.00	%

New Accounting Pronouncements. For a discussion of new accounting pronouncements and their impact on the Company, see Note 1 of the Notes to the Consolidated Financial Statements included in Item 8 of this Form 10-K.

CRITICAL ACCOUNTING POLICIES

The Company’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America. The financial information contained within these statements is, to a significant extent, financial information that is based on approximate measures of the financial effects of transactions and events that have already occurred. Based on its evaluation of accounting policies that involve the most complex and subjective decisions and assessments, management has identified the following as its most critical accounting policies.

Allowance for Credit Losses

The Company’s allowance for credit loss methodology incorporates a variety of risk considerations, both quantitative and qualitative, in establishing an allowance for credit losses that management believes is appropriate at each reporting date. Quantitative factors include the Company’s historical loss experience, delinquency and charge-off trends, collateral values, changes in nonperforming loans, and other factors. Quantitative factors also incorporate known information about individual loans, including borrowers’ sensitivity to interest rate movements. Qualitative factors include the general economic environment in the Company’s markets, including economic conditions and, in particular, the state of certain industries. Size and complexity of individual credits in relation to loan structure, existing loan policies and pace of portfolio growth are other qualitative factors that are considered in the methodology. As the Company adds new products and increases the complexity of its loan portfolio, it intends to enhance its methodology accordingly. A materially different amount could be reported for the provision for credit losses in the statement of operations to change the allowance for credit losses if management’s assessment of the above factors were different. This discussion and analysis should be read in conjunction with the Company’s financial statements and the accompanying notes presented elsewhere herein, as well as the portion of this Management’s Discussion and Analysis section entitled “Allowance and Provision for Credit Losses.” See “Risk Factors” above for a discussion of certain risks faced by the Company.

Goodwill

Goodwill is initially recorded when the purchase price paid for an acquisition exceeds the estimated fair value of the net identified tangible and intangible assets acquired. Goodwill is presumed to have an indefinite useful life and is tested, at least annually, for impairment at the reporting unit level. The Company performs an annual review each year, or more frequently if indicators of potential impairment exist, to determine if the recorded goodwill is impaired. The Company’s impairment review process compares the fair value of the Company to its carrying value, including the goodwill related to the Company. If the fair value exceeds the carrying value, goodwill of the Company is not considered impaired and no additional analysis is necessary. As of December 31, 2007, there have been no events or changes in circumstances that would indicate a potential impairment.

ASSET AND LIABILITY MANAGEMENT

The largest component of the Company’s earnings is net interest income. Interest income and interest expense are affected by general economic conditions, competition in the market place, market interest rates and repricing and maturity characteristics of the Company’s assets and liabilities. Exposure to interest rate risk is primarily a function of differences between the maturity and repricing schedules of assets (principally loans and investment securities) and liabilities (principally deposits). Assets and liabilities are described as interest sensitivity for a given period of time when they mature or can reprice within that period. The difference between the amount of interest sensitive assets and interest sensitive liabilities is referred to as the interest sensitivity “GAP” for any given period. The “GAP” may be either positive or negative. If positive, more assets reprice than liabilities. If negative, the reverse is true.

Certain shortcomings are inherent in the interest sensitivity “GAP” method of analysis. Complexities such as prepayment risk and customer responses to interest rate changes are not taken into account in the “GAP” analysis. Accordingly, management also utilizes a net interest income simulation model to measure interest rate sensitivity. Simulation modeling gives a broader view of net interest income variability, by providing various rate shock exposure estimates. Management regularly reviews the interest rate risk position and provides measurement reports to the Board of Directors.

The following table shows the dollar amount of interest sensitive assets and interest sensitive liabilities at December 31, 2007 and differences between them for the maturity or repricing periods indicated.

				Due after
	Due in one			one through			Due after
(dollars in thousands)	year or less			five years			five years			Total
Interest earning assets
Loans, including loans held for sale	$	293,816		$	113,137		$	49,120		$	456,073
Investment securities		5,545			9,703			31,993			47,241
Fed Funds sold and interest bearing
balances with banks		253			—			—			253
Federal Home Loan Bank stock		—			—			1,858			1,858
Total interest earning assets	$	299,614		$	122,840		$	82,971		$	505,425

Interest bearing liabilities
Interest bearing demand deposits	$	44,305		$	—		$	—		$	44,305
Savings deposits		160,470			—			—			160,470
Time deposits		148,893			26,785			—			175,678
Short term borrowings		10,125			—			—			10,125
Long term borrowings		—			12,500			—			12,500
Secured borrowings		—			1,418			—			1,418
Junior subordinated debentures		8,248			5,155			—			13,403
Total interest bearing liabilities	$	372,041		$	45,858		$	—		$	417,899

Net interest rate sensitivity GAP	$	(72,427	)	$	76,982		$	82,971		$	87,526
Cumulative interest rate sensitivity GAP					4,555			87,526			87,526
Cumulative interest rate sensitivity GAP
as a % of earning assets					.9	%		17.3	%		17.3	%

Effects of Changing Prices. The results of operations and financial condition presented in this report are based on historical cost information, and are unadjusted for the effects of inflation. Since the assets and liabilities of financial institutions are primarily monetary in nature, the performance of the Company is affected more by changes in interest rates than by inflation. Interest rates generally increase as the rate of inflation increases, but the magnitude of the change in rates may not be the same.

The effects of inflation on financial institutions are normally not as significant as its influence on businesses which have investments in plants and inventories. During periods of high inflation there are normally corresponding increases in the money supply, and financial institutions will normally experience above-average growth in assets, loans and deposits. Inflation does increase the price of goods and services, and therefore operating expenses increase during inflationary periods.

ITEM 7A. Quantitative and Qualitative Disclosures About Market Risk

The Company’s results of operations are largely dependent upon its ability to manage interest rate risk. Management considers interest rate risk to be a significant market risk that could have a material effect on the Company’s financial condition and results of operations. The Company does not currently use derivatives to manage market and interest rate risks. All of the Company’s transactions are denominated in U.S. dollars. Approximately 75% of the Company’s loans have interest rates that float with the Company’s reference rate. Fixed rate loans generally are made with a term of five years or less.

In the Asset and Liability Management section of the Management’s Discussion and Analysis in Item 7 is a table presenting estimated maturity or pricing information indicating the Company’s exposure to interest rate changes. The following table discloses the balances of financial instruments held by the Company, including their fair value, as of December 31, 2007.

The expected maturities are disclosed based on contractual schedules. Principal repayments are not considered. The expected maturities for financial liabilities with no stated maturity reflect estimated future roll-off rates. The roll-off rates for non-interest bearing deposits, interest bearing demand deposits, money market accounts, and savings deposits are 15%, 25%, 25% and 20%, respectively. The interest rates disclosed are based on rates in effect at December 31, 2007. Fair values are estimated in accordance with generally accepted accounting principles as disclosed in the financial statements.

Expected Maturity
Year ended December 31, 2007																There-					Fair
(dollars in thousands)	2008			2009			2010			2011			2012			after			Total		Value
Financial Assets
Cash and cash equivalents
Non-interest bearing	$	15,044		$	—		$	—		$	—		$	—		$	—		$	15,044	$	15,044
Interest bearing deposits in banks		253			—			—			—			—			—			253		253
Weighted average interest rate		3.65	%		—			—			—			—			—
Securities available for sale
Fixed rate		4,899			3,912			1,227			2,296			1,484			21,328			35,146		35,146
Weighted average interest rate		4.87	%		4.99	%		5.47	%		4.93	%		5.24	%		5.26	%
Variable rate		—			—			—			—			—			7,766			7,766		7,766
Weighted average interest rate		—			—			—			—			—			5.31	%
Securities held to maturity
Fixed rate		646			34			750			—			—			2,899			4,329		4,368
Weighted average interest rate		3.87	%		9.29	%		6.93	%		—			—			6.22	%
Loans receivable
Fixed rate		41,388			6,936			5,973			6,356			7,704			45,620			113,977		109,431
Weighted average interest rate		7.52	%		7.38	%		7.48	%		7.50	%		7.77	%		7.09	%
Adjustable rate		251,754			28,773			38,225			5,955			13,206			4,183			342,096		342,096
Weighted average interest rate		7.95	%		8.12	%		8.38	%		8.47	%		8.21	%		7.53	%
Federal Home Loan Bank stock		—			—			—			—			—			1,858			1,858		1,858
Weighted average interest rate		—			—			—			—			—			.40	%

Financial Liabilities
Non-interest bearing deposits	$	13,032		$	11,078		$	9,416		$	8,004		$	6,803		$	38,550		$	86,883	$	86,883
Interest bearing checking accounts		11,076			8,307			6,230			4,673			3,505			10,514			44,305		44,305
Weighted average interest rate		.40	%		.40	%		.40	%		.40	%		.40	%		.40	%
Money Market accounts		26,315			19,736			14,802			11,102			8,326			24,979			105,260		105,260
Weighted average interest rate		3.18	%		3.18	%		3.18	%		3.18	%		3.18	%		3.18	%
Savings accounts		11,042			8,834			7,067			5,653			4,523			18,091			55,210		55,210
Weighted average interest rate		2.32	%		2.32	%		2.32	%		2.32	%		2.32	%		2.32	%
Certificates of deposit
Fixed rate		146,985			6,974			4,045			6,778			8,583			—			173,365		174,355
Weighted average interest rate		4.78	%		4.15	%		4.43	%		5.11	%		4.93	%		—
Variable rate		1,909			404			—			—			—			—			2,313		2,313
Weighted average interest rate		3.81	%		3.88	%		—			—			—			—
Short Term borrowings		10,125			—			—			—			—			—			10,125		10,093
Weighted average interest rate		4.26	%		—			—			—			—			—
Long Term Borrowings
Fixed rate		—			11,000			1,500			—			—			—			12,500		12,436
Weighted average interest rate		—			3.84	%		4.12	%		—			—			—
Secured borrowings		—			351			—			175			892			—			1,418		1,418
Weighted average interest rate		—			6.81	%		—			6.66	%		7.56	%		—
Junior subordinated debentures		—			—			—			—			—			13,403			13,403		13,275
Weighted average interest rate		—			—			—			—			—			6.67	%

As illustrated in the table above, our balance sheet is currently sensitive to decreasing interest rates, meaning that more interest bearing assets mature or re-price than interest earning liabilities. Therefore, if our asset and liability mix were to remain unchanged, and there was a decrease in market rates of interest, the Company would expect that its net income would be adversely affected. In contrast, an increasing interest rate environment would positively affect income. While the table presented above provides information about the Company’s interest sensitivity, it does not predict the trends of future earnings. For this reason, financial modeling is used to forecast earnings under varying interest rate projections. While this process assists in managing interest rate risk, it does require significant assumptions for the projection of loan prepayments, loan origination volumes and liability funding sources that may prove to be inaccurate.

ITEM 8. Financial Statements and Supplementary Data

Information required for this item is included in Item 15 of this report.

ITEM 9. Changes in and disagreements with accountants on accounting and financial disclosure

None.

ITEM 9A. Controls and Procedures

Disclosure Controls and Procedures. 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.

Management’s Report on Internal Control Over Financial Reporting. The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting. The Company’s internal control system is designed to provide reasonable assurance to our management and the board of directors regarding the preparation and fair presentation of published financial statements. Nonetheless, all internal control systems, no matter how well designed, have inherent limitations. Because of these inherent limitations, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may occur and not be detected. Even systems determined to be effective as of a particular date can provide only reasonable assurance with respect to financial statement preparation and presentation and may not eliminate the need for restatements.

The Company’s management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2007. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission in Internal Control - Integrated Framework. Based on our assessment, we believe that, as of December 31, 2007, the Company’s internal control over financial reporting is effective based on those criteria.

Report of Independent Registered Public Accounting Firm

To the Board of Directors and Stockholders of

Pacific Financial Corporation

Aberdeen, Washington

We have audited the internal control over financial reporting of Pacific Financial Corporation and subsidiary (the "Company") as of December 31, 2007, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company's internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company's internal control over financial reporting is a process designed by, or under the supervision of, the company's principal executive and principal financial officers, or persons performing similar functions, and effected by the company's board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.

Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2007, based on the criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements as of and for the year ended December 31, 2007 of the Company and our report dated March 14, 2008 expressed an unqualified opinion on those financial statements.

/s/ Deloitte & Touche LLP

Portland, Oregon

March 14, 2008

Changes in Internal Control Over Financial Reporting. There have not been any changes in the Company’s internal control over financial reporting, as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act, during the Company’s fiscal quarter ended December 31, 2007 that have materially affected, or are reasonable likely to materially affect, the Company’s internal control over financial reporting.

ITEM 9B. Other Information

None.

Part III

ITEM 10. Directors and Executive Officers of the Registrant

Information concerning directors and executive officers requested by this item is contained in the Company’s 2008 Proxy Statement for its annual meeting of shareholders to be held on April 23, 2008 ("2008 Proxy Statement"), in the sections entitled “CURRENT EXECUTIVE OFFICERS,” “PROPOSAL NO. 1 - ELECTION OF DIRECTORS,” and “SECTION 16(a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE” and is incorporated into this report by reference.

The Board of Directors adopted a Code of Ethics for the Company’s executive officers that requires the Company’s officers to maintain the highest standards of professional conduct. A copy of the Executive Officer Code of Ethics is available on the Company’s Web site www.thebankofpacific.com under the link for Stockholder Info and CEO’s Newsletter.

The Company has a separately designated Audit Committee established in accordance with Section 3(a)(58)(A) of the Exchange Act. The committee is composed of Directors Duane E. Hagstrom, Gary C. Forcum, Joseph A. Malik, John Ferlin and G. Dennis Archer, each of whom is independent. In determining independence of audit committee members, the Company’s Board of Directors applied the definition of independence for audit committee members found in the Nasdaq listing standards.

The Company’s Board of Directors has determined that Duane E. Hagstrom, Gary C. Forcum and G. Dennis Archer are audit committee financial experts as defined in Item 401(h) of the SEC’s Regulation S-K. Directors Hagstrom, Forcum, Malik, Ferlin and Archer are independent as that term is used for audit committee members in the Nasdaq listing standards.

ITEM 11. Executive Compensation

Information concerning executive and director compensation and certain matters regarding participation in the Company's compensation committee required by this item is contained in the registrant’s 2008 Proxy Statement in the sections entitled “DIRECTOR COMPENSATION FOR 2007” and “EXECUTIVE COMPENSATION,” and is incorporated into this report by reference.

ITEM 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

Information concerning security ownership of certain beneficial owners and management requested by this item is contained in the registrant’s 2008 Proxy Statement in the section entitled “SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT,” and is incorporated into this report by reference.

Equity Compensation Plan Information. The following table summarizes share and exercise price information about the Company’s equity compensation plans as of December 31, 2007.

Plan Category	(a) Number of securities to be issued upon exercise of outstanding options, warrants and rights			(b) Weighted-average exercise price of outstanding options, warrants and rights		(c) Number remaining available for future issuance under equity compensation plans (excluding securities reflected in column (a)
Equity compensation plans approved
by security holders:		621,797	(1)	$	13.87		279,250

Equity compensation plans not approved
by security holders:		—			—		—

Total		621,797	(1)				279,250

(1) Excludes 5,356 shares under outstanding options, with an aggregate exercise price of $6.18, granted by the Company pursuant to a merger agreement in substitution of BNW Bancorp, Inc. options.

ITEM 13. Certain Relationships and Related Transactions

Information concerning certain relationships and related transactions requested by this item is contained in the registrant’s 2008 Proxy Statement in the sections entitled “COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION” and "RELATED PERSON TRANSACTIONS" is incorporated into this report by reference.

ITEM 14. Principal Accountant Fees and Services

Information concerning fees paid to our independent public accountants required by this item is included under the heading “AUDITORS - Fees Paid to Auditors” in the registrant’s 2008 Proxy Statement and is incorporated into this report by reference.

Part IV

ITEM 15. Exhibits and Financial Statement Schedules

(a)	(1) The following financial statements are filed below:

Report of Independent Registered Public Accounting Firm - Deloitte & Touche LLP

Report of Independent Registered Public Accounting Firm - McGladrey & Pullen LLP

Consolidated Balance Sheets

Consolidated Statements of Income

Consolidated Statements of Shareholders’ Equity

Consolidated Statements of Cash Flows

Notes to Consolidated Financial Statements

(a)	(2) Schedules: None

(a)	(3) Exhibits: See Exhibit Index immediately following the signature page.

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders of

Pacific Financial Corporation

Aberdeen, Washington

We have audited the accompanying consolidated balance sheets of Pacific Financial Corporation and subsidiary (the "Company") as of December 31, 2007 and 2006, and the related consolidated statements of income, shareholders' equity, and cash flows for each of the two years in the period ended December 31, 2007. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Pacific Financial Corporation and subsidiary as of December 31, 2007 and 2006, and the results of their operations and their cash flows for each of the two years in the period ended December 31, 2007, in conformity with accounting principles generally accepted in the United States of America.

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company's internal control over financial reporting as of December 31, 2007, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 14, 2008 expressed an unqualified opinion on the Company's internal control over financial reporting.

/s/ Deloitte & Touche LLP

Portland, Oregon

March 14, 2008

F-1

Report of Independent Registered Public Accounting Firm

To the Board of Directors

Pacific Financial Corporation

Aberdeen, Washington

We have audited the accompanying consolidated statement of income, shareholders’ equity and cash flows of Pacific Financial Corporation and Subsidiary for the year ended December 31, 2005. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the results of operations and cash flows of Pacific Financial Corporation and Subsidiary for the year ended December 31, 2005, in conformity with United States generally accepted accounting principles.

/s/ McGladrey & Pullen, LLP

Tacoma, Washington

March 13, 2006

F-2

Pacific Financial Corporation and Subsidiary

December 31, 2007 and 2006

Consolidated Balance Sheets

(Dollars in Thousands)

	2007			2006
Assets
Cash and due from banks	$	15,044		$	14,964
Interest bearing deposits in banks		253			5,479
Federal funds sold		—			20,345
Securities available for sale, at fair value (amortized cost of $43,323 and $37,090)		42,912			36,608
Securities held to maturity (fair value of $4,368 and $6,101)		4,329			6,104
Federal Home Loan Bank stock, at cost		1,858			1,858
Loans held for sale		17,162			14,368
Loans		438,911			424,801
Allowance for credit losses		5,007			4,033
Loans - net		433,904			420,768
Premises and equipment		15,427			11,537
Accrued interest receivable		3,165			3,006
Cash surrender value of life insurance		15,111			9,714
Goodwill		11,282			11,282
Other intangible assets		1,728			1,871
Other assets		3,412			4,480

Total assets	$	565,587		$	562,384

Liabilities and Shareholders’ Equity

Liabilities
Deposits:
Demand, non-interest bearing	$	86,883		$	91,657
Savings and interest-bearing demand		204,775			199,505
Time, interest-bearing		175,678			175,679
Total deposits		467,336			466,841

Accrued interest payable		1,399			1,415
Secured borrowings		1,418			1,906
Short-term borrowings		10,125			—
Long-term borrowings		12,500			21,500
Junior subordinated debentures		13,403			13,403
Other liabilities		8,707			8,335
Total liabilities		514,888			513,400

Commitments and Contingencies (See note 12)		—			—

Shareholders’ Equity
Common stock (par value $1); authorized: 25,000,000 shares; issued and outstanding: 2007 - 6,606,545 shares; 2006 - 6,524,407 shares		6,607			6,524
Additional paid-in capital		27,163			26,047
Retained earnings		17,807			16,731
Accumulated other comprehensive loss		(878	)		(318	)
Total shareholders’ equity		50,699			48,984

Total liabilities and shareholders’ equity	$	565,587		$	562,384

See notes to consolidated financial statements.

F-3

Pacific Financial Corporation and Subsidiary

Years Ended December 31, 2007, 2006 and 2005

Consolidated Statements of Income

(Dollars in Thousands, Except Per Share Amounts)

	2007			2006		2005
Interest and Dividend Income
Loans	$	37,658		$	33,883	$	27,611
Federal funds sold and deposits in banks		426			909		344
Securities available for sale:
Taxable		1,290			946		933
Tax-exempt		528			434		446
Securities held to maturity:
Taxable		46			57		71
Tax-exempt		181			215		226
Federal Home Loan Bank stock dividends		7			—		—
Total interest and dividend income		40,136			36,444		29,631

Interest Expense
Deposits		13,460			10,846		6,412
Short-term borrowings		329			75		4
Long-term borrowings		820			868		768
Secured borrowings		110			141		163
Junior subordinated debentures		914			647		—
Total interest expense		15,633			12,577		7,347

Net interest income		24,503			23,867		22,284

Provision for Credit Losses		482			625		1,100

Net interest income after provision for credit losses		24,021			23,242		21,184

Non-Interest Income
Service charges on deposit accounts		1,494			1,452		1,470
Income from and gains on sale of foreclosed real estate		—			5		—
Net gains from sales of loans		1,984			1,895		1,809
Net gain (loss) on sales of securities available for sale		(20	)		—		2
Earnings on bank owned life insurance		397			354		393
Other operating income		620			470		407
Total non-interest income		4,475			4,176		4,081

Non-Interest Expense
Salaries and employee benefits		12,280			10,609		10,073
Occupancy		1,336			1,266		1,035
Equipment		1,192			1,152		1,002
State taxes		436			375		348
Data processing		393			422		479
Professional services		541			647		302
Other		4,201			3,647		3,327
Total non-interest expense		20,379			18,118		16,566

Income before income taxes		8,117			9,300		8,699

Income Taxes		2,086			2,749		2,653

Net income	$	6,031		$	6,551	$	6,046

Earnings Per Share
Basic	$	0.92		$	1.01	$	0.94
Diluted	$	0.90		$	0.99	$	0.92
Weighted Average Shares Outstanding:
Basic		6,581,203			6,483,370		6,425,615
Diluted		6,668,042			6,585,807		6,538,250

See notes to consolidated financial statements.

F-4

Pacific Financial Corporation and Subsidiary

Years Ended December 31, 2007, 2006 and 2005

Consolidated Statements of Shareholders’ Equity

(Dollars in Thousands, Except Per Share Amounts)

													Accumulated
	Shares of						Additional						Other
	Common			Common			Paid-in			Retained			Comprehensive
	Stock			Stock			Capital			Earnings			Income (Loss)			Total
Balance at January 1, 2005		6,421,396		$	6,421		$	25,003		$	13,746		$	133		$	45,303

Comprehensive income:
Net income		—			—			—			6,046			—			6,046
Other comprehensive income, net of tax:
Change in fair value of securities available for sale		—			—			—			—			(456	)		(456	)
Comprehensive income																	5,590

Stock options exercised		42,620			43			362			—			—			405
Issuance of common stock		520			—			—			—			—			—
Stock compensation expense		—			—			12			—			—			12
Cash dividends declared ($0.73 per share)		—			—			—			(4,719	)		—			(4,719	)
Tax benefit from exercise of stock options		—			—			9			—			—			9
Balance at December 31, 2005		6,464,536		$	6,464		$	25,386		$	15,073		$	(323	)	$	46,600

Comprehensive income:
Net income		—			—			—			6,551			—			6,551
Other comprehensive income, net of tax:
Change in fair value of securities available for sale		—			—			—			—			5			5
Comprehensive income																	6,556

Stock options exercised		44,945			45			364			—			—			409
Issuance of common stock		14,926			15			218			—			—			233
Stock compensation expense		—			—			36			—			—			36
Cash dividends declared ($0.75 per share)		—			—			—			(4,893	)		—			(4,893	)
Tax benefit from exercise of stock options		—			—			43			—			—			43
Balance at December 31, 2006		6,524,407		$	6,524		$	26,047		$	16,731		$	(318	)	$	48,984

Comprehensive income:
Net income		—			—			—			6,031			—			6,031
Other comprehensive income, net of tax:
Change in fair value of securities available for sale		—			—			—			—			46			46
Prior service cost at initiation of defined benefit plan		—			—			—			—			(704	)		(704	)
Amortization of unrecognized prior service costs and net gains/losses		—			—			—			—			98			98
Comprehensive income																	5,471

Stock options exercised		74,026			74			775			—			—			849
Issuance of common stock		25,012			25			395			—			—			420
Common stock repurchased and retired		(16,900	)		(16	)		(203	)								(219	)
Stock compensation expense		—			—			97			—			—			97
Cash dividends declared ($0.75 per share)		—			—			—			(4,955	)		—			(4,955	)
Tax benefit from exercise of
stock options		—			—			52			—			—			52
Balance at December 31, 2007		6,606,545		$	6,607		$	27,163		$	17,807		$	(878	)	$	50,699

See notes to consolidated financial statements.

F-5

Pacific Financial Corporation and Subsidiary

Years Ended December 31, 2007, 2006 and 2005

Consolidated Statements of Cash Flows

(Dollars in Thousands)

	2007			2006			2005
Cash Flows from Operating Activities
Net income	$	6,031		$	6,551		$	6,046
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Depreciation and amortization		1,476			1,257			1,127
Provision for credit losses		482			625			1,100
Deferred income tax (benefit)		(305	)		759			(24	)
Originations of loans held for sale		(123,406	)		(109,444	)		(117,364	)
Proceeds from sales of loans held for sale		122,549			107,082			110,914
Net gains on sales of loans		(1,984	)		(1,895	)		(1,809	)
(Gain) loss on sale of securities available for sale		20			—			(2	)
Gains on sales of foreclosed real estate		—			(5	)		—
Loss on sale of premises and equipment		18			3			8
Earnings on bank owned life insurance		(397	)		(354	)		(393	)
Increase in accrued interest receivable		(159	)		(642	)		(491	)
Increase (decrease) in accrued interest payable		(16	)		868			162
Write-down of foreclosed real estate		—			—			3
Other - net		1,129			(864	)		(291	)
Net cash provided by (used in) operating activities		5,438			3,941			(1,014	)

Cash Flows from Investing Activities
Net (increase) decrease in interest bearing deposits in banks		5,226			(5,196	)		5,177
Net (increase) decrease in federal funds sold		20,345			(20,345	)		6,034
Activity in securities available for sale:
Sales		805			—			3,645
Maturities, prepayments and calls		8,807			4,822			7,944
Purchases		(15,090	)		(11,783	)		(6,394	)
Activity in securities held to maturity:
Maturities		943			392			691
Investment in PFC Statutory Trust I and II		—			(248	)		(155	)
Proceeds from sales of SBA loan pools		1,139			—			3,405
Increase in loans made to customers, net of principal collections		(14,821	)		(27,959	)		(56,633	)
Purchases of premises and equipment		(5,191	)		(2,718	)		(4,377	)
Proceeds from sales of premises and equipment		190			4			124
Proceeds from sales of foreclosed real estate		—			42			—
Purchase of bank owned life insurance		(5,000	)		—			—
Deposit assumption and transfer		—			(1,268	)		—
Net cash used in investing activities		(2,647	)		(64,257	)		(40,539	)

(continued)

See notes to consolidated financial statements.

F-6

Pacific Financial Corporation and Subsidiary

Years Ended December 31, 2007, 2006 and 2005

Consolidated Statements of Cash Flows

(concluded) (Dollars in Thousands)

	2007			2006			2005
Cash Flows from Financing Activities
Net increase in deposits	$	495		$	67,115		$	36,225
Net increase (decrease) in short-term borrowings		3,125			(3,985	)		3,985
Decrease in secured borrowings		(488	)		(244	)		(1,583	)
Proceeds from issuance of long-term borrowings		—			2,000			8,000
Repayments of long-term borrowings		(2,000	)		(5,000	)		(5,000	)
Proceeds from junior subordinated debentures		—			8,248			5,155
Common stock issued		1,269			642			405
Repurchase and retirement of common stock		(219	)		—			—
Cash dividends paid		(4,893	)		(4,719	)		(4,624	)
Net cash provided by (used in) financing activities		(2,711	)		64,057			42,563

Net change in cash and due from banks		80			3,741			1,010

Cash and Due from Banks
Beginning of year		14,964			11,223			10,213

End of year	$	15,044		$	14,964		$	11,223

Supplemental Disclosures of Cash Flow Information
Interest paid	$	15,649		$	11,709		$	7,185
Income taxes paid		2,297			1,667			3,020

Supplemental Disclosures of Non-Cash Investing Activities
Fair value adjustment of securities available for sale, net of tax	$	46		$	5		$	(456	)
Transfer of securities held to maturity to available for sale		825			—			—

See notes to consolidated financial statements.

F-7

Pacific Financial Corporation and Subsidiary

December 31, 2007 and 2006 and for the three years ended December 31, 2007

Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts

Note 1 - Summary of Significant Accounting Policies

Principles of Consolidation

The consolidated financial statements include the accounts of Pacific Financial Corporation (the Company), and its wholly owned subsidiary, The Bank of the Pacific (the Bank), after elimination of intercompany transactions and balances. The Company has two wholly owned subsidiaries, PFC Statutory Trust I and II (the Trusts), which do not meet the criteria for consolidation under Financial Accounting Standards Board Interpretation No. 46 (revised), “Consolidation of Variable Interest Entities,” and therefore, are not consolidated in the Company’s financial statements.

Nature of Operations

The Company is a holding company which operates primarily through its subsidiary bank. The Bank operates eighteen branches located in Grays Harbor, Pacific, Skagit, Whatcom and Wahkiakum Counties in western Washington and one in Clatsop County, Oregon. The Bank provides loan and deposit services to customers, who are predominately small- and middle-market businesses and middle-income individuals in western Washington and Oregon.

On June 23, 2006, the Bank completed a deposit transfer and assumption transaction with an Oregon-based bank for a $1,268 premium. In connection with completion of the transaction, the Oregon Department of Consumer and Business Services issued a Certificate of Authority to the Bank authorizing it to conduct a banking business in the State of Oregon. The premium, and the resultant right to conduct business in Oregon, has been recorded as an indefinite-lived intangible asset.

Consolidated Financial Statement Presentation

The consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America and practices within the banking industry. The preparation of consolidated financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, and the disclosure of contingent assets and liabilities, as of the date of the balance sheet, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for credit losses and the valuation of deferred tax assets.

Securities Available for Sale

Securities available for sale consist of debt securities, marketable equity securities and mutual funds that the Company intends to hold for an indefinite period, but not necessarily to maturity. Such securities may be sold to implement the Company’s asset/liability management strategies and in response to changes in interest rates and similar factors. Securities available for sale are reported at fair value. Unrealized gains and losses, net of the related deferred tax effect, are reported as a net amount in a separate component of shareholders' equity entitled “accumulated other comprehensive income (loss).” Realized gains and losses on securities available for sale, determined using the specific identification method, are included in earnings. Amortization of premiums and accretion of discounts are recognized in interest income over the period to maturity. For mortgage-backed securities, actual maturity may differ from contractual maturity due to principal payments and amortization of premiums and accretion of discounts may vary due to prepayment speed assumptions.

F-8

Pacific Financial Corporation and Subsidiary

December 31, 2007 and 2006 and for the three years ended December 31, 2007

Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts

Securities Held to Maturity

Debt securities for which the Company has the positive intent and ability to hold to maturity are reported at cost, adjusted for amortization of premiums and accretion of discounts, which are recognized in interest income over the period to maturity.

Declines in the fair value of individual securities held to maturity and available for sale below their cost that are other than temporary result in write-downs of the individual securities to their fair value. Such write-downs are included in earnings as realized losses. Management evaluates individual securities for other than temporary impairment on a quarterly basis based on the securities’ current credit quality, interest rates, term to maturity and management’s intent and ability to hold the securities until the net book value is recovered.

Federal Home Loan Bank Stock

The Company, as a member of the Federal Home Loan Bank (FHLB) system, is required to maintain an investment in capital stock of the FHLB in an amount equal to the greater of 1% of its outstanding home loans or 5% of advances from the FHLB. The recorded amount of FHLB stock equals its fair value because the shares can only be redeemed by the FHLB at the $100 per share par value.

Loans Held for Sale

Mortgage loans originated for sale in the foreseeable future in the secondary market are carried at the lower of aggregate cost or estimated market value. Gains and losses on sales of loans are recognized at settlement date and are determined by the difference between the sales proceeds and the carrying value of the loans. All sales are made without recourse. Net unrealized losses are recognized through a valuation allowance established by charges to income.

Loans Receivable

Loans receivable that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off are reported at their outstanding principal balances adjusted for any charge-offs, the allowance for credit losses, and any deferred fees or costs on originated loans, and unamortized premiums or discounts on purchased loans. Loan fees and certain direct loan origination costs are deferred, and the net fee or cost is recognized as an adjustment of yield over the contractual life of the related loans using the effective interest method.

Interest income on loans is accrued over the term of the loans based upon the principal outstanding. The accrual of interest on loans is discontinued when, in management’s opinion, the borrower may be unable to meet payments as they come due. When interest accrual is discontinued, all unpaid accrued interest is reversed against interest income. Interest income is subsequently recognized only to the extent that cash payments are received until, in management’s judgment, the borrower has the ability to make contractual interest and principal payments, in which case the loan is returned to accrual status.

Allowance for Credit Losses

The allowance for credit losses is established as losses are estimated to have occurred through a provision for credit losses charged to earnings. Losses are charged against the allowance when management believes the collectibility of a loan balance is unlikely. Subsequent recoveries, if any, are credited to the allowance.

The allowance for credit losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectability of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions. The evaluation is inherently subjective, as it requires estimates that are susceptible to significant revision as more information becomes available. The Company’s methodology for assessing the appropriateness of the allowance consists of several key elements, which include the formula allowance and impaired allowances. The formula portion of the general credit loss allowance is established by applying a loss percentage factor to the different loan types based on historical loss experience adjusted for qualitative factors.

F-9

Pacific Financial Corporation and Subsidiary

December 31, 2007 and 2006 and for the three years ended December 31, 2007

Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts

A loan is considered impaired when, based on current information and events, it is probable the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls are generally not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into considerations all of the circumstances surrounding the loan and the borrowers, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan by loan basis for commercial, construction and real estate loans by either the present value of the expected future cashflows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent. Large groups of smaller balance homogeneous loans are collectively evaluated for impairment.

Premises and Equipment

Premises and equipment are stated at cost less accumulated depreciation, which is computed on the straight-line method over the estimated useful lives of the assets. Asset lives range from 3 to 39 years. Leasehold improvements are amortized over the terms of the respective leases or the estimated useful lives of the improvements, whichever is less. Gains or losses on dispositions are reflected in earnings.

Foreclosed Real Estate

Real estate properties acquired through, or in lieu of, foreclosure are to be sold and are initially recorded at the lower of cost or fair value of the properties less estimated costs of disposal. Any write-down to fair value at the time of transfer to other real estate owned is charged to the allowance for credit losses. Properties are evaluated regularly to ensure that the recorded amounts are supported by their current fair values, and that valuation allowances to reduce the carrying amounts to fair value less estimated costs to dispose are recorded as necessary. Any subsequent reductions in carrying values, and revenue and expense from the operations of properties, are charged to operations.

Goodwill and other intangible assets

At December 31, 2007, the Company had $13,010 in goodwill and other intangible assets. Goodwill and other intangibles with indefinite lives are tested, at least annually on June 30, or more frequently if indicators of potential impairment exist, for impairment. As of December 31, 2007, there have been no events or changes in circumstances that would indicate a potential impairment. Core deposit intangibles are amortized to non-interest expense using a straight line method over seven years. Net unamortized core deposit intangible totaled $461 at December 31, 2007. Amortization expense related to core deposit intangible totaled $142 during each of the years ended December 31, 2007, 2006, and 2005. Amortization expense for the core deposit intangible is estimated to be $142 for each of the next three years.

F-10

Pacific Financial Corporation and Subsidiary

December 31, 2007 and 2006 and for the three years ended December 31, 2007

Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts

Impairment of long-lived assets

Management periodically reviews the carrying value of its long-lived assets to determine if an impairment has occurred or whether changes in circumstances have occurred that would require a revision to the remaining useful life, of which there have been none. In making such determination, management evaluates the performance, on an undiscounted basis, of the underlying operations or assets which give rise to such amount.

Transfers of Financial Assets

Transfers of financial assets are accounted for as sales when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from the Bank, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and (3) the Bank does not maintain effective control over the transferred assets through either an agreement to repurchase them before their maturity, or the ability to cause the buyer to return specific assets.

Income Taxes

Deferred tax assets and liabilities result from differences between the financial statement carrying amounts and the tax bases of assets and liabilities, and are reflected at currently enacted income tax rates applicable to the period in which the deferred tax assets or liabilities are expected to be realized or settled. Deferred tax assets are reduced by a valuation allowance when management determines that it is more likely than not that some portion or all of the deferred tax assets will not be realized. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes.

The Company files a consolidated federal income tax return. The Bank provides for income taxes separately and remits to the Company amounts currently due in accordance with a Tax Allocation Agreement between the Company and the Bank.

Stock-Based Compensation

Prior to January 1, 2006, the Company accounted for stock option plans under recognition and measurement principles of Accounting Principles Bulletin (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. No stock-based employee compensation cost was reflected in net income for previous awards, as all options granted under the plans had an exercise price equal to the market value of the underlying common stock on the date of grant.

Effective January 1, 2006, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 123R, Share Based Payment, which requires measurement of compensation cost for all stock based awards based on the grant date fair value and recognition of compensation cost over the service period of stock based awards. The Company has adopted SFAS No. 123R using the modified prospective method, which provides for no restatement of prior periods and no cumulative adjustment to equity awards. It also provides for expense recognition for both new and existing unvested stock-based awards.

F-11

Pacific Financial Corporation and Subsidiary

December 31, 2007 and 2006 and for the three years ended December 31, 2007

Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts

The following illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS No. 123, Accounting for Stock-Based Compensation, to stock-based compensation awards for all options granted for the year ended December 31, 2005:

Net income, as reported	$	6,046
Add stock compensation expensed		12
Less total stock-based compensation expense determined under fair value method for all qualifying awards, net of tax		586
Pro forma net income	$	5,472

Earnings Per Share
Basic - as reported	$	0.94
Basic - Pro forma		0.85
Diluted - as reported		0.92
Diluted - pro forma		0.84

The Company’s stock compensation plans are described more fully in Note 14.

Cash Equivalents and Cash Flows

The Company considers all amounts included in the balance sheet caption “Cash and due from banks” to be cash equivalents. Cash flows from loans, interest bearing deposits in banks, federal funds sold, short-term borrowings, secured borrowings and deposits are reported net.

The Company maintains balances in depository institution accounts which, at times, may exceed federally insured limits. The Company has not experienced any losses in such accounts.

Earnings Per Share

Basic earnings per share excludes dilution and is computed by dividing net income by the weighted average number of common shares outstanding. Diluted earnings per share reflect the potential dilution that could occur if common shares were issued pursuant to the exercise of options under the Company’s stock option plans. Stock options excluded from the calculation of diluted earnings per share because they are antidilutive, were 213,700, 252,550 and 272,600 in 2007, 2006 and 2005, respectively.

Comprehensive Income

Accounting principles generally require that recognized revenue, expenses, gains and losses be included in net income. Certain changes in assets and liabilities, such as prior service costs and amortization of prior service costs related to defined benefit plans and unrealized gains and losses on securities available for sale, are reported as a separate component of the equity section of the consolidated balance sheets, such items, along with net income, are components of comprehensive income. Gains and losses on securities available for sale are reclassified to net income as the gains or losses are realized upon sale of the securities. Other-than-temporary impairment charges are reclassified to net income at the time of the charge.

Business Segment

The Company operates a single business segment. The financial information that is used by the chief operating decision maker in allocating resources and assessing performance is only provided for one reportable segment as of December 31, 2007, 2006 and 2005.

F-12

Pacific Financial Corporation and Subsidiary

December 31, 2007 and 2006 and for the three years ended December 31, 2007

Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts

Recent Accounting Pronouncements

In July 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 48 (“FIN 48”), “Accounting for Uncertainty in Income Taxes - an Interpretation of FASB Statement No. 109.” FIN 48 prescribes a comprehensive model for how a company should recognize, measure, present and disclose in its financial statements uncertain tax positions that it has taken or expects to take on a tax return. FIN 48 was effective as of the beginning of the Company’s 2007 fiscal year. The cumulative effect, if any, of applying FIN 48 is to be reported as an adjustment to the opening balance of retained earnings in the year of adoption. The Company adopted FIN 48 on January 1, 2007. As of January 1, 2007 and December 31, 2007, the Company had no unrecognized tax benefits. The Company’s policy is to recognize interest and penalties on unrecognized tax benefits in “Provision for income taxes” in the consolidated statements of income. There were no amounts related to interest and penalties recognized for the year ended December 31, 2007. The tax years that remain subject to examination by federal and state taxing authorities are the years ended December 31, 2006, 2005 and 2004.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements,” which establishes a framework for reporting fair value and expands disclosures about fair value measurements. SFAS No. 157 becomes effective for the Company on January 1, 2008. The Company is currently evaluating the impact of this standard on its consolidated financial statements.

In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Post-retirement Plans,” an amendment of FASB Statements No. 87, 88, 106 and 132(R). SFAS No. 158 requires recognition of the funded status of the Company’s defined benefit and post retirement plans as an asset or liability in the consolidated financial statements for fiscal years ending after December 15, 2006. SFAS No. 158 also requires that assets and obligations that determine funded status be measured as of the end of the fiscal year. The requirement to use the fiscal year-end date as the measurement date is effective for fiscal years ending after December 15, 2008. The Company is currently assessing the measurement date requirement of SFAS No. 158 and its impact, if any, on the Company’s consolidated financial statements.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities,” which is effective for fiscal years beginning after November 15, 2007. SFAS No. 159 permits entities to choose to measure financial assets and liabilities at fair value. The election to measure a financial asset or liability at fair value can be made on an instrument-by-instrument basis and is irrevocable. The difference in carrying value and fair value at election is recorded as a transition adjustment to opening retained earnings. Subsequent changes in fair value are recognized in earnings. The Company did not early adopt SFAS No. 159, and is currently assessing the impact the adoption of this standard will have on its consolidated financial statements.

In December 2007, the FASB issued SFAS No. 141(R), “Business Combinations”. SFAS No. 141(R) requires the acquiring entity in a business combination to recognize the full fair value of assets acquired and liabilities assumed in the transaction (whether a full or partial acquisition); establishes the acquisition date fair value as the measurement objective for all assets acquired and liabilities assumed; requires expensing most transaction and restructuring costs; and requires the acquirer to disclose to investors and other users all of the information needed to evaluate and understand the nature and financial effect of the business combination. SFAS No. 141(R) applies prospectively to business combinations for which the acquisition date is on or after January 1, 2009.

F-13

Pacific Financial Corporation and Subsidiary

December 31, 2007 and 2006 and for the three years ended December 31, 2007

Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts

Note 2 - Restricted Assets

Federal Reserve Board regulations require that the Bank maintain certain minimum reserve balances in cash on hand and on deposit with the Federal Reserve Bank, based on a percentage of deposits. The average amount of such balances for the years ended December 31, 2007 and 2006 was approximately $653 and $665, respectively.

Note 3 - Securities

Investment securities have been classified according to management’s intent. The amortized cost of securities and their approximate fair value are as follows:

			Gross		Gross
	Amortized		Unrealized		Unrealized		Fair
Securities Available for Sale	Cost		Gains		Losses		Value
December 31, 2007
U.S. Government agency securities	$	3,796	$	22	$	—	$	3,818
Obligations of states and political subdivisions		16,248		83		195		16,136
Mortgage-backed securities		18,706		23		189		18,540
Corporate bonds		1,532		—		20		1,512
Mutual funds		3,041		—		135		2,906
	$	43,323	$	128	$	539	$	42,912

December 31, 2006
U.S. Government agency securities	$	8,346	$	22	$	57	$	8,311
Obligations of states and political subdivisions		13,719		69		169		13,619
Mortgage-backed securities		10,434		27		229		10,232
Corporate bonds		1,550		—		38		1,512
Mutual funds		3,041		—		107		2,934
	$	37,090	$	118	$	600	$	36,608

Securities Held to Maturity

December 31, 2007
State and municipal securities	$	3,562	$	48	$	5	$	3,605
Mortgage-backed securities		767		—		4		763

	$	4,329	$	48	$	9	$	4,368

December 31, 2006
State and municipal securities	$	5,155	$	38	$	35	$	5,158
Mortgage-backed securities		949		—		6		943

	$	6,104	$	38	$	41	$	6,101

For all the above investment securities, the unrealized losses are primarily due to changes in interest rates and, as such, are considered to be temporary by the Company. 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 interest rate environment. Additionally, the contractual cash flows of mortgage-backed securities are guaranteed by an agency of the U.S. Government. The Company did not engage in originating subprime mortgage loans and it does not believe that it has 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 or structured investment vehicles.

F-14

Pacific Financial Corporation and Subsidiary

December 31, 2007 and 2006 and for the three years ended December 31, 2007

Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts

Note 3 - Securities (continued)

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 December 31, 2007 and 2006 are summarized as follows:

	Less than 12 Months				More than 12 Months				Total
	Fair		Unrealized		Fair		Unrealized		Fair		Unrealized
	Value		Loss		Value		Loss		Value		Loss
December 31, 2007

Available for Sale
Obligations of states and political subdivisions	$	2,984	$	38	$	6,460	$	157	$	9,444	$	195
Mortgage-backed securities		10,582		88		4,435		101		15,017		189
Corporate bonds		—		—		1,512		20		1,512		20
Mutual funds		—		—		2,906		135		2,906		135

Total	$	13,566	$	126	$	15,313	$	413	$	28,879	$	539

Held to Maturity
State and municipal securities	$	83	$	—	$	980	$	5	$	1,063	$	5
Mortgage-backed securities		—		—		763		4		763		4

Total	$	83	$	—	$	1,743	$	9	$	1,826	$	9

December 31, 2006

Available for Sale
U.S. Government agency securities	$	2,988	$	1	$	4,050	$	56	$	7,038	$	57
Obligations of states and political subdivisions		4,927		114		3,471		55		8,398		169
Mortgage-backed securities		948		21		6,503		208		7,451		229
Corporate bonds		—		—		1,513		38		1,513		38
Mutual funds		—		—		2,934		107		2,934		107

Total	$	8,863	$	136	$	18,471	$	464	$	27,334	$	600

Held to Maturity
State and municipal securities	$	—	$	—	$	2,392	$	35	$	2,392	$	35
Mortgage-backed securities		943		6		—		—		943		6

Total	$	943	$	6	$	2,392	$	35	$	3,335	$	41

The contractual maturities of investment securities held to maturity and available for sale at December 31, 2007 are shown below. Investments in mortgage-backed securities are shown separately as maturities may differ from contractual maturities because borrowers have the right to call or prepay obligations, with or without call or prepayment penalties. Investments in mutual funds are shown separately due to the short-term nature of the investments and because mutual funds do not have a stated maturity date.

F-15

Pacific Financial Corporation and Subsidiary

December 31, 2007 and 2006 and for the three years ended December 31, 2007

Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts

Note 3 - Securities (concluded)

	Held to Maturity				Available for Sale
	Amortized		Fair		Amortized		Fair
	Cost		Value		Cost		Value
Due in one year or less	$	646	$	642	$	1,998	$	1,994
Due from one year to five years		784		792		8,667		8,680
Due from five to ten years		1,128		1,144		3,530		3,564
Due after ten years		1,004		1,027		7,381		7,228
Mortgage-backed securities		767		763		18,706		18,540
Mutual funds		—		—		3,041		2,906
Total	$	4,329	$	4,368	$	43,323	$	42,912

Gross gains realized on sales of securities were $0, $0 and $65 and gross losses realized were $20, $0 and $63 in 2007, 2006, and 2005 respectively. In 2007, the Bank transferred $825 in municipal bonds from held to maturity to available for sale as a result of significant deterioration in the credit quality of the bond issuer. The bonds were subsequently sold and the Bank realized a loss on sale of $20.

Securities carried at approximately $17,708 at December 31, 2007 and $15,830 at December 31, 2006 were pledged to secure public deposits, borrowings at the Federal Home Loan Bank of Seattle, and for other purposes required or permitted by law.

Note 4 - Loans

Loans (including loans held for sale) at December 31 consist of the following:

	2007			2006
Commercial and agricultural	$	128,145		$	132,843
Real estate:
Construction		93,249			87,063
Residential 1-4 family		60,616			64,545
Multi-family		6,353			6,927
Commercial		137,620			117,608
Farmland		20,125			20,126
Consumer		10,646			10,658
		456,754			439,770
Less unearned income		(681	)		(601	)
	$	456,073		$	439,169

Changes in the allowance for credit losses for the years ended December 31 are as follows:

	2007			2006			2005
Balance at beginning of year	$	4,033		$	5,296		$	4,236
Provision for credit losses		482			625			1,100

Charge-offs		(151	)		(1,945	)		(65	)
Recoveries		643			57			25
Net (charge-offs) recoveries		492			(1,888	)		(40	)
Balance at end of year	$	5,007		$	4,033		$	5,296

F-16

Pacific Financial Corporation and Subsidiary

December 31, 2007 and 2006 and for the three years ended December 31, 2007

Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts

Note 4 - Loans (concluded)

Following is a summary of information pertaining to impaired loans:

	2007		2006		2005
December 31
Impaired loans without a valuation allowance	$	3,379	$	7,328	$	1,733
Impaired loans with a valuation allowance		3,052		51		4,917

Total impaired loans	$	6,431	$	7,379	$	6,650
Valuation allowance related to impaired loans	$	72	$	17	$	924

Years Ended December 31
Average investment in impaired loans	$	2,938	$	6,475	$	6,925
Interest income recognized on a cash basis on impaired loans		457		272		569

At December 31, 2007, there were no commitments to lend additional funds to borrowers whose loans have been modified. Loans 90 days and over past due and still accruing interest at December 31, 2007 and 2006 were $2,932 and $376, respectively.

Certain related parties of the Company, principally directors and their affiliates, were loan customers of the Bank in the ordinary course of business during 2007 and 2006. Total related party loans outstanding at December 31, 2007 and 2006 to key officers and directors were $1,223 and $2,072, respectively. During 2007 and 2006, new loans of $43 and $2,027, respectively, were made, and repayments totaled $892 and $4,722, respectively. In management’s opinion, these loans and transactions were on the same terms as those for comparable loans and transactions with non-related parties. No loans to related parties were on non-accrual, past due or restructured at December 31, 2007.

Note 5 - Premises and Equipment

The components of premises and equipment at December 31 are as follows:

	2007		2006
Land and premises	$	12,261	$	11,962
Equipment, furniture and fixtures		7,569		7,246
Construction in progress		4,462		664
		24,292		19,872
Less accumulated depreciation and amortization		8,865		8,335

Total premises and equipment	$	15,427	$	11,537

Depreciation expense was $975, $844, and $705 for 2007, 2006 and 2005, respectively. The Bank leases premises under operating leases. Rental expense of leased premises was $426, $378 and $327 for 2007, 2006 and 2005, respectively, which is included in occupancy expense.

F-17

Pacific Financial Corporation and Subsidiary

December 31, 2007 and 2006 and for the three years ended December 31, 2007

Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts

Note 5 - Premises and Equipment (concluded)

Minimum net rental commitments under noncancelable operating leases having an original or remaining term of more than one year for future years ending December 31 are as follows:

2008	$	268
2009		218
2010		91
2011		58
2012		45

Total minimum payments required	$	680

Certain leases contain renewal options from five to ten years and escalation clauses based on increases in property taxes and other costs.

Note 6 - Deposits

The composition of deposits at December 31 is as follows:

	2007		2006
Demand deposits, non-interest bearing	$	86,883	$	91,657
NOW and money market accounts		149,565		147,277
Savings deposits		55,210		52,228
Time certificates, $100,000 or more		99,540		99,863
Other time certificates		76,138		75,816

Total	$	467,336	$	466,841

Scheduled maturities of time certificates of deposit are as follows for future years ending December 31:

2008	$	148,893
2009		7,378
2010		4,046
2011		6,778
2012		8,583

	$	175,678

Note 7 - Borrowings

Long-term borrowings at December 31, 2007 and 2006 represent advances from the Federal Home Loan Bank of Seattle. Advances at December 31, 2007 bear interest at 3.49% to 4.27% and mature in various years as follows: 2009 - $11,000; and 2010 - $1,500. The Bank has pledged $77,984 of securities and loans as collateral for these borrowings at December 31, 2007.

Secured borrowings at December 31, 2007 and 2006 represent borrowings collateralized by participation interests in loans originated by the Bank. These borrowings are repaid as payments (normally monthly) are made on the underlying loans, bearing interest ranging from 6.66% to 7.75%. Original maturities range from May 2009 to May 2012.

F-18

Pacific Financial Corporation and Subsidiary

December 31, 2007 and 2006 and for the three years ended December 31, 2007

Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts

Note 7 - Borrowings (concluded)

Short-term borrowings represent federal funds purchased that generally mature within one to four days from the transaction date and term borrowings with scheduled maturity dates within one year. The following is a summary of short-term borrowings for the years ended:

	2007			2006			2005
Amount outstanding at end of year	$	10,125		$	—		$	3,985
Weighted average interest rate at December 31		4.26	%		—			5.13	%
Maximum month-end balance during the year		18,695			6,500			3,985
Average balance during the year		5,961			1,388			69
Average interest rate during the year		5.52	%		5.40	%		5.80	%

Note 8 - Junior Subordinated Debentures

At December 31, 2007, two wholly-owned subsidiary grantor trusts established by the Company had outstanding $13,000 of pooled Trust Preferred Securities (“trust preferred securities”). Trust preferred securities accrue and pay distributions periodically at specified annual rates as provided in the indentures. The trusts used the net proceeds from the offering to purchase a like amount of Junior Subordinated Debentures (the “Debentures”) of the Company. The Debentures are the sole assets of the trusts. The Company’s obligations under the Debentures and the related documents, taken together, constitute a full and unconditional guarantee by the Company of the obligations of the trusts. The trust preferred securities are mandatory redeemable upon the maturity of the Debentures, or upon earlier redemption as provided in the indentures. The Company has the right to redeem the Debentures in whole or in part on or after specified dates, at a redemption price specified in the indentures plus any accrued but unpaid interest to the redemption date.

The following table is a summary of the trust preferred securities and debentures at December 31, 2007:

(dollars in thousands)

Issuance

Preferred

Rate

Initial

Rate at

Maturity

Issuance Trust

Date

Security

Type

Rate

12/31/07

Date

PFC Statutory Trust I

12/2005

5,000

Fixed

(1)

6.39

3/2036

PFC Statutory Trust II

6/2006

8,000

Variable

(2)

7.02

6.84

7/2036

(1)	Fixed rate until March 15, 2011, at which time becomes a variable rate, adjusted quarterly, equal to 145 basis points over the three month LIBOR rate.

(2)	The variable rate preferred securities reprice quarterly.

The total amount of trust preferred securities outstanding at both December 31, 2007 and 2006, was $13,000. The interest rate on the trust preferred securities issued in June 2006 resets quarterly and is tied to the London Interbank Offered Rate (“LIBOR”). The Company has the right to redeem the debentures issued in the December 2005 offering in March 2011, and the June 2006 offering in July 2011.

The Debentures issued by the Company to the grantor trusts totaling $13,000 are reflected in the consolidated balance sheet in the liabilities section under the caption “junior subordinated debentures.” The Company records interest expense on the corresponding junior subordinated debentures in the consolidated statements of income. The Company recorded $403 in the consolidated balance sheet at December 31, 2007 and 2006, respectively, for the common capital securities issued by the issuer trusts.

F-19

Pacific Financial Corporation and Subsidiary

December 31, 2007 and 2006 and for the three years ended December 31, 2007

Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts

Note 8 - Junior Subordinated Debentures (concluded)

On July 2, 2003, the Federal Reserve Board (“Federal Reserve”) issued Supervisory Letter SR 03-13 clarifying that Bank Holding Companies should continue to report trust preferred securities in accordance with current Federal Reserve Bank instructions which allows trust preferred securities to be counted in Tier 1 capital subject to certain limitations. The Federal Reserve has indicated it will review the implications of any accounting treatment changes and, if necessary or warranted, will provide appropriate guidance.

Note 9 - Income Taxes

Income taxes for the years ended December 31 is as follows:

	2007			2006		2005
Current	$	2,391		$	1,990	$	2,677
Deferred provision (benefit)		(305	)		759		(24	)

Total income taxes	$	2,086		$	2,749	$	2,653

The tax effects of temporary differences that give rise to significant portions of deferred tax assets and liabilities at December 31 are:

	2007			2006
Deferred Tax Assets
Allowance for credit losses	$	1,579		$	1,213
Deferred compensation		160			166
Supplemental executive retirement plan		275			—
Unrealized loss on securities available for sale		140			164
Loan fees/costs		242			204
Other		132			135

Total deferred tax assets		2,528			1,882

Deferred Tax Liabilities
Depreciation	$	88		$	103
Loan fees/costs		2,346			1,937
Core deposit intangible		157			205
Other		378			359
Total deferred tax liabilities		2,969			2,604

Net deferred tax liabilities	$	(441	)	$	(722	)

Net deferred tax assets are recorded in other assets and net deferred tax liabilities are recorded in other liabilities in the consolidated financial statements.

F-20

Pacific Financial Corporation and Subsidiary

December 31, 2007 and 2006 and for the three years ended December 31, 2007

Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts

Note 9 - Income Taxes (concluded)

The following is a reconciliation between the statutory and effective federal income tax rate for the years ended December 31:

				Percent						Percent						Percent
	2007			of Pre-tax			2006			of Pre-tax			2005			Pre-tax
	Amount			Income			Amount			Income			Amount			Income
Income tax at statutory rate	$	2,841			35.0	%	$	3,255			35.0	%	$	3,031			35.0	%
Adjustments resulting from:
Tax-exempt income		(316	)		(3.9	)		(275	)		(2.9	)		(244	)		(2.8	)
Net earnings on life insurance policies		(139	)		(1.7	)		(112	)		(1.2	)		(125	)		(1.4	)
Other		(300	)		(3.7	)		(119	)		(1.3	)		(9	)		(.1	)

Total income tax expense	$	2,086			25.7	%	$	2,749			29.6	%	$	2,653			30.7	%

Note 10 - Employee Benefits

Incentive Compensation Plan

The Bank has a plan that provides incentive compensation to key employees if the Bank meets certain performance criteria established by the Board of Directors. The cost of this plan was $943, $1,016, and $1,023 in 2007, 2006 and 2005, respectively.

401(k) Plans

The Bank has established a 401(k) profit sharing plan for those employees who meet the eligibility requirements set forth in the plan. Eligible employees may contribute up to 15% of their compensation. Matching contributions by the Bank are at the discretion of the Board of Directors. Contributions totaled $398, $334 and $290 for 2007, 2006 and 2005, respectively.

Director and Employee Deferred Compensation Plans

The Company has director and employee deferred compensation plans. Under the terms of the plans, a director or employee may participate upon approval by the Board. The participant may then elect to defer a portion of his or her earnings (directors’ fees or salary) as designated at the beginning of each plan year. Payments begin upon retirement, termination, death or permanent disability, sale of the Company, the ten-year anniversary of the participant’s participation date, or at the discretion of the Company. There are currently two participants in the plans. Total deferrals plus earnings were $145, $149 and $134 at December 31, 2007, 2006 and 2005, respectively. There is no ongoing expense to the Company for this plan.

The directors of a bank acquired by the Company in 1999 adopted two deferred compensation plans for directors - one plan providing retirement income benefits for all directors and the other, a deferred compensation plan, covering only those directors who have chosen to participate in the plan. At the time of adopting these plans, the Bank purchased life insurance policies on directors participating in both plans which may be used to fund payments to them under these plans. Cash surrender values on these policies were $3,232 and $3,124 at December 31, 2007 and 2006, respectively. In 2007, 2006 and 2005, the net benefit recorded from these plans, including the cost of the related life insurance, was $371, $306 and $334, respectively. Both of these plans were fully funded and frozen as of September 30, 2001. Plan participants were given the option to either remain in the plan until reaching the age of 70 or to receive a lump-sum distribution. Participants electing to remain in the plan will receive annual payments over a ten-year period upon reaching 70 years of age. The liability associated with these plans totaled $326 and $339 at December 31, 2007 and 2006, respectively.

F-21

Pacific Financial Corporation and Subsidiary

December 31, 2007 and 2006 and for the three years ended December 31, 2007

Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts

Note 10 - Employee Benefits (continued)

Non-Qualified Deferred Compensation Plan

The Company has a non-qualified deferred compensation plan to cover selected employees. Its annual contributions to the plan totaled $0, $5 and $5 in 2007, 2006 and 2005, respectively. Covered employees may also contribute to the plan. The liability associated with this plan totaled $0 and $6 at December 31, 2007 and 2006.

Supplemental Executive Retirement Plan

Effective January 1, 2007, the Company adopted a non-qualifed Supplemental Executive Retirement Plan (SERP) that provides retirement benefits to its executive officers. The SERP is unsecured and unfunded and there are no plan assets. The post-retirement benefit provided by the SERP is designed to supplement a participating officer’s retirement benefits from social security, in order to provide the officer with a certain percentage of final average income at retirement age. The benefit is generally based on average earnings, years of service and age at retirement. At the inception of the SERP, the Company recorded a prior service cost to accumulated other comprehensive income of $634. The Company has purchased bank owned life insurance covering all participants in the SERP. The cash surrender value of these policies totaled $5,058 at December 31, 2007.

The following table sets forth the net periodic pension cost and obligation assumptions used in the measurement of the benefit obligation for the year ended December 31, 2007:

Net periodic pension cost:
Service Cost	$	91
Interest Cost		41
Amortization of prior service cost		70
Net periodic pension cost	$	202

Weighted average assumptions:
Discount rate		5.94	%
Rate of compensation increases		5.00

The following table sets forth the change in benefit obligation at December 31, 2007:

Change in Benefit Obligation:
Benefit obligation at inception of plan during the year	$	704
Service cost		91
Interest cost		41
Actuarial gain		(28	)
Benefit obligation at end of year		808

F-22

Pacific Financial Corporation and Subsidiary

December 31, 2007 and 2006 and for the three years ended December 31, 2007

Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts

Note 10 - Employee Benefits (concluded)

The following table sets forth the amounts recognized in accumulated other comprehensive loss at December 31, 2007:

Net gain	$	(28	)
Prior service cost		634
Total recognized in accumulative other comprehensive loss	$	606

The following table summarizes the projected and accumulated benefit obligations at December 31, 2007:

Projected benefit obligation		$	808
Accumulated benefit obligation			633

Estimated future benefit payments as of December 31, 2007 are as follows:

2008 - 2012		$	0
2013 - 2017			33

Note 11 - Dividend Reinvestment Plan

In November 2005, the Company instituted a dividend reinvestment plan which allows for all or part of cash dividends to be reinvested in shares of Company common stock based upon shareholder election. Under the plan, 1,000,000 shares are authorized for dividend reinvestment, of which 39,938 shares have been issued through December 31, 2007.

Note 12 - Commitments and Contingencies

	2007		2006
Commitments to extend credit	$	108,095	$	100,792
Standby letters of credit		3,489		2,650

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. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Bank’s experience has been that approximately 67% of loan commitments are drawn upon by customers. The Bank evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Bank upon extension of credit, is based on management’s credit evaluation of the party.

F-23

Pacific Financial Corporation and Subsidiary

December 31, 2007 and 2006 and for the three years ended December 31, 2007

Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts

Note 12 - Commitments and Contingencies (concluded)

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. Those guarantees are primarily issued to support public and private borrowing arrangements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Collateral held varies as specified above and is required in instances where the Bank deems necessary.

Certain executive officers have entered into employment contracts with the Bank which provide for contingent payments subject to future events.

The Bank has agreements with commercial banks for lines of credit totaling $41,000, of which $3,125 was used at December 31, 2007. In addition, the Bank has a credit line with the Federal Home Loan Bank of Seattle totaling 20% of assets, $19,500 of which was used at December 31, 2007. These borrowings are collateralized under blanket pledge and custody agreements.

Because of the nature of its activities, the Company is subject to various pending and threatened legal actions which arise 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 financial condition, results of operations or cash flows of the Company.

Note 13 - Significant Concentrations of Credit Risk

Most of the Bank’s business activity is with customers and governmental entities located in the state of Washington, including investments in state and municipal securities. Loans are generally limited by state banking regulations to 20% of the Bank’s shareholder’s equity, excluding accumulated other comprehensive income (loss). Standby letters of credit were granted primarily to commercial borrowers. The Bank, as a matter of practice, generally does not extend credit to any single borrower or group of borrowers in excess of $7,500.

Note 14 - Stock Options

The Company’s three stock incentive plans, adopted in 1995, 1997 and 2000, provide for granting incentive stock options, as defined under current tax laws, to key personnel. The plan adopted in 2000 also provides for non-qualified stock options and other types of stock based awards. Under the first plan, options are exercisable 90 days from the date of grant. These options terminate if not exercised within ten years from the date of grant. If after six years from the date of grant fewer than 20% of the options have been exercised, they will expire at a rate of 20% annually. Under the second plan, the options become exercisable one year from the date of grant, at a rate of 10% annually. Options terminate if not exercised when they become available. No additional grants will be made under these two plans. The 2000 plan authorizes the issuance of up to a total of 1,000,000 shares (279,250 shares are available for grant at December 31, 2007). Under the 2000 plan, options either become exercisable ratably over five years or vest fully five years from the date of grant. Under the 2000 plan, the Company may grant up to 150,000 options for its common stock to a single individual in a calendar year.

The Company uses the Black-Scholes option pricing model to calculate the fair value of stock-based awards based on assumptions noted in the following table. Expected volatility is based on historical volatility of the Company’s common shares. 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.

F-24

Pacific Financial Corporation and Subsidiary

December 31, 2007 and 2006 and for the three years ended December 31, 2007

Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts

Note 14 - Stock Options (continued)

Grant period ended	Expected Life		Risk Free Interest Rate			Expected Volatility			Dividend Yield			Average Fair Value
December 31, 2007		6.5 years		4.59	%		15.66	%		4.92	%	$	1.69
December 31, 2006		6.5 years		4.97	%		16.53	%		4.83	%	$	1.88
December 31, 2005		10 years		4.47	%		17.23	%		4.44	%	$	4.37

A summary of the status of the Company’s stock option plans as of December 31, 2007, 2006 and 2005, and changes during the years ending on those dates, is presented below:

	2007					2006					2005
				Weighted					Weighted					Weighted
				Average					Average					Average
				Exercise					Exercise					Exercise
	Shares			Price		Shares			Price		Shares			Price
Outstanding at beginning of year		699,729		$	13.70		687,674		$	13.28		619,794		$	12.51

Granted		97,250			15.32		57,000			15.13		122,500			16.22
Exercised		(74,026	)		11.47		(44,945	)		9.13		(42,620	)		9.50
Expired		(1,700	)		5.88		—			—		—			—
Forfeited		(94,100	)		16.60		—			—		(12,000	)		16.77

Outstanding at end of year		627,153		$	13.80		699,729		$	13.70		687,674		$	13.28

Exercisable at end of year		450,895		$	13.46		570,523		$	13.66		543,668		$	14.15

A summary of the status of the Company’s nonvested options as of December 31, 2007 and 2006 and changes during the period then ended are presented below:

				Weighted average
	Shares			Fair value
Non-vested January 1, 2006		144,006		$	2.01

Granted		57,000			1.82
Vested		(71,800	)		1.26
Forfeited		—			—

Non-vested December 31, 2006		129,206		$	2.37

Granted		97,250			1.69
Vested		(32,898	)		2.61
Forfeited		(17,300	)		2.02

Non-vested December 31, 2007		176,258		$	1.98

F-25

Pacific Financial Corporation and Subsidiary

December 31, 2007 and 2006 and for the three years ended December 31, 2007

Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts

Note 14 - Stock Options (concluded)

The following information summarizes information about stock options outstanding and exercisable at December 31, 2007:

	Options Outstanding						Options Exercisable
Range of exercise prices	Number		Weighted average remaining contractual life (years)		Weighted average exercise price		Number		Weighted average remaining contractual life (years)		Weighted average exercise price
$5.88 - $6.18		5,356		2.0	$	6.18		5,356		2.0	$	6.18
11.11 - 12.49		242,797		3.6		11.32		224,189		3.4		11.27
12.50 - 14.74		86,800		5.4		13.30		41,300		2.5		13.33
14.75 - 15.99		78,500		8.4		15.28		19,100		7.0		15.31
16.00 - 17.50		213,700		7.3		16.47		160,950		7.7		16.57

		627,153		5.7	$	13.80		450,895		4.7	$	13.46

The aggregate intrinsic value of all options outstanding at December 31, 2007 and 2006 was $188 and $2,275, respectively. The aggregate intrinsic value of all options that were exercisable at December 31, 2007 and 2006 was $0 and $1,878, respectively. The total intrinsic value of stock options exercised was $282 and $314, respectively for the 2007 and 2006. Cash received from the exercise of stock options during 2007 totaled $861. Stock based compensation recognized in 2007 and 2006 was $97 ($64 net of tax and $36 ($24 net of tax), respectively. Future compensation expense for unvested awards outstanding as of December 31, 2007 is estimated to be $181 recognized over a weighted average period of 1.9 years.

In July 2005, the Board of Directors approved the acceleration of vesting of 257,600 out of the money options previously awarded under the 2000 Stock Option Plan. As a result, the accelerated stock options became exercisable immediately.

Note 15 - Regulatory Matters

The Company and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s consolidated financial statements. Under capital adequacy guidelines on the regulatory framework for prompt corrective action, the Bank must meet specific capital adequacy guidelines that involve quantitative measures of the Bank’s assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. The Bank’s capital classification is also subject to qualitative judgments by the regulators about components, risk weightings and other factors.

Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios (set forth in the table below) of Tier 1 capital (as defined in the regulations) to total average assets (as defined), and minimum ratios of Tier 1 and total capital (as defined) to risk-weighted assets (as defined).

F-26

Pacific Financial Corporation and Subsidiary

December 31, 2007 and 2006 and for the three years ended December 31, 2007

Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts

Note 15 - Regulatory Matters (concluded)

As of December 31, 2007, the most recent notification from the Bank’s regulator categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, the Bank must maintain minimum total risk-based, Tier 1 risk-based, and Tier 1 leverage ratios as set forth in the table. There are no conditions or events since that notification that management believes have changed the institution’s category.

The Company and the Bank’s actual capital amounts and ratios are also presented in the table. Management believes, as of December 31, 2007, the Company and the Bank meet all capital requirements to which they are subject.

											To be Well
											Capitalized
											Under Prompt
						Capital Adequacy					Corrective Action
	Actual					Purposes					Provisions
	Amount		Ratio			Amount		Ratio			Amount		Ratio
December 31, 2007
Tier 1 capital (to average assets):
Company	$	50,825		9.28	%	$	21,906		4.00	%		NA		NA
Bank		50,210		9.19			21,860		4.00		$	27,325		5.00	%
Tier 1 capital (to risk-weighted assets):
Company		50,825		11.37			17,887		4.00			NA		NA
Bank		50,210		11.26			17,840		4.00			26,760		6.00
Total capital (to risk-weighted assets):
Company		55,832		12.49			35,774		8.00			NA		NA
Bank		55,217		12.38			35,679		8.00			44,599		10.00

December 31, 2006
Tier 1 capital (to average assets):
Company	$	49,042		9.27	%	$	21,173		4.00	%		NA		NA
Bank		48,162		9.11			21,147		4.00		$	26,432		5.00	%
Tier 1 capital (to risk-weighted assets):
Company		49,042		11.03			17,784		4.00			NA		NA
Bank		48,162		10.91			17,662		4.00			26,493		6.00
Total capital (to risk-weighted assets):
Company		53,075		11.94			35,567		8.00			NA		NA
Bank		52,195		11.82			35,324		8.00			44,155		10.00

At December 31, 2007 and 2006, approximately $6,031 and $6,551, respectively, of undistributed earnings of the Bank, included in consolidated retained earnings, was available for distribution as dividends without prior regulatory approval.

F-27

Pacific Financial Corporation and Subsidiary

December 31, 2007 and 2006 and for the three years ended December 31, 2007

Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts

Note 16 - Other Comprehensive Income

Net unrealized gains and losses, net of tax, include $46 and $5 of unrealized gains and $455 of unrealized losses arising during 2007, 2006 and 2005, respectively, less reclassification adjustments of $0, $0 and $1 for gains included in net income in 2007, 2006 and 2005, respectively, as follows:

	Before-			Tax
	Tax			Benefit			Net-of-Tax
	Amount			(Expense)			Amount
2007
Unrealized holding gains arising during the year	$	71			($25	)	$	46
Reclassification adjustments for gains realized in net income		—			—			—

Net unrealized gains	$	71			($25	)	$	46

2006
Unrealized holding gains arising during the year	$	8			($3	)	$	5
Reclassification adjustments for gains realized in net income		—			—			—

Net unrealized gains	$	8			($3	)	$	5

2005
Unrealized holding losses arising during the year	$	(689	)	$	234		$	(455	)
Reclassification adjustments for gains realized in net income		(2	)		1			(1	)

Net unrealized losses	$	(691	)	$	235		$	(456	)

Note 17 - Fair Value of Financial Instruments

The estimated fair value of the Company’s financial instruments at December 31 are as follows:

	2007				2006
	Carrying		Fair		Carrying		Fair
	Amount		Value		Amount		Value
Financial Assets
Cash and due from banks, interest-bearing
deposits in banks, and federal funds sold	$	15,297	$	15,297	$	40,788	$	40,788
Securities available for sale		42,912		42,912		36,608		36,608
Securities held to maturity		4,329		4,368		6,104		6,101
Investment in PFC Statutory Trusts		403		403		403		403
Federal Home Loan Bank stock		1,858		1,858		1,858		1,858
Loans receivable, net		433,904		434,120		420,768		420,215
Loans held for sale		17,162		17,407		14,368		14,684
Accrued interest receivable		3,165		3,165		3,006		3,006

Financial Liabilities
Deposits	$	467,336	$	468,326	$	466,841	$	466,719
Short-term borrowings		10,125		10,093		—		—
Long-term borrowings		12,500		12,436		21,500		20,880
Secured borrowings		1,418		1,418		1,906		1,906
Junior subordinated debentures		13,403		13,275		13,403		13,403
Accrued interest payable		1,399		1,399		1,415		1,415

Note 17 - Fair Value of Financial Instruments (continued)

The Bank assumes interest rate risk (the risk that general interest rate levels will change) as a result of its normal operations. As a result, the fair values of the Bank’s financial instruments will change when interest rate levels change and that change may either be favorable or unfavorable to the Bank. Management attempts to match maturities of assets and liabilities to the extent believed appropriate to maintain interest rate risk at acceptable levels. However, borrowers with fixed rate obligations are less likely to prepay in a rising rate environment and more likely to prepay in a falling rate environment. Conversely, depositors who are receiving fixed rates are more likely to withdraw funds before maturity in a rising rate environment and less likely to do so in a falling rate environment. Management monitors rates and maturities of assets and liabilities, and attempts to minimize interest rate risk by adjusting terms of new loans and deposits and by investing in securities with terms that mitigate the Bank’s overall interest rate risk.

F-28

Pacific Financial Corporation and Subsidiary

December 31, 2007 and 2006 and for the three years ended December 31, 2007

Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts

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, Interest Bearing Deposits at Other Financial Institutions, and Federal Funds Sold

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

Securities Available for Sale and Held to Maturity

Fair values for securities are based on quoted market prices.

Federal Home Loan Bank Stock

The carrying value of Federal Home Loan Bank stock approximates its fair value.

Investment in PFC Statutory Trust I and II

The carrying value of the Investment in PFC Statutory Trust I and II approximates their fair value and is recorded in other assets.

Loans

For variable rate loans that reprice frequently and have no significant change in credit risk, fair values are based on carrying values. Fair values for fixed rate loans are estimated using discounted cash flow analysis, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality. Fair values of loans held for sale are based on their estimated market prices. Fair values

for impaired loans are estimated using discounted cash flow analysis or underlying collateral values, where applicable.

Deposit Liabilities

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.

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.

Note 17 - Fair Value of Financial Instruments (concluded)

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.

F-29

Pacific Financial Corporation and Subsidiary

December 31, 2007 and 2006 and for the three years ended December 31, 2007

Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts

Long-Term Borrowings and Junior Subordinated Debentures

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

Accrued Interest Receivable and Payable

The carrying amounts of accrued interest receivable and payable approximate their fair values.

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.

Note 18 - Earnings Per Share Disclosures

Following is information regarding the calculation of basic and diluted earnings per share for the years indicated.

	Net Income		Shares		Per Share
	(Numerator)		(Denominator)		Amount
Year Ended December 31, 2007
Basic earnings per share:	$	6,031		6,581,203	$	0.92
Effect of dilutive securities:		—		86,839		(.02	)
Diluted earnings per share:	$	6,031		6,668,042	$	0.90

Year Ended December 31, 2006
Basic earnings per share:	$	6,551		6,483,370	$	1.01
Effect of dilutive securities:		—		102,437		(.02	)
Diluted earnings per share:	$	6,551		6,585,807	$	0.99

Year Ended December 31, 2005
Basic earnings per share:	$	6,046		6,425,615	$	0.94
Effect of dilutive securities:		—		112,635		(.02	)
Diluted earnings per share:	$	6,046		6,538,250	$	0.92

The number of shares shown for “options” is the number of incremental shares that would result from the exercise of options and use of the proceeds to repurchase shares at the average market price during the year.

F-30

Pacific Financial Corporation and Subsidiary

December 31, 2007 and 2006 and for the three years ended December 31, 2007

Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts

Condensed Statements of Income - Years Ended December 31

Note 19 - Condensed Financial Information - Parent Company Only

Condensed Balance Sheets - December 31

	2007		2006
Assets
Cash	$	4,929	$	5,183
Investment in the Bank		63,084		61,104
Due from the Bank		783		731
Other assets		403		403
Total assets	$	69,199	$	67,421

Liabilities and Shareholders’ Equity
Dividends payable	$	4,955	$	4,893
Junior subordinated debentures		13,403		13,403
Other liabilities		142		141
Shareholders’ equity		50,699		48,984

Total liabilities and shareholders’ equity	$	69,199	$	67,421

Condensed Statements of Income - Years Ended December 31

	2007			2006			2005
Dividend Income from the Bank	$	4,700		$	5,150		$	4,250
Other Income		27			19			—
Total Income		4,727			5,169			4,250

Expenses		(1,236	)		(934	)		(205	)

Income before income tax benefit		3,491			4,235			4,045

Income Tax Benefit		—			294			69

Income before equity in undistributed income of the Bank		3,491			4,529			4,114

Equity in Undistributed Income of the Bank		2,540			2,022			1,932

Net income	$	6,031		$	6,551		$	6,046

F-31

Pacific Financial Corporation and Subsidiary

December 31, 2007 and 2006 and for the three years ended December 31, 2007

Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts

Note 19 - Condensed Financial Information - Parent Company Only (concluded)

Condensed Statements of Cash Flows - Years Ended December 31

	2007			2006			2005
Operating Activities
Net income	$	6,031		$	6,551		$	6,046
Adjustments to reconcile net income to net cash provided by operating activities:
Equity in undistributed income of subsidiary		(2,540	)		(2,022	)		(1,932	)
Net change in other assets		—			(294	)		(69	)
Net change in other liabilities		1			141			—
Other - net		97			35			12
Net cash provided by operating activities		3,589			4,411			4,057

Investing Activities
Contribution to subsidiary		—			(8,000	)		(5,000	)
Purchase of trust common securities		—			(248	)		(155	)
Net cash used in investing activities		—			(8,248	)		(5,155	)

Financing Activities
Proceeds from junior subordinated debentures		—			8,248			5,155
Common stock issued		1,269			642			405
Repurchase and retirement of common stock		(219	)		—			—
Dividends paid		(4,893	)		(4,719	)		(4,624	)
Net cash provided by (used in) financing activities		(3,843	)		4,171			936

Net increase (decrease) in cash		(254	)		334			(162	)

Cash
Beginning of year		5,183			4,849			5,011

End of year	$	4,929		$	5,183		$	4,849

F-32

Quarterly Data (Unaudited)

	First		Second		Third		Fourth
	Quarter		Quarter		Quarter		Quarter
Year Ended December 31, 2007

Interest income	$	9,811	$	10,346	$	10,331	$	9,648
Interest expense		3,806		4,033		4,000		3,794
Net interest income		6,005		6,313		6,331		5,854

Provision for credit losses		257		105		60		60
Non-interest income		946		1,149		1,063		1,317

Non-interest expenses		4,820		5,184		5,017		5,358

Income before income taxes		1,874		2,173		2,317		1,753

Income taxes		340		607		686		453

Net income	$	1,534	$	1,566	$	1,631	$	1,300

Earnings per common share:
Basic	$	.23	$	.24	$	.24	$	.21
Diluted		.23		.24		.24		.19


Year Ended December 31, 2006

Interest income	$	8,126	$	8,763	$	9,765	$	9,790
Interest expense		2,493		2,864		3,510		3,710
Net interest income		5,633		5,899		6,255		6,080

Provision for credit losses		—		—		550		75

Non-interest income		946		1,089		1,091		1,050

Non-interest expenses		4,314		4,466		4,636		4,702

Income before income taxes		2,265		2,522		2,160		2,353

Income taxes		675		777		617		680

Net income	$	1,590	$	1,745	$	1,543	$	1,673

Earnings per common share:
Basic	$	.25	$	.27	$	.24	$	.25
Diluted		.24		.27		.23		.25

F-33

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) 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, on the 14^th day of March, 2008.

			PACIFIC FINANCIAL CORPORATION (Registrant)
/s/ Dennis A. Long			/s/ Denise Portmann
Dennis A. Long, President and CEO			Denise Portmann, CFO

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated, on the 14^th day of March, 2008.

Principal Executive Officer and Director		Principal Financial and Accounting Officer


/s/ Dennis A. Long		/s/ Denise Portmann
Dennis A. Long, President and CEO and Director		Denise Portmann, CFO
Principal Executive Officer		Principal Financial and Accounting Officer

Remaining Directors


/s/ Gary C. Forcum		/s/ G. Dennis Archer
Gary C. Forcum (Chairman of the Board)		G. Dennis Archer


/s/ Joseph A. Malik		/s/ Duane E. Hagstrom
Joseph A. Malik		Duane E. Hagstrom


/s/ Steward L. Thomas		/s/ John Ferlin
Steward L. Thomas		John Ferlin


/s/ Douglas M. Schermer		/s/ Robert J. Worrell
Douglas M. Schermer		Robert J. Worrell


/s/ Susan C. Freese		/s/ Randy W. Rognlin
Susan C. Freese		Randy W. Rognlin


/s/ Randy Rust		/s/ Edwin Ketel
Randy Rust		Edwin Ketel

Exhibit Index

EXHIBIT NO.		EXHIBIT

3.1		Restated Articles of Incorporation. Incorporated by reference to Exhibit 3.2 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2000.

3.2		Bylaws. Incorporated by reference to Exhibit 2b to Form 8-A filed by the Company and declared effective on March 7, 2000 (Registration No. 000-29329).

10.1*		Employment Agreement with Dennis A. Long dated July 1, 2005. Incorporated by reference to Exhibit 10.1 to the Company's Annual Report on Form 10-K for the year ended December 31, 2006 (the "2005 10-K").*

10.2		Employment Agreement with John Van Dijk dated July 1, 2005. Incorporated by reference to Exhibit 10.2 to the 2005 10-K.*

10.3		Employment Agreement with Bruce D. MacNaughton dated July 1, 2005. Incorporated by reference to Exhibit 10.3 to the 2005 10-K.*

10.4		Employment Agreement with Denise Portmann dated July 1, 2005. Incorporated by reference to Exhibit 10.4 to the 2005 10-K.*

10.5		Bank of the Pacific Incentive Stock Option Plan. Incorporated by reference to Exhibit 10.7 to the Company’s Annual Report on Form 10-K for the year ended December 31, 1999 (the "1999 10-K").*

10.6		The Bank of Grays Harbor Incentive Stock Option Plan. Incorporated by reference to Exhibit 10.8 of the 1999 10-K.*

10.7		2000 Stock Incentive Compensation Plan, as amended (the "2000 Plan"). Incorporated by reference to Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2007 (the "March 2007 10-Q").*

10.8		Forms of stock option agreements under the 2000 Plan. Incorporated by reference to Exhibits 10.2 and 10.3 to the March 2007 10-Q.*

10.9		Senior Officer Incentive Plan.*

10.10		The Bank of Grays Harbor Employee Deferred Compensation Plan. Incorporated by reference to Exhibit 10.10 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2000.*

10.11		Supplemental Executive Retirement Plan effective January 1, 2007. Incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K dated March 13, 2008 (the "March 2008 8-K")*.

10.12		Individual Participation Agreement (SERP) dated March 13, 2008, between the Company and Dennis A. Long. Incorporated by reference to Exhibit 10.2 to the March 2008 8-K.*

10.13		Individual Participation Agreement (SERP) dated March 13, 2008, between the Company and John Van Dijk. Incorporated by reference to Exhibit 10.3 to the March 2008 8-K.*

10.14		Individual Participation Agreement (SERP) dated March 13, 2008, between the Company and Bruce MacNaughton. Incorporated by reference to Exhibit 10.4 to the March 2008 8-K.*

10.15		Individual Participation Agreement (SERP) dated March 13, 2008, between the Company and Denise Portmann. Incorporated by reference to Exhibit 10.5 to the March 2008 8-K.*

21		Subsidiaries of Registrant - Bank of the Pacific, organized under Washington law

23.1		Consent of Deloitte & Touche, LLP, Independent Registered Public Accounting Firm

23.2		Consent of McGladrey & Pullen, LLP, Independent Registered Public Accounting Firm

31.1		Certification of Chief Executive Officer Pursuant to Rule 13a-14(a)

31.2		Certification of Chief Financial Officer Pursuant to Rule 13a-14(a)

32		Certifications Under 18 U.S.C. 1350

99		Description of common stock of the Company. Incorporated by reference to Exhibit 99 to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2000.

* Listed document is a management contract, compensation plan or arrangement.