PACIFIC FINANCIAL CORP - Quarter Report: 2009 September (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended September 30, 2009

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

For the transition period from ____________ to ____________

Commission File Number 000-29829

PACIFIC FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

	Washington (State or other jurisdiction of incorporation or organization)	91-1815009 (IRS Employer Identification No.)
	1101 S. Boone Street Aberdeen, Washington 98520-5244 (360) 533-8870 (Address, including zip code, and telephone number, including area code, of Registrant's principal executive offices)

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

Yes x No o

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

Yes o No o

Indicate by check mark whether the registrant is a large accelerated filer, accelerated filer or non-accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Large accelerated filer o Accelerated Filer x Non-accelerated filer 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 number of shares of the issuer's common stock, par value $1.00 per share, outstanding as of October 31, 2009, was 10,121,853 shares.

TABLE OF CONTENTS

PART I	FINANCIAL INFORMATION	3

ITEM 1.	FINANCIAL STATEMENTS	3

	CONDENSED CONSOLIDATED BALANCE SHEETS SEPTEMBER 30, 2009 AND DECEMBER 31, 2008	3

	CONDENSED CONSOLIDATED STATEMENTS OF INCOME THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2009 AND 2008	4

	CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS NINE MONTHS ENDED SEPTEMBER 30, 2009 AND 2008	5

	CONDENSED CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY NINE MONTHS ENDED SEPTEMBER 30, 2009 AND 2008	6

	NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS	7

ITEM 2.	MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
	CONDITION AND RESULTS OF OPERATIONS	18

ITEM 3.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT
	MARKET RISK	29

ITEM 4.	CONTROLS AND PROCEDURES	30

PART II	OTHER INFORMATION	30

ITEM 1.	LEGAL PROCEEDINGS	30

ITEM 1A.	RISK FACTORS	30

ITEM 2.	UNREGISTERED SALES OF EQUITY SECURITIES AND
	USE OF PROCEEDS	31

ITEM 3.	DEFAULTS UPON SENIOR SECURITIES	31

ITEM 4.	SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS	31

ITEM 5.	OTHER INFORMATION	31

ITEM 6.	EXHIBITS	31

	SIGNATURES	31

PART I – FINANCIAL INFORMATION

ITEM 1 – FINANCIAL STATEMENTS

PACIFIC FINANCIAL CORPORATION

Condensed Consolidated Balance Sheets

September 30, 2009 and December 31, 2008

(Dollars in thousands) (Unaudited)

	September 30, 2009			December 31, 2008
Assets
Cash and due from banks	$	13,529		$	16,182
Interest bearing deposits in banks		49,967			582
Federal funds sold		5,000			775
Investment securities available-for-sale (amortized cost of
$55,396 and $52,930)		54,425			49,493
Investment securities held-to-maturity (fair value of $7,724
and $6,418)		7,558			6,386
Federal Home Loan Bank stock, at cost		3,183			2,170
Loans held for sale		9,075			11,486

Loans		485,351			486,318
Allowance for credit losses		11,580			7,623
Loans, net		473,771			478,695

Premises and equipment		16,141			16,631
Foreclosed real estate		10,193			6,810
Accrued interest receivable		2,713			2,772
Cash surrender value of life insurance		16,082			15,718
Goodwill		11,282			11,282
Other intangible assets		1,480			1,587
Other assets		7,759			5,266

Total assets	$	682,158		$	625,835

Liabilities and Shareholders' Equity
Deposits:
Demand, non-interest bearing	$	85,774		$	80,066
Savings and interest-bearing demand		223,878			213,277
Time, interest-bearing		269,153			217,964
Total deposits		578,805			511,307

Accrued interest payable		1,079			1,002
Secured borrowings		989			1,354
Short-term borrowings		4,500			23,500
Long-term borrowings		21,000			22,500
Junior subordinated debentures		13,403			13,403
Other liabilities		2,601			2,695
Total liabilities		622,377			575,761

Commitments and Contingencies (Note 6)

Shareholders' Equity
Common Stock (par value $1); 25,000,000 shares authorized; 10,121,853 shares issued and outstanding at September 30, 2009 and 7,317,430 at December 31, 2008		10,122			7,318
Additional paid-in capital		41,255			31,626
Retained earnings		9,599			13,937
Accumulated other comprehensive loss		(1,195	)		(2,807	)
Total shareholders' equity		59,781			50,074
Total liabilities and shareholders' equity	$	682,158		$	625,835

See notes to condensed consolidated financial statements.

PACIFIC FINANCIAL CORPORATION

Condensed Consolidated Statements of Income

Three and nine months ended September 30, 2009 and 2008

(Dollars in thousands, except per share data)

(Unaudited)

	Three Months Ended September 30,						Nine Months Ended September 30,
	2009			2008			2009			2008
Interest and dividend income
Loans		7,508		$	7,842		$	22,485		$	23,875
Investment securities and FHLB dividends		751			608			2,224			1,777
Deposits with banks and federal funds sold		43			10			71			24
Total interest and dividend income		8,302			8,460			24,780			25,676

Interest Expense
Deposits		2,355			2,242			7,196			7,450
Other borrowings		407			542			1,426			1,603
Total interest expense		2,762			2,784			8,622			9,053

Net Interest Income		5,540			5,676			16,158			16,623
Provision for credit losses		3,170			600			8,544			2,954
Net interest income after provision for credit losses		2,370			5,076			7,614			13,669

Non-interest Income
Service charges on deposits		427			389			1,249			1,164
Gain on sales of loans		1,028			304			3,605			1,197
Gain (loss) on sale of investments available-for-sale		116			(165	)		419			(165	)
Other operating income		417			368			1,244			1,202
Total non-interest income		1,988			896			6,517			3,398

Non-interest Expense
Salaries and employee benefits		3,366			3,008			10,315			9,419
Occupancy and equipment		687			726			2,013			2,113
Write-down of foreclosed real estate		22			—			2,539			—
Professional services		182			281			587			646
FDIC and State assessments		950			84			1,573			141
Data processing		245			176			793			341
Other		1,617			1,096			4,001			3,373
Total non-interest expense		7,069			5,371			21,821			16,033

Income (loss) before income taxes		(2,711	)		601			(7,690	)		1,034
Provision (benefit) for income taxes		(952	)		14			(3,352	)		72

Net Income (Loss)	$	(1,759	)	$	587		$	( 4,338	)	$	962

Earnings (loss) per common share:
Basic	$	(0.19	)	$	0.08		$	(0.54	)	$	0.13
Diluted		(0.19	)		0.08			(0.54	)		0.13
Weighted Average shares outstanding:
Basic		9,424,229			7,317,830			8,005,901			7,309,522
Diluted		9,424,229			7,322,801			8,005,901			7,331,503

See notes to condensed consolidated financial statements.

PACIFIC FINANCIAL CORPORATION

Condensed Consolidated Statements of Cash Flows

Nine months ended September 30, 2009 and 2008

(Dollars in thousands)

(Unaudited)

	2009			2008
OPERATING ACTIVITIES
Net income (loss)	$	(4,338	)	$	962
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for credit losses		8,544			2,954
Depreciation and amortization		1,167			1,199
Deferred income taxes		(1	)		—
Origination of loans held for sale		(219,572	)		(72,585	)
Proceeds of loans held for sale		225,678			77,513
Gain on sales of loans		(3,605	)		(1,197	)
(Gain) loss on sale of investments available for sale		(419	)		165
Decrease in accrued interest receivable		59			266
Increase (decrease) in accrued interest payable		77			(549	)
Write-down of foreclosed real estate		3,226			72
Other, net		(3,554	)		(1,103	)

Net cash provided by operating activities		7,262			7,697

INVESTING ACTIVITIES
Net increase in federal funds sold		(4,225	)		(4,675	)
Net (increase) decrease in interest bearing balances with banks		(49,385	)		129
Purchase of securities held-to-maturity		(1,312	)		(867	)
Purchase of securities available-for-sale		(19,304	)		(6,823	)
Proceeds from maturities of investments held-to-maturity		138			104
Proceeds from sales of securities available-for-sale		9,991			4,263
Proceeds from maturities of securities available-for-sale		6,308			5,208
Net increase in loans		(11,560	)		(30,482	)
Additions to premises and equipment		(479	)		(2,509	)
Proceeds from sales of foreclosed real estate		1,219			—

Net cash used in investing activities		(68,609	)		(35,652	)

FINANCING ACTIVITIES
Net increase in deposits		67,498			1,583
Net increase (decrease) in short-term borrowings		(23,500	)		16,875
Net decrease in secured borrowings		(365	)		(47	)
Proceeds from issuance of long-term borrowings		3,000			18,500
Repayments of long-term borrowings		—			(7,000	)
Issuance of common stock, net of issuance costs		12,394			624
Repurchase and retirement of common stock		—			(26	)
Payment of cash dividends		(333	)		(4,955	)

Net cash provided by financing activities		58,694			25,554

Net decrease in cash and due from banks		(2,653	)		(2,401	)

Cash and due from Banks
Beginning of period		16,182			15,044

End of period	$	13,529		$	12,643

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash payments for:
Interest	$	8,545		$	9,602
Income taxes		90			1,073

SUPPLEMENTAL SCHEDULE OF NONCASH INVESTING AND FINANCING ACTIVITIES
Change in fair value of securities available-for-sale, net of tax	$	1,628		$	(624	)
Foreclosed real estate acquired in settlement of loans		(7,828	)		(3,430	)
Reclass of long-term borrowings to short-term borrowings		4,500			6,500

See notes to condensed consolidated financial statements.

PACIFIC FINANCIAL CORPORATION

Condensed Consolidated Statements of Shareholders' Equity

Nine months ended September 30, 2009 and 2008

(Dollars in thousands)

(Unaudited)

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

Balance January 1, 2008		6,606,545		$	6,607		$	27,163		$	17,807		$	(878	)	$	50,699

Other comprehensive income (loss):
Net income											962						962
Unrealized holding loss on securities of $733 (net of tax of $484) less reclassification adjustment for net losses included in net income of $109 (net of tax of $56)														(624	)		(624	)
Amortization of unrecognized prior service costs and net (gains)/losses														54			54
Comprehensive income (loss)																	392

Stock options exercised		6,656			6			52									58
Issuance of common stock		41,672			42			524									566
Common stock repurchased and retired		(2,300	)		(2	)		(24	)								(26	)
Stock compensation expense								65									65
Tax benefit from exercise of stock options								1									1

Balance September 30, 2008		6,652,573		$	6,653		$	27,781		$	18,769		$	(1,448	)	$	51,755

Other comprehensive income:
Net loss											(4,338	)					(4,338	)
Unrealized holding gain on securities of $1,905 (net of tax of $1,257) less reclassification adjustment for net gains included in net income of $277 (net of tax of $142)														1,628			1,628
Amortization of unrecognized prior service costs and net (gains)/losses														(16	)		(16	)
Comprehensive loss																	(2,726	)

Issuance of common stock		2,804,423			2,804			9,590									12,394
Stock compensation expense								39									39

Balance September 30, 2009		10,121,853		$	10,122		$	41,255		$	9,599		$	(1,195	)	$	59,781

See notes to condensed consolidated financial statements.

PACIFIC FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

(Dollars in thousands, except per share amounts)

Note 1 – Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared by Pacific Financial Corporation ("Pacific" or the "Company") in accordance with accounting principles generally accepted in the United States of America for interim financial information and with instructions to Form 10-Q. Accordingly, these financial statements do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the nine months ended September 30, 2009, are not necessarily indicative of the results anticipated for the year ending December 31, 2009. Certain information and footnote disclosures included in the Company's consolidated financial statements for the year ended December 31, 2008, have been condensed or omitted from this report. Accordingly, these statements should be read in conjunction with the financial statements and notes thereto included in the Company's Annual Report on Form 10-K for the year ended December 31, 2008.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates.

We have evaluated subsequent events through November 9, 2009, the date of this filing. We do not believe there are any material subsequent events other than those disclosed that require further disclosure.

Current Period Adjustment – In prior periods, expenses related to regular assessments for Federal Deposit Insurance Corporation (“FDIC”) insurance were not properly recorded. For the quarter ended September 30, 2009, the Company recorded a cumulative adjustment of $597 in FDIC and State assessments to appropriately recognize the expense in the financial statements, of which approximately $207 relates to the quarter ended June 30, 2009, $162 relates to the quarter ended March 31, 2009, $180 relates to the year ended December 31, 2008, and $48 relates to the year ended December 31, 2007.

Note 2 – Earnings per Share

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

	Three Months Ended September 30,					Nine Months Ended September 30,
	2009			2008		2009			2008
Basic:
Net income (loss)	$	(1,759	)	$	587	$	(4,338	)	$	962
Weighted average shares outstanding		9,424,229			7,317,830		8,005,901			7,309,522
Basic earnings (loss) per share	$	(0.19	)	$	0.08	$	(0.54	)	$	0.13

Diluted:
Net income (loss)	$	(1,759	)	$	587	$	(4,338	)	$	962
Weighted average shares outstanding		9,424,229			7,317,830		8,005,901			7,309,522
Effect of dilutive stock options		—			4,971		—			21,981
Weighted average shares outstanding assuming dilution		9,424,229			7,322,801		8,005,901			7,331,503
Diluted earnings (loss) per share	$	(0.19	)	$	0.08	$	(0.54	)	$	0.13

As of September 30, 2009 and 2008, there were 642,397 and 413,270 shares, respectively, subject to outstanding options and 699,642 and 0 shares, respectively, subject to outstanding warrants with exercise prices in excess of the current market value. These shares are not included in the table above, as exercise of these options and warrants would not be dilutive to shareholders.

Note 3 – Investment Securities

Investment securities consist principally of short and intermediate term debt instruments issued by the U.S. Treasury, other U.S. government agencies, state and local government units, and other corporations.

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

September 30, 2009
State and municipal securities	$	7,039	$	143	$	—	$	7,182
Mortgage-backed securities		519		23		—		542
Total	$	7,558	$	166	$	—	$	7,724

December 31, 2008
State and municipal securities	$	5,750	$	40	$	12	$	5,778
Mortgage-backed securities		636		5		1		640
Total	$	6,386	$	45	$	13	$	6,418

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

September 30, 2009
U.S. Government securities	$	1,937	$	61	$	—	$	1,998
State and municipal securities		20,708		935		37		21,606
Mortgage-backed securities		26,234		353		2,336		24,251
Corporate securities		1,517		54		1		1,570
Mutual funds		5,000		—		—		5,000
Total	$	55,396	$	1,403	$	2,374	$	54,425

December 31, 2008
U.S. Government securities	$	1,671	$	88	$	—	$	1,759
State and municipal securities		19,876		158		450		19,584
Mortgage-backed securities		30,370		330		3,495		27,205
Corporate securities		1,013		—		68		945
Total	$	52,930	$	576	$	4,013	$	49,493

As of September 30, 2009, the fair value of mortgage-backed securities (“MBS”) in the available-for-sale and held-to-maturity portfolios consists of $10,898 of agency MBS and $13,895 of non-agency MBS.

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 September 30, 2009 and December 31, 2008 are summarized as follows:

	Less than 12 Months				12 months or More				Total
Held-to-Maturity	Fair Value		Unrealized Losses		Fair Value		Unrealized Losses		Fair Value		Unrealized Losses

September 30 2009
State and municipal securities	$	—	$	—	$	—	$	—	$	—	$	—
Mortgage-backed securities		—		—		—		—		—		—
Total	$	—	$	—	$	—	$	—	$	—	$	—

December 31, 2008
State and municipal securities	$	378	$	12	$	—	$	—	$	378	$	12
Mortgage-backed securities		160		1		—		—		160		1
Total	$	538	$	13	$	—	$	—	$	538	$	13

Available-for-Sale

September 30, 2009
State and municipal securities	$	1,043	$	9	$	2,645	$	28	$	3,688	$	37
Mortgage-backed securities		3,190		286		8,959		2,050		12,149		2,336
Corporate securities		—		—		499		1		499		1
Total	$	4,233	$	295	$	12,103	$	2,079	$	16,336	$	2,374

December 31, 2008
State and municipal securities	$	8,756	$	349	$	889	$	101	$	9,645	$	450
Mortgage-backed securities		10,522		3,006		4,302		489		14,824		3,495
Corporate securities		945		68		—		—		945		68
Total	$	20,223	$	3,423	$	5,191	$	590	$	25,414	$	4,013

At September 30, 2009, there were 17 investment securities in an unrealized loss position, of which 13 were in a continuous loss position for 12 months or more. The unrealized losses on these securities were caused by changes in interest rates, widening credit spreads and market illiquidity, causing a decline in the fair value subsequent to their purchase. Management monitors published credit ratings on these securities for adverse changes, and, for MBS, monitors expected future cash flows to determine whether any loss in principal is anticipated. 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. Based on management’s evaluation and because the Company does not have the intent to sell these securities and it is not more likely than not that it will have to sell the securities before recovery of cost basis, the Company does not consider these investments to be other-than-temporarily impaired at September 30, 2009.

Gross gains realized on sales of securities were $419 and $12 and gross losses realized were $0 and $177 during the nine months ended September 30, 2009 and 2008, respectively.

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.

Note 4 – Allowance for Credit Losses

	Three Months Ended September 30,						Nine Months Ended September 30,						Twelve Months Ended Ended December 31,

	2009			2008			2009			2008			2008

Balance at beginning of period	$	10,203		$	6,654		$	7,623		$	5,007		$	5,007

Provision for credit losses		3,170			600			8,544			2,954			4,791

Charge-offs		(1,808	)		(721	)		(4,616	)		(1,448	)		(2,226	)
Recoveries		15			26			29			46			51
Net charge-offs		(1,793	)		(695	)		(4,587	)		(1,402	)		(2,175	)

Balance at end of period	$	11,580		$	6,559		$	11,580		$	6,559		$	7,623

Loans on which the accrual of interest has been discontinued were $16,022 and $14,676 at September 30, 2009 and December 31, 2008, respectively. Interest income foregone on non-accrual loans was $2,066 and $1,168 during the nine months ended September 30, 2009 and 2008, respectively.

At September 30, 2009 and December 31, 2008, the Company’s recorded investment in certain loans that were considered to be impaired was $29,398 and $22,117, respectively. At September 30, 2009, $544 of these impaired loans had a specific related valuation allowance of $150, while $28,854 did not require a specific valuation allowance. At December 31, 2008, $462 of these impaired loans had a specific valuation allowance of $118, while $21,655 did not require a specific valuation allowance. The balance of the allowance for loan losses in excess of these specific reserves is available to absorb the inherent losses, existing at that date, from all other loans in the portfolio. The average investment in impaired loans was $29,721 and $16,915 during the nine months ended September 30, 2009 and the year ended December 31, 2008, respectively. The related amount of interest income recognized on a cash basis for loans that were impaired was $352 and $31 during the nine months ended September 30, 2009 and 2008, respectively. Loans past due 90 days or more and still accruing interest at September 30, 2009 and December 31, 2008 were $793 and $2,274, respectively and were made up largely of loans that were fully guaranteed by the United States Department of Agriculture or Small Business Administration.

Note 5 – Stock Based Compensation

Effective January 1, 2006, the Company adopted accounting guidance regarding share-based payments, 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 adopted the guidance using the modified prospective method, which provides for no restatement of prior periods and no cumulative adjustment to equity accounts. It also provides for expense recognition for both new and existing unvested stock-based awards. Stock-based compensation expense during the nine months ended September 30, 2009 and 2008 was $39 and $65 ($26 and $43 net of tax), respectively. Future compensation expense for unvested awards outstanding as of September 30, 2009 is estimated to be $62 recognized over a weighted average period of 1.4 years. There were no options granted or exercised during the nine months ended September 30, 2009. Cash received from the exercise of stock options during the nine months ended September 30, 2008 totaled $58. The total intrinsic value of stock options exercised during the nine months ended September 30, 2008 was $29.

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

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

September 30, 2008	6.5 years		3.75	%		16.19	%		6.05	%	$	0.83

A summary of stock option activity under the stock option plans as of September 30, 2009 and 2008, and changes during the nine months then ended are presented below:

	Shares			Weighted Average Exercise Price		Weighted Average Remaining Contractual Term ( Years)		Aggregate Intrinsic Value
September 30, 2009

Outstanding beginning of period		684,527		$	12.58
Granted		—			—
Exercised		—			—
Forfeited		(42,130	)		13.76
Outstanding end of period		642,397		$	12.50		3.8	$	—
Exercisable end of period		560,832		$	12.35		3.3	$	—

	Shares			Weighted Average Exercise Price		Weighted Average Remaining Contractual Term ( Years)		Aggregate Intrinsic Value
September 30, 2008

Outstanding beginning of period		689,868		$	12.55
Granted		8,250			11.27
Exercised		(7,322	)		7.93
Forfeited		(4,070	)		13.32
Outstanding end of period		686,726		$	12.57		5.0	$	—

Exercisable end of period		555,387		$	12.31		4.2	$	—

A summary of the status of the Company’s nonvested options as of September 30, 2009 and 2008 and changes during the nine months then ended are presented below:

	2009					2008
	Shares			Weighted Average Fair Value		Shares			Weighted Average Fair Value

Non-vested beginning of period		126,940		$	1.62		193,884		$	1.80
Granted		—			—		8,250			0.83
Vested		(26,235	)		1.87		(69,584	)		2.08
Forfeited		(19,140	)		1.50		(1,210	)		1.85
Non-vested end of period		81,565		$	1.56		131,340		$	1.63

Note 6 – Commitments and Contingencies

The Company is currently not party to any material pending litigation. However, because of the nature of its activities, the Company is subject to various pending and threatened legal actions which may 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 results of operations or financial condition of the Company.

Note 7 – Recent Accounting Pronouncements

In March 2008, the Financial Accounting Standards Board (“FASB”) issued guidance on Disclosures about Derivative Instruments and Hedging Activities, which requires enhanced disclosures to provide a better understanding of how and why an entity uses derivative instruments, how derivative instruments and related hedge items are accounted for, and their effect on an entity’s financial position, financial performance, and cash flows. The guidance is effective for fiscal years beginning after November 15, 2008. Adoption of the guidance did not have a material impact on the Company’s consolidated financial statements.

In April 2009, the FASB issued the following rules to provide additional guidance and enhance disclosures regarding fair value measurements and impairment of securities.

Interim Disclosures about the Fair Value of Financial Instruments which require an entity to provide disclosures about fair values of financial instruments in interim financial statements. The guidance is effective for interim periods ending after June 15, 2009 with early adoption permitted for periods ending after March 15, 2009. The Company adopted the guidance as of June 30, 2009 and it did not have a material impact on the Company’s consolidated financial statements.

Recognition and Presentation of Other-Than-Temporary Impairments which applies to investments in debt securities for which other-than-temporary impairments may be recorded. If any entity’s management asserts that it does not have the intent to sell a debt security and it is more likely than not that it will not have to sell the security before recovery of its cost basis, then an entity may separate other-than-temporary impairments into two components: 1) the amount related to credit losses recorded in earnings, and 2) all other amounts recorded in other comprehensive income. The guidance is effective for interim periods ending after June 15, 2009 with early adoption permitted. The Company adopted the guidance as of June 30, 2009 and it did not have a material impact on the Company’s consolidated financial statements.

Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly which provides additional guidance for estimating fair values and on identifying circumstances that indicate a transaction is not orderly. The guidance is effective for interim periods ending after June 15, 2009 with early adoption permitted. The Company adopted the guidance as of June 30, 2009 and it did not have a material impact on the Company’s consolidated financial statements.

In May 2009, the FASB issued accounting guidance on Subsequent Events, which establishes general standards of accounting for and disclosures of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. It requires entities to disclose the date through which they have evaluated subsequent events and the basis for that date. The guidance is effective for interim and annual periods ending after June 15, 2009. It was effective for the Company as of June 30, 2009. Adoption of the guidance did not have a material impact on the Company’s consolidated financial statements.

In June 2009, the FASB issued accounting guidance which eliminates exceptions to consolidating qualifying special-purpose entities, contains new criteria for determining the primary beneficiary, and increases the frequency of required reassessments to determine whether a company is the primary beneficiary of a variable interest entity. The guidance also contains a new requirement that any term, transaction, or arrangement that does not have a substantive effect on an entity’s status as a variable interest entity, a company’s power over a variable interest entity, or a company’s obligation to absorb losses or its right to receive benefits of an entity must be disregarded. The elimination of the qualifying special-purpose entity concept and its consolidation exceptions means more entities will be subject to consolidation assessments and reassessments. This guidance requires additional disclosures regarding an entity’s involvement in a variable interest entity. It is effective for annual reporting periods beginning after November 15, 2009, and for interim periods therein. The Company is currently evaluating the impact of the guidance on the Company’s consolidated financial statements.

In June 2009, the FASB issued accounting guidance on FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles which requires the FASB Accounting Standards Codification to become the single source of authoritative U.S. accounting and reporting standards for nongovernmental entities in addition to the guidance issued by the Securities and Exchange Commission. The guidance significantly changes the way financial statement preparers and auditors perform accounting research. The guidance is effective for financial statements issued for interim and annual periods ending after September 15, 2009. It was effective for the Company as of September 30, 2009 and adoption of the guidance did not have a material impact on the Company’s consolidated financial statements.

Note 8 – Supplemental Executive Retirement Plan

The Company has an unqualified 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 following table sets forth the net periodic pension cost and obligation assumptions used in the measurement of the benefit obligation for the three and nine months ended September 30:

	Three months ended September 30,				Nine months ended September 30,
	2009		2008		2009			2008
Net periodic pension cost:
Service cost	$	30	$	23	$	89		$	70
Interest cost		18		12		55			36
Amortization of prior service cost and net (gains)/losses		20		18		(16	)		54

Net periodic pension cost	$	68	$	53	$	128		$	160

Note 9 – Fair Value Measurements

Effective January 1, 2008, the Company adopted accounting guidance on fair value measurements, which established a hierarchy for measuring fair value that is intended to maximize the use of observable inputs and minimize the use of unobservable inputs. This hierarchy uses three levels of inputs to measure the fair value of assets and liabilities as follows:

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

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

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

The following table presents the balances of assets and liabilities measured at fair value on a recurring basis at September 30, 2009 and December 31, 2008:

	Readily Available Market Prices Level 1		Observable Market Prices Level 2		Significant Unobservable Inputs Level 3		Total

September 30, 2009
Securities available-for-sale
U.S. Government securities	$	—	$	1,998	$	—	$	1,998
State and municipal securities		—		21,606		—		21,606
Mortgage-backed securities		—		24,251		—		24,251
Corporate securities		499		1,071		—		1,570
Mutual funds		5,000		—		—		5,000
Total	$	5,499	$	48,926	$	—	$	54,425

December 31, 2008
Securities available-for-sale
U.S. Government securities	$	—	$	1,759	$	—	$	1,759
State and municipal securities		—		19,584		—		19,584
Mortgage-backed securities		—		27,205		—		27,205
Corporate securities		—		945		—		945
Total	$	—	$	49,493	$	—	$	49,493

The Company uses a third party pricing service to assist the Company in determining the fair value of the investment portfolio. The Company did not have any Level 3 inputs in the investment portfolio during the quarter.

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

Impaired loans – A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due (both interest and principle) according to the contractual terms of the loan agreement. Impaired loans are measured based on the present value of expected future cash flows or by the fair market value of the collateral if the loan is collateral dependent.

Other real estate owned – OREO is initially recorded at the lower of the carrying amount of the loan or fair value of the property less estimated costs to sell. This amount becomes the property’s new basis. Management considers third party appraisals in determining the fair value of particular properties. Any write-downs based on the property fair value less estimated costs to sell at the date of acquisition are charged to the allowance for credit losses. Management periodically reviews OREO in an effort to ensure the property is carried at the lower of its new basis or fair value, net of estimated costs to sell. Any additional write-downs based on re-evaluation of the property fair value are charged to non-interest expense.

The following table presents the Company’s financial assets that were accounted for at fair value on a nonrecurring basis at September 30, 2009 and December 31, 2008:

	Readily Available Market Prices Level 1		Observable Market Prices Level 2		Significant Unobservable Inputs Level 3		Total

September 30, 2009
Impaired loans	$	—	$	—	$	6,322	$	6,322
OREO	$	—	$	—	$	10,735	$	10,735

December 31, 2008
Impaired loans	$	—	$	—	$	9,532	$	9,532
OREO	$	—	$	—	$	6,810	$	6,810

Other real estate owned with a carrying amount of $7,828 was acquired during the nine months ended September 30, 2009. Upon foreclosure, these assets were written down $687 to their fair value, less estimated costs to sell, which was charged to the allowance for loan and lease losses during the period.

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.

Loans, and Loans Held for Sale

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

Deposits

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

Short-Term Borrowings

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

Long-Term Borrowings

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

Secured borrowings

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

Junior Subordinated Debentures

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

Off-Balance-Sheet Instruments

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

The estimated fair value of the Company’s financial instruments at September 30, 2009 and December 31, 2008 are as follows:

	2009				2008
	Carrying		Fair		Carrying		Fair
	Amount		Value		Amount		Value
Financial Assets
Cash and due from banks, interest-bearing
deposits in banks, and federal funds sold	$	68,496	$	68,496	$	17,539	$	17,539
Securities available for sale		54,425		54,425		49,493		49,493
Securities held to maturity		7,558		7,724		6,386		6,418
Loans held for sale		9,075		9,617		11,486		11,752
Loans, net		473,771		357,282		478,695		440,597

Financial Liabilities
Deposits	$	578,805	$	581,117	$	511,307	$	512,926
Short-term borrowings		4,500		4,616		23,500		23,779
Long-term borrowings		21,000		21,646		22,500		23,033
Secured borrowings		989		989		1,354		1,354
Junior subordinated debentures		13,403		6,661		13,403		7,113

Note 10 – Common Stock Offering

On August 27, 2009, the Company completed the private sale of 2,798,582 shares of common stock, together with warrants to purchase 699,642 additional shares for total proceeds of $12,356 net of issuance costs. Warrants issued in the transaction have a five-year term, an exercise price of $6.50 per share, and are exercisable in whole or in part at any time upon written notice of exercise. All warrants include a cashless exercise feature.

ITEM 2 – MANAGEMENT'S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

A Warning About Forward-Looking Information

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

Any forward-looking statements in this document are subject to risks described in our Annual Report on Form 10-K for the year ended December 31, 2008 (the “2008 10-K”), as well as risks relating to, among other things, 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 key employees, and maintain or increase our interest margins and fee income;

2. changing laws, regulations, standards, and government programs that may significantly increase our costs, including compliance and insurance costs, decrease our access to liquidity, place additional burdens on our limited management resources, or further change the competitive balance among financial institutions;

3. adverse economic or business conditions nationally and in the regions in which we do business that are expected to result in, among other things, a deterioration in credit quality and/or reduced demand for credit, increases in nonperforming assets, elevated levels of net charge-offs, and increased workout, foreclosed real estate (“OREO”) and regulatory expenses;

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

5. changes in the interest rate environment that may reduce our margins, decrease our customers' capacity to repay loans, or decrease the value of our securities; and

6. a lack of liquidity in the market for our common stock that may make it difficult or impossible to sell our stock or lead to distortions in the market price of our stock.

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

Overview

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

The Company conducts its banking business through the Bank, which operates 16 branches located in communities in Grays Harbor, Pacific, Whatcom, Skagit and Wahkiakum counties in the state of Washington and one in Clatsop County, Oregon.

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

Critical Accounting Policies

Critical accounting policies are discussed in the 2008 10-K under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operation – Critical Accounting Policies.” There have been no material changes in our critical accounting policies from the 2008 10-K.

Recent Accounting Pronouncements

Please see Note 7 of the Company's Notes to Condensed Consolidated Financial Statements above for a discussion of recent accounting pronouncements and the likely effect on the Company.

Financial Summary

The following are significant trends reflected in the Company’s results of operations for the three and nine months ended September 30, 2009 and financial condition as of that date:

Total assets were $682,158,000 at September 30, 2009, an increase of $56,323,000, or 9.00%, over year-end 2008. Growth in interest bearing deposits in banks, federal funds sold and investments available-for-sale were the primary contributors to overall asset growth.

The Bank remains well capitalized with a total risk-based capital ratio of 13.26% at September 30, 2009, compared to 11.65% at December 31, 2008. During the second and third quarter, the Company raised capital by issuing common shares and warrants in connection with its private offering, with proceeds to the Company of $12,356,000, further strengthening its capital ratios. See Footnote 10 to the condensed consolidated financial statements for further information.

Non-performing assets decreased during the quarter by $2,926,000, or 9.8%, to $27,008,000 at September 30, 2009, due primarily to a slight reduction in non-accrual loans and disposition of two OREO properties. Non-performing assets increased compared to December 31, 2008 by $3,248,000, or 13.7%, mainly due to non-performing construction and land development loans and related OREO, which represented $21,283,000, or 78.8%, of non-performing assets.

The Company continues to be successful in reducing overall exposure to construction, land acquisition and other land loans, which declined $17.7 million during the nine months ended September 30, 2009. This segment of the portfolio, totaling $83.0 million at September 30, 2009, accounts for approximately 16.8% of the total loan portfolio.

Total deposits increased $67,498,000, or 13.2%, for the nine months ended September 30, 2009, compared to December 31, 2008, which reflects management’s continued focus on a strong deposit base and seasonal trends.

As a result of deposit growth, lower borrowings and increased borrowing capacity with the Federal Reserve, the Company’s liquidity ratio of approximately 37% at September 30, 2009 translates into over $255 million in available funding for general operations and to meet loan and deposit needs.

Return on average assets and return on average equity were (0.88%) and (11.0%), respectively, for the nine months ended September 30, 2009, due to increases in the provision for credit losses and OREO write-downs, which is reflective of the deterioration in credit quality.

Results of Operations

Net income. For the three and nine months ended September 30, 2009, net income (loss) was $(1,759,000) and $(4,338,000), respectively, compared to $587,000 and $962,000 for the same periods in 2008. The decrease in net income for the three and nine month period was primarily due to increased provisions for credit losses necessary to absorb current period losses, OREO write-downs resulting from updated appraisals, and continued net interest margin compression, which was partially offset by an increase in non-interest income and a reduction in core net overhead (non-interest expense excluding OREO write-downs minus non-interest income divided by average assets).

Management initiated a number of measures to control expenses during recent quarters, including a reduction in workforce, consolidation of two unprofitable branches, and tightening of other non-interest expenses. As a result, core net overhead for the nine months ended September 30, 2009 decreased to 2.59% compared to 2.93% for the same period in 2008.

Net interest income. Net interest income for the three and nine months ended September 30, 2009 decreased $136,000 and $465,000, or 2.40% and 2.80%, respectively, compared to the same periods in 2008. See the table below and the accompanying discussion for further information on interest income and expense. The net interest margin (net interest income divided by average earning assets) decreased to 3.60% for the nine months ended September 30, 2009 from 4.27% for the same period last year. The decline in net interest margin is due in part to a decrease in the average yield earned on loans from 6.85% for the nine months ended September 30, 2008 to 6.02% for the current nine month period that was only partially offset by a decrease in the Company’s average cost of funds to 2.18% at September 30, 2009 from 2.78% one year ago. In addition, increasing levels of nonperforming loans and the reversal of interest income on loans placed on non-accrual status have also negatively affected our net interest margin. The net interest margin for the three months ended September 30, 2009 of 3.60% represented a slight increase from 3.58% for the three months ended June 30, 2009 due mostly to decreases in rates paid on interest bearing liabilities.

The Federal Reserve Board (the “FRB”) heavily influences market interest rates, including deposit and loan rates offered by many financial institutions. As a bank holding company, we derive the greatest portion of our income from net interest income. The Federal Open Market Committee (“FOMC”) of the FRB cut the target federal funds rate 175 basis points between September 2008 and September 2009. Approximately 76% of the Company’s loan portfolio is tied to short-term rates, and therefore, re-price immediately when interest rate changes occur. The Company’s funding sources also re-price when rates change; however, there is a meaningful lag in the timing of the re-pricing of deposits as compared to loans and the benefits of declining rates paid decrease as rates approach zero. As a result of these and other factors, the Company has continued to experience net interest margin compression in 2009.

The following table sets forth information with regard to average balances of interest earning assets and interest bearing liabilities and the resultant yields or cost, net interest income, and the net interest margin on a tax equivalent basis. Loans held for sale and non-accrual loans are included in total loans.

Nine Months Ended September 30,

				2009									2008
				Interest									Interest
(dollars in thousands)	Average			Income			Avg			Average			Income			Avg
	Balance			(Expense)			Rate			Balance			(Expense)			Rate
Interest Earning Assets
Loans (1)	$	502,193		$	22,677	*		6.02	%	$	466,979		$	24,004	*		6.85	%
Taxable securities		34,217			1,448			5.64			30,653			1,201			5.22
Tax-exempt securities		24,700			1,176	*		6.35			18,470			844	*		6.09
Federal Home Loan Bank Stock		3,119			—			—			1,973			19			1.28
Interest earning balances with banks		34,241			71			0.28			1,361			24			2.35

Total interest earning assets	$	598,470		$	25,372			5.65	%	$	519,436		$	26,092			6.70	%

Cash and due from banks		10,455									11,632
Bank premises and equipment (net)		16,520									16,424
Other real estate owned		8,476									—
Other assets		31,459									33,748
Allowance for credit losses		(8,898	)								(5,628	)

Total assets	$	656,482								$	575,612

Interest Bearing Liabilities
Savings and interest bearing demand	$	205,413		$	(1,356	)		0.88	%	$	202,998		$	(2,255	)		1.48	%
Time deposits		269,330			(5,840	)		2.89			178,019			(5,195	)		3.89
Total deposits		474,743			(7,196	)		2.02			381,017			(7,450	)		2.61

Short-term borrowings		4,154			(26	)		0.83			16,762			(342	)		2.72
Long-term borrowings		33,736			(928	)		3.67			22,161			(637	)		3.83
Secured borrowings		1,325			(59	)		5.94			1,395			(72	)		6.88
Junior subordinated debentures		13,403			(413	)		4.11			13,403			(552	)		5.49
Total borrowings		52,618			(1,426	)		3.61			53,721			(1,603	)		3.98

Total interest-bearing liabilities	$	527,361		$	(8,622	)		2.18	%	$	434,738		$	(9,053	)		2.78	%

Demand deposits		74,795									84,083
Other liabilities		1,695									4,794
Shareholders’ equity		52,631									51,997

Total liabilities and shareholders’ equity	$	656,482								$	575,612

Net interest income				$	16,750	*							$	17,039	*
Net interest spread								3.73	%								4.37	%
Net interest margin								3.60	%								4.27	%
Tax equivalent adjustment				$	592	*							$	416	*

* Tax equivalent basis – 34% tax rate used

(1) Interest income on loans includes loan fees of $701 and $829 in 2009 and 2008, respectively.

Interest and dividend income for the three and nine months ended September 30, 2009 decreased $158,000 and $896,000, or 1.87% and 3.49%, respectively, compared to the same periods in 2008. The decrease was primarily due to the decline in yield earned on our loan portfolio as a direct result of cuts in the federal funds rate during 2008. Additionally, loans placed on non-accrual increased to $16,022,000 at September 30, 2009, placing further strain on interest income. Loans averaged $502.2 million with an average yield of 6.02% for the nine months ended September 30, 2009, compared to average loans of $467.0 million with an average yield of 6.85% for the same period in 2008. The decline in loan yield was partially offset by an increase in yield on investments. Interest and dividend income on investment securities for the nine months ended September 30, 2009 increased $447,000, or 25.15%, compared to the same period in 2008. The average yield on taxable securities increased to 5.64% at September 30, 2009, from 5.22% at September 30, 2008. The increase is due primarily to the purchase of certain AAA mortgage-backed securities in the second half of 2008. Most of these purchases were made at discounts during a period of significant market illiquidity.

Average interest earning balances with banks for the nine months ended September 30, 2009 were $34.2 million with an average yield of 0.28% compared to $1.4 million with an average yield of 2.35% for the same period in 2008. The increase in average interest earning balances with banks is mostly due to the increase in cash balances resulting from deposit growth during the year, which was partially offset by a slight increase in average loan and investment balances outstanding.

Interest expense for the three months ended September 30, 2009 decreased $22,000, or 0.79%, compared to the same period in 2008. The decrease is primarily attributable to a decrease in borrowings outstanding and continued rate reductions on $8.2 million in variable rate junior subordinated debentures which is tied to the three month London Interbank Officer Rate, which has decreased considerably since September 30, 2008. Interest expense for the nine months ended September 30, 2009 decreased $431,000, or 4.76%, compared to the same period in 2008, which is mainly due to rate decreases on interest-bearing balances. Average interest-bearing deposit balances for the nine months ended September 30, 2009 and 2008 were $474.7 million and $381.0 million, respectively, with an average cost of 2.02% and 2.61%, respectively.

Average borrowings for the nine months ended September 30, 2009 were $52.6 million with an average cost of 3.61% compared to $53.7 million with an average cost of 3.98% for the same period in 2008. The decrease in borrowing rates is primarily attributable to rate decreases in short-term borrowings and junior subordinated debentures, which were partially offset by the funding of the Company’s loan growth in late 2008 with Federal Home Loan Bank Advances, which are more expensive as compared to funding such growth with lower cost demand, money market or savings deposits. Average long-term borrowings for the nine months ended September 30, 2009 were $33.7 million compared to $22.2 million one year ago.

Provision and allowance for credit losses. The allowance for credit losses reflects management's current estimate of the amount required to absorb probable losses on loans in its loan portfolio based on factors present as of the end of the period. Loans deemed uncollectible are charged against and reduce the allowance. Periodically, a provision for credit losses is charged to current expense. This provision acts to replenish the allowance for credit losses in order to maintain the allowance at a level that management deems adequate.

Periodic provisions for credit 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 based on volumes and types of loans, volumes and trends in delinquencies and non-accrual loans, trends in portfolio volume, results of internal and independent external credit reviews, and anticipated economic conditions. For additional information, please see the discussion under the heading "Critical Accounting Policy" in Item 7 of our 2008 10-K.

During the three and nine months ended September 30, 2009, provision for credit losses totaled $3,170,000 and $8,544,000, compared to $600,000 and $2,954,000 for the same periods in 2008. The significant increase in provision for credit losses in the current year is the result of increases in loan loss rates compared to September 30, 2008 and an increase in classified loans, primarily within our land acquisition and development and residential construction loan portfolios. During the three months ended September 30, 2009, the Company increased loss rates specifically on land acquisition and development by 2% from 3.50% to 5.50% and speculative residential construction by 1.25% from 3.75% to 5.00% based upon increased charge-offs in these categories within the last twelve to eighteen months.

Credit quality continues to be problematic due to the prolonged downturn in the economy and unfavorable conditions in the residential real estate market. However, the Company believes that non-performing assets are near their peak and beginning to show signs of improvement. Loans past due 30 days or more at September 30, 2009 improved during the quarter to $18,044,000 compared to $21,015,000 at June 30, 2009. This represents 3.66% of total loans (including loans held for sale), compared to 4.24% at June 30, 2009 and 4.64% at December 31, 2008. Additionally, as discussed below, nonperforming assets also decreased slightly during the quarter to $27,008,000 at September 30, 2009, compared to $29,934,000 at June 30, 2009.

For the three and nine months ended September 30, 2009, net charge-offs were $1,793,000 and $4,587,000 compared to $695,000 and $1,402,000 for the same periods in 2008. Net charge-offs for the twelve months ended December 31, 2008 were $2,175,000. Net charge-offs continue to be centered in the residential construction and land development portfolios, which accounted for approximately $3,109,000 of total net charge-offs for the year. The ratio of net charge-offs to average loans outstanding for the nine months ended September 30, 2009 and 2008 was 0.91% and 0.30%, respectively.

At September 30, 2009, the allowance for credit losses was $11,580,000 compared to $7,623,000 at December 31, 2008, and $6,559,000 at September 30, 2008. The increase from September 30, 2008 is attributable to additional provision for credit losses arising out of increases in loan loss rates, adversely classified loans and an increase in the unallocated portion of the allowance, and is reflective of the depressed and deteriorating economic conditions in our markets. The ratio of the allowance for credit losses to total loans outstanding (including loans held for sale) was 2.34%, 1.53% and 1.37%, at September 30, 2009, December 31, 2008 and September 30, 2008, respectively.

The Company’s loan portfolio includes a significant portion of government guaranteed loans which are fully guaranteed by the United States Government. Government guaranteed loans were $46,003,000, $49,934,000, and $52,268,000 at September 30, 2009, December 31, 2008 and September 30, 2008, respectively. The ratio of allowance for credit losses to total loans outstanding excluding the government guaranteed loans was 2.58%, 1.70%, and 1.54%, respectively.

There is no precise method of predicting specific credit losses or amounts that ultimately may be charged off. The determination that a loan may become uncollectible, in whole or in part, is a matter of judgment. Similarly, the adequacy of the allowance for credit losses is a matter of judgment that requires consideration of many factors, including (a) economic conditions and the effect on particular industries and specific borrowers; (b) a review of borrowers' financial data, together with industry data, the competitive situation, the borrowers' management capabilities and other factors; (c) a continuing evaluation of the loan portfolio, including monitoring by lending officers and staff credit personnel of all loans which are identified as being of less than acceptable quality; (d) an in-depth analysis, on a monthly basis, of all loans judged to present a possibility of loss (if, as a result of such monthly analysis, the loan is judged to be not fully collectible, the carrying value of the loan is reduced to that portion considered collectible); and (e) an evaluation of the underlying collateral for secured lending, including the use of independent appraisals of real estate properties securing loans. An analysis of the adequacy of the allowance is conducted by management quarterly and is reviewed by the board of directors. Based on this analysis and applicable accounting standards, management considers the allowance for credit losses to be adequate at September 30, 2009.

Non-performing assets and foreclosed real estate. Non-performing assets totaled $27,008,000 at September 30, 2009. This represents 3.96% of total assets, compared to $23,760,000, or 3.80%, at December 31, 2008, and $10,976,000, or 1.86%, at September 30, 2008. Construction and land development loans, including related OREO balances, continue to be the primary component of non-performing assets, representing $21,283,000, or 78.8%, of non-performing assets. Of this amount, $15,274,000 is comprised of 8 relationships as follows: 5 condominium projects totaling $9,846,000 and 3 residential lot subdivisions totaling $5,428,000. Loans past due ninety days or more and still accruing interest of $793,000 and $2,274,000 at September 30, 2009 and December 31, 2008, respectively, were made up almost entirely of loans that were fully guaranteed by the United Stated Department of Agriculture or Small Business Administration. The following table presents information related to the Company’s non-performing assets:

SUMMARY OF NON-PERFORMING ASSETS (in thousands)	September 30, 2009		December 31, 2008		September 30, 2008

Accruing loans past due 90 days or more	$	793	$	2,274	$	—
Non-accrual loans:
Construction, land development and other land loans		11,090		11,787		6,621
Real estate residential		1,140		615		636
Real estate commercial		2,156		1,477		249
Commercial and industrial		1,636		797		97
Installment		—		—		15
Total non-accrual loans		16,022		14,676		7,618
Foreclosed real estate		10,193		6,810		3,358
TOTAL	$	27,008	$	23,760	$	10,976

The increase in non-performing assets reflects the continued weakness in the housing industry. The Company continues to aggressively monitor and identify non-performing assets and take appropriate action based upon updated market information. Given the trend of rapidly declining residential real estate values, the Company reevaluated several non-performing real estate loans and all OREO assets during the nine months ended September 30, 2009. As a result of these appraisals, the Company recorded charge-offs of $4,157,000 and OREO write-downs of $2,539,000 during the period based on the most recent appraisals. The Company will continue to reevaluate non-performing assets over the coming months as market conditions change. Currently, it is our practice to obtain new appraisals on non-performing collateral dependent loans and/or foreclosed real estate every six to nine months. Based upon the appraisal review for non-performing loans, the Company will record the loan at the lower of cost or market (less costs to sell) by recording a charge-off to the allowance for credit losses or by designating a specific reserve per accounting principles generally accepted in the United States. Generally, the Company will record the charge-off rather than designate a specific reserve. As a result, the carrying amount of non-performing loans may not exceed the value of the underlying collateral. This process enables the Company to adequately reserve for non-performing loans within the allowance for credit losses.

Foreclosed real estate at September 30, 2009 totaled $10,193,000 and is made up as follows: seven land or land development properties totaling $2,551,000, four speculative residential real estate properties totaling $1,617,000, two condominium complexes totaling $5,823,000 and one unfinished residential triplex valued at $202,000. The balances are recorded at the estimated net realizable value less selling costs. During the three months September 30, 2009, the Company sold two properties totaling $1,219,000, which was partially offset by the addition of two new properties totaling $449,000.

Non-interest income and expense. Non-interest income for the three and nine months ended September 30, 2009 increased $1,092,000 and $3,119,000, or 121.9% and 91.8%, compared to the same periods in 2008. Gain on sales of loans, the largest component of non-interest income, totaled $3,605,000 and $1,197,000 for the nine months ended September 30 2009 and 2008, respectively. The increase for the nine month period is due to increased mortgage refinancing activity as the result of historically low mortgage rates and government incentive programs such as the $8,000 tax credit for first time home buyers. Origination of loans held for sale more than tripled to a total of $219,572,000 for the nine months ended September 30, 2009, compared to $72,585,000 for the same period in 2008. Management expects gain on sale of loans to remain strong for 2009 due to refinance and new mortgage activity driven by historically low interest rates and increased purchase money transactions.

Services charges on deposits for the nine months ended September 30, 2009 increased $85,000, or 7.3%, compared to the same period in 2008. The Company continues to emphasize exceptional customer service and believes this emphasis, together with a long standing strong core deposit base and continued deposit growth, contributed to the increase in service charge revenue.

The Bank recorded gains on sale of mortgage-backed securities of $419,000 during the nine months ended September 30, 2009.

Total non-interest expense for the three and nine months ended September 30, 2009 increased $1,698,000 and $5,788,000 compared to the same periods in 2008. The increase was largely due to write-downs on foreclosed real estate totaling $22,000 and $2,539,000 for the current three and nine month periods. Additionally, non-interest expense for the nine month period was adversely impacted by $306,000 during the second quarter for the Company’s share of the special assessment imposed by the Federal Deposit Insurance Corporation (“FDIC”) on all insured depository institutions, as well as increases in assessment rates effective April 1, 2009. FDIC assessment expense for the three and nine months ended September 30, 2009 totaled $950,000 and $1,573,000, respectively, compared to $84,000 and $141,000 for the same periods in the prior year. The effect of increased assessment rates was amplified in the current quarter as the Company recorded a cumulative adjustment of $597,000 related to prior periods.

Salaries and employee benefits for the three and nine months ended September 30, 2009, increased $358,000 and $896,000, or 11.9% and 9.5%, respectively, compared to the same period in 2008, due primarily to increases in commissions paid on the sale of loans held for sale which was partially offset by a reduction in workforce. Full time equivalent employees at September 30, 2009 were 212 compared to 221 at December 31, 2008. During the second quarter, the Company completed the closure of the Birch Bay branch by consolidating it into the nearby Ferndale, Washington branch. This combined with an ongoing effort to reduce non-interest expenses, has reduced net overhead (excluding OREO write-downs) from 2.93% at December 31, 2008 to 2.59% at September 30, 2009.

The increase in other operating expenses for the nine months ended September 30, 2009 was primarily due to increases in insurance expense, data processing expenses, and OREO operating costs, which were up $81,000, $452,000 and $289,000, respectively, over the same period in the prior year.

Income taxes. The federal income tax provision (benefit) for the three and nine months ended September 30, 2009 and 2008 was $(952,000) and $(3,352,000), and $14,000 and $72,000, respectively. The effective tax rate for the three and nine months ended September 30, 2009 was (35.1)% and (43.6)%, respectively.

Financial Condition

Assets. Total assets were $682,158,000 at September 30, 2009, an increase of $56,323,000, or 9.00%, over year-end 2008. Loans, including loans held for sale, were $494,426,000 at September 30, 2009, a decrease of $3,378,000, or 0.68%, over year-end 2008. Growth in interest bearing deposits in banks and investments available-for-sale were the primary contributors to overall asset growth.

Investments. The investment portfolio provides the Company with an income alternative to loans. The Company’s investment portfolio at September 30, 2009 was $61,983,000 compared to $55,879,000 at the end of 2008, an increase of $6,104,000, or 10.92%. During 2009, the Company sold $9.6 million in mortgage-backed securities for a gain of $419,000 to help offset OREO write-downs. These securities were replaced with purchases of similar securities during the period. Additionally, during the quarter ended September 30, 2009, the Company invested $5 million in a money market mutual fund as an alternative to federal funds sold to increase the return on short-term cash.

Loans. Total loans were $494,426,000 at September 30, 2009, a decrease of $3,378,000 or 0.68%, compared to December 31, 2008. The reduction in total loans was driven primarily by decreases in construction and land development loans of $17,717,000 through a combination of loan payoffs and pay-downs as well as loan charge-offs, which was partially offset by increases in residential real estate, owner occupied commercial real estate and farmland loans. Loan detail by category, including loans held for sale, as of September 30, 2009 and December 31, 2008 follows (in thousands):

	September 30, 2009			December 31, 2008

Commercial and industrial	$	91,043		$	91,888
Construction, land development and other land loans		83,008			100,725
Real estate residential		95,554			90,328
Real estate commercial – owner occupied		94,301			88,056
Real estate commercial – non owner occupied		98,195			100,388
Farmland		23,359			18,092
Installment		7,351			7,293
Credit cards and overdrafts		2,528			1,959
Less unearned income		(913	)		(925	)
Total Loans		494,426			497,804
Allowance for credit losses		(11,580	)		(7,623	)

Net Loans	$	482,846		$	490,181

Interest and fees earned on our loan portfolio is our primary source of revenue. Gross loans represented 72% of total assets as of September 30, 2009, compared to 80% at December 31, 2008. 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.

Construction and land development loans and commercial real estate loans have been significant in our loan portfolio, representing 16.8% and 38.9%, respectively, of our loan portfolio at September 30, 2009. Conditions in the construction and land development arena in our market areas remain strained, resulting in elevated delinquencies and foreclosures in this portion of our portfolio, which have contributed to the increased provision for credit losses for 2009 and, to a lesser extent, 2008. Our commercial real estate portfolio generally consists of a wide cross-section of retail, small office, warehouse, and industrial type properties. Loan to value ratios for the Company’s commercial real estate loans at origination generally do not exceed 75% and debt service ratios are generally 125% or better. While we have significant balances within this lending category, we believe that our lending policies and underwriting standards are sufficient to minimize risk even in a moderate downturn in the commercial real estate market. Additionally, this is a sector in which we have significant long-term management experience.

Beginning in late 2006 and continuing into 2007, the Company strengthened its underwriting criteria for advance rates on raw land loans, land development loans, residential lots, speculative construction for condominiums and all construction loans as the housing market softened. Additionally, during 2008, the Company put in place further restrictions on loans secured by all types of real estate, including home equity lines of credit and land and land development loans, and tightened underwriting policies on hospitality projects. In 2009, the Bank implemented further restrictions on non-owner occupied commercial real estate loans in order to reduce our concentration in this sector. The Bank is not engaging in new land acquisition and development financing. Limited residential speculative construction financing is provided for a very select and small group of borrowers, which is designed to augment exit from the related credits. It is the Company’s strategic objective to reduce concentrations in land and residential construction and total commercial real estate below the regulatory hurdles of 100% and 300% of risk based capital, respectively. During the quarter ended September 30, 2009, concentration in commercial real estate fell below 300% to 287%. Concentration in land and residential construction remains at 109%; however this represents a significant decline from the prior quarter when the concentration was 147%.

Deposits. Total deposits were $578,805,000 at September 30, 2009, an increase of $67,498,000 or 13.2%, compared to December 31, 2008. Deposit detail by category as of September 30, 2009 and December 31, 2008 follows (in thousands):

	September 30, 2009		December 31, 2008

Non-interest bearing demand	$	85,774	$	80,066
Interest bearing demand		84,696		68,113
Money market deposits		88,117		93,216
Savings deposits		51,065		51,948
Time deposits		269,153		217,964

Total deposits	$	578,805	$	511,307

Non-interest bearing demand deposits increased $5,708,000, or 7.1%, which is consistent with the cyclical pattern of our deposits for our tourist heavy locations in which balances typically reach their highest point in the third quarter of the year. Interest bearing demand deposits increased $16,583,000, or 24.4%, due to the continued success of Dream Checking, a high-yield retail checking account which was introduced in 2008 to attract new deposits. The Dream Checking account pays a high rate of interest upon meeting certain electronic requirements such as debit card and automated clearing house transactions. The balances in Dream Checking accounts totaled $26.2 million and $15.3 million at September 30, 2009 and December 31, 2008, respectively. Money market accounts decreased $5,099,000, or 5.5%, primarily due to decreased balances from escrow and title companies which have significantly reduced balances due to the sluggish real estate market. Time deposits increased $51,189,000, or 23.5%, due to a combination of increases in retail deposits of $20,914,000 and increases in brokered deposits of $30,275,000. The increase in retail deposits is mostly attributable to increased brand awareness in the Whatcom County market, and our commitment to maintain a disciplined deposit strategy, focusing on enhancing long-term customer relationships. Additionally, recent adverse press and other media relating to banks in our market facing regulatory cease and desist orders have contributed to growth in retail deposits.

Brokered deposits totaled $65,580,000 and $35,305,000 at September 30, 2009 and December 31, 2008, respectively. The increase in brokered deposits was primarily to replace maturing public deposits totaling $22,206,000 that have become less attractive due to regulatory pledging requirements and to further strengthen on-balance sheet liquidity to take advantage of business opportunities within our markets. Due to the successful growth in retail deposits and current excess liquidity, the Company presently intends to roll off brokered deposits as they come due as follows: $5,207,000 – 2009; $36,153,000 – 2010; and $24,220,000 - 2011. Changes in the market or new regulatory restrictions could limit our ability to maintain or acquire brokered deposits in the future.

It is our strategic goal to grow deposits through increased brand awareness, continued success from new branches opened in recent years, and by paying competitive rates in our local markets. Competitive pressures from banks in our market areas with strained liquidity positions or public regulatory enforcement actions may slow our deposit growth. In addition, the slowing economy and public fears from recent bank failures could also impact our ability to grow deposits. In the long-term we anticipate continued growth in our core deposits through both the addition of new customers and our current client base. We have established and expanded a branch system to serve our consumer and business depositors. In addition, management’s strategy for funding asset growth is to make use of brokered and other wholesale deposits on an as-needed basis.

Liquidity. We believe adequate liquidity continues to be available to accommodate fluctuations in deposit levels, fund operations, provide for customer credit needs, and meet obligations and commitments on a timely basis. The Bank’s primary sources of funds are customer deposits, maturities of investment securities, loan sales, loan repayments, net income, and other borrowings. When necessary, liquidity can be increased by taking advances from credit available to the Bank. The Bank believes it has a strong liquidity position at September 30, 2009, with $68.5 million in cash, including interest bearing deposits with banks, and federal funds sold and other sources of liquidity currently totaling $172 million. The Bank maintains credit facilities with correspondent banks totaling $17,750,000, of which none was used at September 30, 2009. In addition, the Bank has a credit line with the Federal Home Loan Bank of Seattle for up to 20% of assets, of which $25,500,000 was used at September 30, 2009. For its funds, the Company relies on dividends from the Bank and, historically, proceeds from the issuance of trust preferred securities, both of which are used for various corporate purposes, including dividends.

At September 30, 2009, two wholly-owned subsidiary grantor trusts established by the Company had issued and outstanding $13,403,000 of trust preferred securities. During the second quarter of 2009, the Company elected to exercise the right to defer interest payments on trust preferred debentures. Under the terms of the indenture, the Company has the right to defer interest payments for up to twenty consecutive quarterly periods without going in to default. During the period of deferral, the principal balance and unpaid interest will continue to bear interest as set forth in the indenture. In addition, the Company will not be permitted to pay any dividends or distributions on, or redeem or make a liquidation payment with respect to, any of the Company’s common stock during the deferral period. As of September 30, 2009, deferred interest totaled $278,000 and is included in accrued interest payable on the balance sheet.

For additional information regarding trust preferred securities, see the 2008 10-K under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity”. The Company does not expect the issuance of new trust preferred securities to be a source of liquidity in 2009.

Capital. Total shareholders' equity was $59,781,000 at September 30, 2009, an increase of $9,707,000, or 19.4%, compared to December 31, 2008. For more information regarding a $12.4 million common stock offering completed during the quarter ended September 30, 2009, see Note 10 to the condensed consolidated financial statements included elsewhere in this report. The Federal Reserve and the FDIC have established minimum guidelines that mandate risk-based capital requirements for bank holding companies and member banks. Under the guidelines, risk percentages are assigned to various categories of assets and off-balance sheet items to calculate a risk-adjusted capital ratio. Regulatory minimum risk-based capital guidelines under the Federal Reserve require Tier 1 capital to risk-weighted assets of 4% and total capital to risk-weighted assets of 8% to be considered adequately capitalized. To qualify as well capitalized under the FDIC, banks must have a Tier 1 leverage ratio of 5%, a Tier 1 risk-based ratio of 6%, and a Total risk-based capital ratio of 10%. Failure to qualify as well capitalized can negatively impact a bank’s ability to expand and to engage in certain activities.

The Company and the Bank qualify as well capitalized at September 30, 2009 and December 31, 2008 as demonstrated in the table below.

	Company						Bank						Requirements
	9/30/09			12/31/08			9/30/09			12/31/08			Adequately Capitalized			Well Capitalized

Tier 1 leverage ratio		9.34	%		8.87	%		9.28	%		8.75	%		4	%		5	%
Tier 1 risk-based capital ratio		12.08	%		10.54	%		12.00	%		10.40	%		4	%		6	%
Total risk-based capital ratio		13.35	%		11.79	%		13.26	%		11.65	%		8	%		10	%

The Company and the Bank are subject to certain restrictions on the payment of dividends without prior regulatory approval.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

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

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

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

It should be noted that the simulation model does not take into account future management actions that could be undertaken should actual market rates change during the year. Also, the simulation model results are not exact measures of the Company's actual interest rate risk. They are only indicators of rate risk exposure based on assumptions produced in a simplified modeling environment designed to heighten sensitivity to changes in interest rates. The rate risk exposure results of the simulation model typically are greater than the Company's actual rate risk. That is due to the conservative modeling environment, which generally depicts a worst-case situation. Management has assessed the results of the simulation reports as of September 30, 2009 and believes that there has been no material change since December 31, 2008.

ITEM 4. CONTROLS AND PROCEDURES

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

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

PART II – OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

Not applicable.

ITEM 1A. RISK FACTORS

There has been no material change from the risk factors previously reported in the 2008 10-K.

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

In January 2008, the Company’s board of directors approved a share repurchase program authorizing the purchase of up to 150,000 shares of its common stock. There were no purchases of common stock by the Company during the quarter ended September 30, 2009. We have no current intention to purchase stock under our share repurchase program during 2009.

See Note 10 to the condensed consolidated financial statements included under Item I of this report.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

Previously reported.

ITEM 5. OTHER INFORMATION

None.

ITEM 6. EXHIBITS

See Exhibit Index immediately following signatures below.

SIGNATURES

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

	PACIFIC FINANCIAL CORPORATION

DATED: November 9, 2009	By:	/s/ Dennis A. Long
		Dennis A. Long
		Chief Executive Officer

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

EXHIBIT INDEX

EXHIBIT NO.		EXHIBIT

4.1		Form of Warrant to Purchase Shares of Common Stock. Incorporated by reference to Exhibit 4.1 to the Company’s Current Report on Form 8-K dated August 25, 2009 (the “August 2009 8-K”).

10.1		Securities Purchase Agreement, dated August 25, 2009. Incorporated by reference to Exhibit 10.1 to the August 2009 8-K.

10.2		Registration Rights Agreement, dated August 25, 2009. Incorporated by reference to Exhibit 10.2 to the August 2009 8-K.

31.1		Certification of CEO under Rule 13a – 14(a) of the Exchange Act.

31.2		Certification of CFO under Rule 13a – 14(a) of the Exchange Act.

32		Certification of CEO and CFO under 18 U.S.C. Section 1350.