UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

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

For the quarterly period ended September 30, 2014

¨ 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	(I.R.S. Employer
incorporation or organization)	Identification No.)

1101 S. Boone Street

Aberdeen, Washington 98520-5244

(Address of principal executive offices) (Zip Code)

(360) 533-8870

(Registrant's telephone number, including area code)

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes  x    No ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes  x    No ¨

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

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

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

The number of shares outstanding of Registrant's common stock as of November 7, 2014 was 10,367,460.

Form 10-Q

Table of Contents

Part I	FINANCIAL INFORMATION
Item I.	FINANCIAL STATEMENTS (UNAUDITED)	3
	CONDENSED CONSOLIDATED BALANCE SHEETS SEPTEMBER 30, 2014 AND DECEMBER 31, 2013	3
	CONDENSED CONSOLIDATED STATEMENTS OF INCOME THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2014 AND 2013	4
	CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2014 AND 2013	5
	CONDENSED CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY NINE MONTHS ENDED SEPTEMBER 30, 2014 AND 2013	6
	CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS NINE MONTHS ENDED SEPTEMBER 30, 2014 AND 2013	7
	NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS	8
Item 2.	MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	41
Item 3.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	64
Item 4.	CONTROLS AND PROCEDURES	64
Part II	OTHER INFORMATION
Item 1.	LEGAL PROCEEDINGS	64
Item 1A.	RISK FACTORS	64
Item 2.	UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS	64
Item 3.	DEFAULTS UPON SENIOR SECURITIES	65
Item 4.	MINE SAFETY DISCLOSURES	65
Item 5.	OTHER INFORMATION	65
Item 6.	EXHIBITS	66
SIGNATURES		66

2

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

PACIFIC FINANCIAL CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(Dollars in Thousands, except per share data)

(UNAUDITED)

	September 30,			December 31,
	2014			2013
ASSETS
Cash and cash equivalents:
Cash and due from banks	$	15,284		$	12,214
Interest-bearing deposits in banks		25,497			23,734
Total cash and cash equivalents		40,781			35,948
Interest-bearing certificates of deposit (original maturities greater than 90 days)		2,727			2,727
Federal Home Loan Bank stock, at cost		2,926			3,013
Pacific Coast Bankers' Bank stock, at cost		1,000			-
Investment securities:
Investment securities available-for-sale, at fair market value		89,328			96,144
Investment securities held-to-maturity, at amortized cost (fair value of $1,873 and $2,158)		1,857			2,132
Total investment securities		91,185			98,276
Loans held-for-sale		8,161			7,765
Loans, net of deferred loan fees		552,140			504,666
Allowance for loan losses		(8,255	)		(8,359	)
Loans, net		543,885			496,307
Premises and equipment, net of accumulated depreciation and amortization		16,460			16,790
Other real estate owned and foreclosed assets		1,210			2,771
Accrued interest receivable		2,337			2,307
Cash surrender value of life insurance		18,615			18,237
Goodwill		12,168			12,168
Other intangible assets		1,449			1,481
Other assets		6,143			7,249
TOTAL ASSETS	$	749,047		$	705,039
LIABILITIES AND SHAREHOLDERS' EQUITY
LIABILITIES
Deposits:
Demand	$	182,259		$	145,028
Interest-bearing demand and savings		343,524			336,260
Time deposits		118,221			126,059
Total deposits		644,004			607,347
Accrued interest payable		141			167
Short-term borrowings		-			-
Long-term borrowings		11,491			10,000
Junior subordinated debentures		13,403			13,403
Other liabilities		6,751			6,985
Total liabilities		675,790			637,902
COMMITMENTS AND CONTINGENCIES (Note 7)
SHAREHOLDERS' EQUITY
Preferred Stock, par value none 5,000,000 shares authorized, none outstanding
Common Stock, par value $1 25,000,000 shares authorized, 10,367,460 shares issued and outstanding at 09/30/2014 and 10,182,083 at 12/31/2013		10,367			10,182
Additional paid-in-capital		42,940			41,817
Retained earnings		20,312			16,507
Accumulated other comprehensive income/(loss)		(362	)		(1,369	)
Total shareholders' equity		73,257			67,137
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY	$	749,047		$	705,039

See accompanying notes.

3

PACIFIC FINANCIAL CORPORATION

CONSOLIDATED STATEMENTS OF INCOME

(Dollars in Thousands, Except per Share Data)

(UNAUDITED)

	For the Three Months Ended						For the Nine Months Ended
	September 30,			September 30,			September 30,			September 30,
	2014			2013			2014			2013
INTEREST AND DIVIDEND INCOME
Loans	$	6,894		$	6,116		$	20,132		$	18,158
Deposits in banks and federal funds sold		24			34			62			85
Investment securities:
Taxable		298			220			980			471
Tax-exempt		183			234			645			761
FHLB dividends		1			1			2			1
Total interest and dividend income		7,400			6,605			21,821			19,476
INTEREST EXPENSE
Deposits:
Interest-bearing demand and savings		134			167			415			547
Time		269			307			835			1,026
Long-term borrowings		54			54			158			168
Junior subordinated debentures		61			62			181			186
Total interest expense		518			590			1,589			1,927
Net interest income		6,882			6,015			20,232			17,549
LOAN LOSS PROVISION		100			-			200			(450	)
Net interest income after loan loss provision		6,782			6,015			20,032			17,999
NON-INTEREST INCOME
Service charges on deposit accounts		450			440			1,359			1,281
Net gains (loss) on sale of other real estate owned		(85	)		18			(179	)		43
Net gains from sales of loans		1,120			1,128			2,717			4,306
Net gains (loss) on sales of securities available for sale		38			14			88			401
Net other-than-temporary impairment (net of $0, $7, $15, $2 respectively recognized in other comprehensive income before taxes)		-			(4	)		(48	)		(38	)
Earnings on bank owned life insurance		127			105			378			342
Other operating income		624			531			1,743			1,698
Total non-interest income		2,274			2,232			6,058			8,033
NON-INTEREST EXPENSE
Salaries and employee benefits		4,286			4,098			12,624			12,983
Occupancy		483			473			1,494			1,338
Equipment		261			233			775			619
Data processing		492			449			1,387			1,688
Professional services		220			198			606			696
Other real estate owned write-downs		1			176			67			636
Other real estate owned operating costs		100			67			191			276
State taxes		110			110			314			360
FDIC and state assessments		119			129			381			395
Other non-interest expense		1,061			1,156			3,189			3,389
Total non-interest expense		7,133			7,089			21,028			22,380
INCOME BEFORE PROVISION FOR INCOME TAXES		1,923			1,158			5,062			3,652
PROVISION FOR INCOME TAXES		549			249			1,257			710
NET INCOME APPLICABLE TO COMMON SHAREHOLDERS	$	1,374		$	909		$	3,805			2,942
EARNINGS PER COMMON SHARE:
BASIC	$	0.13		$	0.09		$	0.37			0.29
DILUTED	$	0.13		$	0.09		$	0.37			0.29
WEIGHTED AVERAGE SHARES OUTANDING:
BASIC		10,281,745			10,121,853			10,218,103			10,121,853
DILUTED		10,379,166			10,194,826			10,309,436			10,179,928

See accompanying notes.

4

PACIFIC FINANCIAL CORPORATION

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Dollars in Thousands)

(UNAUDITED)

	For the Three Months Ended					For the Nine Months Ended
	September 30,			September 30,		September 30,		September 30,
	2014			2013		2014		2013
NET INCOME	$	1,374		$	909	$	3,805	$	2,942
OTHER COMPREHENSIVE INCOME (LOSS), NET OF TAX:
Change in fair value of securities available-for-sale		(42	)		509		920		(1,494	)
Defined benefit plan		29			28		87		84
Total other comprehensive income (loss), net of tax		(13	)		537		1,007		(1,410	)
COMPREHENSIVE INCOME	$	1,361		$	1,446	$	4,812	$	1,532

See accompanying notes.

5

PACIFIC FINANCIAL CORPORATION

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY

(Dollars in Thousands, Except Share Amounts)

(UNAUDITED)

										Accumulated
	Common Stock				Additional			Retained		Other Comprehensive			Total Shareholders'
	Shares		Amount		Paid-in Capital			Earnings		Income/(Loss)			Equity
BALANCE - December 31, 2012		10,121,853	$	10,122	$	41,366		$	14,812	$	421		$	66,721
Net income		-		-					2,942		-			2,942
Other comprehensive income, net of tax
Unrealized holding loss on securities less reclassification adjustments for net gains included in net income		-		-		-			-		(1,494	)		(1,494	)
Amortization of unrecognized prior service costs and net gains		-		-		-			-		84			84
Stock-based compensation expense		-		-		83			-		-			83
BALANCE - September 30, 2013		10,121,853	$	10,122	$	41,449		$	17,754	$	(989	)	$	68,336
BALANCE - December 31, 2013		10,182,083	$	10,182	$	41,817		$	16,507	$	(1,369	)	$	67,137
Net income		-		-					3,805		-			3,805
Other comprehensive income, net of tax
Unrealized holding gain on securities less reclassification adjustments for net gains included in net income		-		-		-			-		920			920
Amortization of unrecognized prior service costs and net gains		-		-		-			-		87			87
Stock repurchased (RSU)		-		-		(3	)		-		-			(3	)
Issuance of common stock		185,377		185		1,020			-		-			1,205
Stock-based compensation expense		-		-		106			-		-			106
BALANCE - September 30, 2014		10,367,460	$	10,367	$	42,940		$	20,312	$	(362	)	$	73,257

See accompanying notes.

6

PACIFIC FINANCIAL CORPORATION AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in Thousands)

(UNAUDITED)

	For the Nine Months Ended
	September 30,			September 30,
	2014			2013
CASH FLOWS FROM OPERATING ACTIVITIES
Net Income	$	3,805		$	2,942
Adjustments to reconcile net income to net cash from operating activities
Provision for credit losses		200			(450	)
Depreciation and amortization		1,981			1,710
Originations of loans held for sale		(112,797	)		(201,278	)
Proceeds from sales of loans held for sale		115,117			211,204
Net (gain) on sales of loans		(2,717	)		(4,306	)
Net gain on sales of securities available for sale		(88	)		(401	)
Net OTTI recognized in earnings		48			38
(Gain) loss on sales of other real estate owned		179			(43	)
(Gain) loss on sale of premises and equipment		6			18
Earnings on bank owned life insurance		(378	)		(342	)
Increase in accrued interest receivable		(30	)		(241	)
Decrease in accrued interest payable		(26	)		(33	)
Other real estate owned write-downs		67			636
(Increase) decrease in prepaid expenses		(39	)		2,127
Other — net		2,524			1,192
Net cash provided by operating activities		7,853			12,773
CASH FLOWS FROM INVESTING ACTIVITIES
Net increase in interest bearing balances with banks		(1,763	)		(11,476	)
Purchase of certificates of deposits held for investment, net		-			1,250
Activity in securities available for sale:
Sales		17,755			7,237
Maturities, prepayments and calls		5,552			8,467
Purchases		(16,779	)		(48,892	)
Activity in securities held to maturity:
Maturities, prepayments and calls		275			4,549
(Increase) decrease in loans made to customers, net of principal collections		(47,925	)		(36,395	)
Purchases of premises and equipment		(683	)		(2,012	)
Proceeds from sales of other real estate owned		1,463			1,343
Proceeds from sales of premises and equipment		8			-
Cash received in acquisition, net of cash paid		-			31,941
Net cash used in investing activities		(42,097	)		(43,988	)
CASH FLOWS FROM FINANCING ACTIVITIES
Net increase in deposits		36,657			33,041
Net decrease in short-term borrowings		-			(3,000	)
Proceeds from issuance of long-term debt		1,500			2,500
Repayments of long-term debt		(9	)		-
Warrants exercised		1,205			-
Repurchase of stock (RSU)		(3	)		-
Cash dividends paid		(2,036	)		-
Net cash provided by financing activities		37,314			32,541
NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS		3,070			1,326
CASH AND DUE FROM BANKS - BEGINNING OF THE PERIOD		12,214			14,168
CASH AND DUE FROM BANKS - END OF THE PERIOD	$	15,284		$	15,494
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash paid for interest	$	1,615		$	1,958
Cash paid for taxes	$	-		$	440
SUPPLEMENTAL SCHEDULE OF NON CASH INVESTING AND
FINANCING ACTIVITIES
Change in fair value of securities available-for-sale, net of tax	$	920		$	(1,494	)
Transfer of loans held for sale to loans held for investment	$	-		$	64
Other real estate owned acquired in settlement of loans	$	(842	)	$	(1,591	)
Financed sale of other real estate owned	$	694		$	-

See accompanying notes.

7

PACIFIC FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

As of and for the nine months ended September 30, 2014

(Unaudited)

(Dollars in thousands, except per share amounts)

NOTE 1 – ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Organization – Pacific Financial Corporation (the “Company” or “Pacific”) is a bank holding company headquartered in Aberdeen, Washington. The Company owns one banking subsidiary, Bank of the Pacific (the “Bank”), which is also located in Washington. The Company was incorporated in the State of Washington in February, 1997, pursuant to a holding company reorganization of the Bank.

The Company conducts its banking business through the Bank, which operates 17 branches located in communities in Grays Harbor, Pacific, Whatcom, Clark, Skagit and Wahkiakum counties in the state of Washington and three in Clatsop County, Oregon. In addition, the Bank operates two loan production offices in Burlington and Dupont, Washington and has a residential real estate mortgage department. During second quarter 2013, the Bank completed the acquisition of three branches from Sterling Savings Bank. Total deposits assumed were $37.6 million and loans acquired totaled $4.0 million. Of the three branches purchased, two were consolidated into existing Pacific branches to maximize branch efficiencies resulting in one new branch in Astoria, Oregon. Separately, the Company opened a full-service branch in Warrenton, Oregon in October 2013 that further expands operations on the northern Oregon coast.

The accompanying unaudited condensed consolidated financial statements have been prepared by the Company in accordance with accounting principles generally accepted in the United States of America ("GAAP") for interim financial information and with instructions to Form 10-Q. Accordingly, these financial statements do not include all of the information and footnotes required by GAAP for complete financial statements. In the opinion of Management, adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the nine months ended September 30, 2014, are not necessarily indicative of the results anticipated for the year ending December 31, 2014. Certain information and footnote disclosures included in the Company's consolidated financial statements for the year ended December 31, 2013, 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, 2013 (the “2013 Annual Report”).

Basis of presentation – The consolidated financial statements include the accounts of Pacific Financial Corporation and its wholly-owned subsidiary. All intercompany accounts and transactions have been eliminated in consolidation.

The interim consolidated financial statements are not audited, but include all adjustments that Management considers necessary for a fair presentation of consolidated financial condition and results of operations for the interim periods presented.

Method of accounting and use of estimates – The Company prepares its consolidated financial statements in conformity with accounting principles generally accepted in the United States of America and prevailing practices within the banking industry. This requires Management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of income and expenses during the reporting periods. Actual results could differ from those estimates. Significant estimates made by Management involve the calculation of the allowance for loan losses, impaired loans, the fair value of available-for-sale investment securities, deferred tax assets, and the value of other real estate owned and foreclosed assets.

The Company utilizes the accrual method of accounting, which recognizes income when earned and expenses when incurred.

In preparing these financial statements, the Company has evaluated events and transactions subsequent to September 30, 2014, for potential recognition or disclosure in the financial statements. In Management’s opinion, all accounting adjustments necessary to accurately reflect the financial position and results of operations on the accompanying financial statements have been made. These adjustments include normal and recurring accruals considered necessary for a fair and accurate presentation.

8

NOTE 2 – EARNINGS PER SHARE

The Company’s basic earnings per common share is computed by dividing net income available to common shareholders (net income less dividends declared by the weighted average number of common shares outstanding during the period). The Company’s diluted earnings per common share is computed similar to basic earnings per common share except that the numerator is equal to net income available to common shareholders and the denominator is increased to include the number of additional common shares that would have been outstanding if dilutive potential common shares had been issued. Included in the denominator are the dilutive effects of stock options computed under the treasury stock method and outstanding warrants as if converted to common stock.

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

	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2014		2013		2014		2013
Basic:
Net income	$	1,374	$	909	$	3,805	$	2,942
Weighted average shares outstanding		10,281,745		10,121,853		10,218,103		10,121,853
Basic earnings per share	$	0.13	$	0.09	$	0.37	$	0.29
Diluted:
Net income	$	1,374	$	909	$	3,805	$	2,942
Weighted average shares outstanding		10,281,745		10,121,853		10,218,103		10,121,853
Effect of dilutive stock options		97,421		72,973		91,333		58,075
Weighted average shares outstanding assuming dilution		10,379,166		10,194,826		10,309,436		10,179,928
Diluted earnings per share	$	0.13	$	0.09	$	0.37	$	0.29

	September 30, 2014		September 30, 2013
Shares subject to outstanding options		367,595		433,995
Shares subject to outstanding warrants		-		699,642

As of September 30, 2014 and 2013, the shares subject to outstanding options and for September 30, 2013, the shares subject to outstanding warrants, had exercise prices in excess of the current market value. All of these shares are not included in the table above, as exercise of these options and warrants would not be dilutive to shareholders.

9

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, other corporations, and mortgage backed securities (MBS).

	September 30, 2014
At September 30, 2014	Amortized Cost		Gross unrealized gains		Gross unrealized losses		Fair value
Available-for-sale:
Collateralized mortgage obligations: agency issued	$	40,562	$	209	$	732	$	40,039
Collateralized mortgage obligations: non agency		592		-		13		579
Mortgage-backed securities: agency issued		12,710		24		235		12,499
U.S. Government agency securities		8,637		64		46		8,655
State and municipal securities		26,825		834		103		27,556
Total available-for-sale	$	89,326	$	1,131	$	1,129	$	89,328
Held-to-maturity:
Mortgage-backed securities: agency issued	$	131	$	13	$	-	$	144
State and municipal securities		1,726		4		-		1,730
Total held-to-maturity	$	1,857	$	17	$	-	$	1,874

	December 31, 2013
At September 30, 2014	Amortized Cost		Gross unrealized gains		Gross unrealized losses		Fair value
Available-for-sale:
Collateralized mortgage obligations: agency issued	$	39,791	$	246	$	1,246	$	38,791
Collateralized mortgage obligations: non agency		2,251		3		243		2,011
Mortgage-backed securities: agency issued		13,671		21		303		13,389
U.S. Government agency securities		8,859		34		82		8,811
State and municipal securities		31,973		774		587		32,160
Corporate bonds		991		-		9		982
Total available-for-sale	$	97,536	$	1,078	$	2,470	$	96,144
Held-to-maturity:
Mortgage-backed securities: agency issued	$	159	$	13	$	-	$	172
State and municipal securities		1,973		13		-		1,986
Total held-to-maturity	$	2,132	$	26	$	-	$	2,158

10

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, 2014, and December 31, 2013, are summarized as follows:

(Dollars in Thousands)

	Less than 12 months				12 months or more				Total
			Unrealized				Unrealized				Unrealized
At September 30, 2014	Fair Value		Losses		Fair Value		Losses		Fair Value		Losses
Available-for-sale:
Collateralized mortgage obligations: agency issued	$	10,548	$	75	$	18,934	$	657	$	29,482	$	732
Collateralized mortgage obligations: non agency		361		2		217		11		578		13
Mortgage-backed securities: agency issued		3,442		103		7,576		132		11,018		235
U.S. Government agency securities		-		-		3,607		46		3,607		46
State and municipal securities		1,752		16		6,795		87		8,547		103
Corporate bonds		-		-		-		-		-		-
Total	$	16,103	$	196	$	37,129	$	933	$	53,232	$	1,129

	Less than 12 months				12 months or more				Total
			Unrealized				Unrealized				Unrealized
At December 31, 2013	Fair Value		Losses		Fair Value		Losses		Fair Value		Losses
Available-for-sale:
Collateralized mortgage obligations: agency issued	$	21,043	$	778	$	6,265	$	468	$	27,308	$	1,246
Collateralized mortgage obligations: non agency		389		27		1,619		216		2,008		243
Mortgage-backed securities: agency issued		7,752		218		2,643		85		10,395		303
U.S. Government agency securities		5,550		82		-		-		5,550		82
State and municipal securities		11,551		485		1,821		102		13,372		587
Corporate bonds		982		9		-		-		982		9
Total	$	47,267	$	1,599	$	12,348	$	871	$	59,615	$	2,470

At September 30, 2014, there were 66 investment securities in an unrealized loss position, of which 46 were in a continuous loss position for 12 months or more. The unrealized losses on these securities were caused by changes in interest rates, widening pricing spreads and market illiquidity, leading to a decline in the fair value subsequent to their purchase. The Company has evaluated the securities shown above and anticipates full recovery of amortized cost with respect to these securities at maturity or sooner in the event of a more favorable market environment. Based on management’s evaluation, and because the Company does not have the intent to sell these securities and it is not more likely than not that it will have to sell the securities before recovery of cost basis, the Company does not consider these investments to be other-than-temporarily impaired at September 30, 2014.

11

For non-agency mortgage-backed securities (MBS) the Company estimates expected future cash flows of the underlying collateral, together with any credit enhancements. The expected future cash flows of the underlying collateral are determined using the remaining contractual cash flows adjusted for future expected credit losses (which considers current delinquencies, future expected default rates and collateral value by vintage) and prepayments. The expected cash flows of the security are then discounted to arrive at a present value amount. For the nine months ended September 30, 2014, no non-agency MBS was determined to be other-than-temporarily-impaired. For the nine months ended September 30, 2013, one non-agency MBS was determined to be other-than-temporarily-impaired. This security was sold in second quarter 2014, incurring a loss of $69,000. The Company recorded $48,000 and $38,000 in impairments related to credit losses through earnings for the nine months ended September 30, 2014 and 2013, respectively.

The following table presents the cash proceeds from the sales of securities and their associated gross realized gains and gross realized losses that are included in earnings for the nine months ended September 30, 2014 and 2013:

Investment securities gross gains and losses

(Dollars in Thousands)

	For the Three Months Ended						For the Nine Months Ended
	September 30, 2014			September 30, 2013			September 30, 2014			September 30, 2013
Gross realized gain on sale of securities	$	94		$	57		$	315		$	444
Gross realized loss on sale of securities		(56	)		(43	)		(227	)		(43	)
Net realized gain on sale of securities	$	38		$	14		$	88		$	401
Proceeds from sale of securities	$	3,928		$	308		$	17,755		$	7,237

The Company did not engage in originating subprime mortgage loans, and it does not believe that it has material exposure to subprime mortgage loans or subprime mortgage backed securities. Additionally, the Company does not own any sovereign debt of Eurozone nations or structured financial products, such as collateralized debt obligations or structured investment vehicles, which are known by the Company to have elevated risk characteristics.

The amortized cost and estimated fair value of investment securities at September 30, 2014, by maturity are shown below.  The amortized cost and fair value of collateralized mortgage obligations and mortgage-backed securities are presented by expected average life, rather than contractual maturity.  Expected maturities may differ from contractual maturities because borrowers may have the right to prepay underlying loans without prepayment penalties.

(Dollars in Thousands)

	Held-to-maturity				Available-for-sale
	Amortized				Amortized
	Cost		Fair Value		Cost		Fair Value
Due in one year or less	$	-	$	-	$	1,079	$	1,080
Due after one year through five years		-		-		7,120		7,108
Due after five years through ten years		1,124		1,127		14,334		14,594
Due after ten years		602		603		12,928		13,429
Mortgage-backed securities		131		144		53,865		53,117
Total investment securities	$	1,857	$	1,874	$	89,326	$	89,328

At September 30, 2014, investment securities with an estimated fair value of $49.2 million were pledged to secure public deposits, certain nonpublic deposits and borrowings.

12

As required of all members of the Federal Home Loan Bank (“FHLB”) system, the Company maintains an investment in the capital stock of the FHLB in an amount equal to the greater of $500,000 or 0.5% of home mortgage loans and pass-through securities plus 5.0% of the outstanding balance of mortgage home loans sold to FHLB under the Mortgage Purchase Program. The FHLB system, the largest government sponsored entity in the United States, is made up of 12 regional banks, including the FHLB of Seattle. Participating banks record the value of FHLB stock equal to its par value at $100 per share. At September 30, 2014, the Company held approximately $2.9 million in FHLB stock.

The Company is required to hold FHLB’s stock in order to receive advances and views this investment as long-term. Thus, when evaluating it for impairment, the value is determined based on the recovery of the par value through redemption by the FHLB or from the sale to another member, rather than by recognizing temporary declines in value. The FHLB of Seattle disclosed that it reported net income for the three and nine month periods ended September 30, 2014, at which time it declared a cash dividend. On November 22, 2013, the FHLB of Seattle entered into an amended Stipulation and Consent to the Issuance of a Consent Order with the Federal Housing Finance Agency (“Finance Agency”), modifying the previous order issued on October 25, 2010. The Finance Agency now deems the FHLB of Seattle to be “adequately capitalized” under the Finance Agency’s Prompt Corrective Action rule. The Company has concluded that its investment in FHLB is not impaired as of September 30, 2014, and believes that it will ultimately recover the par value of its investment in this stock.

The Company owns $1.0 million in common stock in Pacific Coast Bankers’ Bancshares (PCBB), from which the Company receives a variety of corresponding banking services through its banking subsidiary Pacific Coast Bankers Bank. An investment by the Company in such an entity is permissible under 12 CFR 362.3(a)(2)(iv). When evaluating this investment for impairment, the value is determined based on the recovery of the par value through any redemption by PCBB or from the sale to another eligible purchaser, rather than by recognizing temporary declines in value. PCBB disclosed that it reported net income for the three and nine month periods ended September 30, 2014 and maintains capital ratios that exceed “well capitalized” standards for regulatory purposes.

NOTE 4 – LOANS AND ALLOWANCE FOR LOAN LOSSES AND CREDIT QUALITY

Loans

Loans held in the portfolio at September 30, 2014 and December 31, 2013, are as follows:

(Dollars in Thousands)	September 30, 2014			December 31, 2013
Commercial and agricultural	$	112,873		$	104,111
Real estate:
Construction and development		25,419			29,096
Residential 1-4 family		94,101			87,762
Multi-family		20,554			17,520
Commercial real estate — owner occupied		122,090			105,594
Commercial real estate — non owner occupied		120,569			117,294
Farmland		22,926			23,698
Consumer/Finance		34,787			20,728
Gross loans		553,319			505,803
Less:  deferred fees		(1,179	)		(1,137	)
Portfolio Loans	$	552,140		$	504,666

13

Allowance for loan losses and credit quality

The allowance for loan losses represents the Company’s estimate as to the probable credit losses inherent in its loan portfolio. The allowance for loan losses is increased through periodic charges to earnings through provision for loan losses and represents the aggregate amount, net of loans charged-off and recoveries on previously charged-off loans, that is needed to establish an appropriate reserve for credit losses. The allowance is estimated based on a variety of factors and using a methodology as described below:

· The Company classifies loans into relatively homogeneous pools by loan type in accordance with regulatory guidelines for regulatory reporting purposes. The Company regularly reviews all loans within each loan category to establish risk ratings for them that include Pass, Watch, Special Mention, Substandard, Doubtful and Loss. Pursuant to ASC 310 “Accounting by Creditors for Impairment of a Loan”, the impaired portion of collateral dependent loans is charged-off. Other risk-related loans not considered impaired have loss factors applied to the various loan pool balances to establish loss potential for provisioning purposes.

· Analyses are performed to establish the loss factors based on historical experience, as well as expected losses based on qualitative evaluations of such factors as the economic trends and conditions, industry conditions, levels and trends in delinquencies and impaired loans, levels and trends in charge-offs and recoveries, among others. The loss factors are applied to loan category pools segregated by risk classification to estimate the loss inherent in the Company’s loan portfolio pursuant to ASC 450 “Accounting for Contingencies.”

· Additionally, impaired loans are evaluated for loss potential on an individual basis in accordance with ASC 310 “Accounting by Creditors for Impairment of a Loan,” and specific reserves are established based on thorough analysis of collateral values where loss potential exists. When an impaired loan is collateral dependent and a deficiency exists in the fair value of collateral securing the loan in comparison to the associated loan balance, the deficiency is charged-off at that time or a specific reserve is established. Impaired loans are reviewed no less frequently than quarterly.

· In the event that a current appraisal to support the fair value of the real estate collateral underlying an impaired loan has not yet been received, but the Company believes that the collateral value is insufficient to support the loan amount, an impairment reserve is recorded. In these instances, the receipt of a current appraisal triggers an updated review of the collateral support for the loan and any deficiency is charged-off or reserved at that time. In those instances where a current appraisal is not available in a timely manner in relation to a financial reporting cut-off date, the Company discounts the most recent third-party appraisal depending on a number of factors including, but not limited to, property location, local price volatility, local economic conditions, and recent comparable sales. In all cases, the costs to sell the subject property are deducted in arriving at the fair value of the collateral.

Changes in the allowance for credit losses for the three and nine months ended September 30, 2014 and 2013 were as follows:

Allowance for Credit Losses

Dollars in Thousands				Commercial Real			Residential
	Commercial			Estate ("CRE")			Real Estate			Consumer			Unallocated			Total
For the three months ended September 30, 2014
Beginning balance	$	904		$	3,807		$	702		$	882		$	2,020		$	8,315
Charge-offs and concessions		-			(127	)		(61	)		(12	)		-			(200	)
Recoveries		7			29			4			-			-			40
Provision / (recapture)		78			(96	)		102			41			(25	)		100
Ending balance	$	989		$	3,613		$	747		$	911		$	1,995		$	8,255
For the nine months ended September 30, 2014
Beginning balance	$	775		$	3,506		$	675		$	744		$	2,659		$	8,359
Charge-offs and concessions		(26	)		(523	)		(105	)		(59	)		-			(713	)
Recoveries		9			381			17			2			-			409
Provision / (recapture)		231			249			160			224			(664	)		200
Ending balance	$	989		$	3,613		$	747		$	911		$	1,995		$	8,255

14

Allowance for Credit Losses

Dollars in Thousands				Commercial Real			Residential
	Commercial			Estate ("CRE")			Real Estate			Consumer			Unallocated			Total
For the three months ended September 30, 2013
Beginning balance	$	809		$	3,414		$	813		$	638		$	3,288		$	8,962
Charge-offs and concessions		(40	)		(37	)		(29	)		(79	)		-			(185	)
Recoveries		20			5			3			1			-			29
Provision / (recapture)		45			164			(16	)		149			(342	)		-
Ending balance	$	834		$	3,546		$	771		$	709		$	2,946		$	8,806
For the nine months ended September 30, 2013
Beginning balance	$	923		$	4,098		$	829		$	531		$	2,977		$	9,358
Charge-offs and concessions		(40	)		(83	)		(95	)		(145	)		-			(363	)
Recoveries		35			220			4			2			-			261
Provision / (recapture)		(84	)		(689	)		33			321			(31	)		(450	)
Ending balance	$	834		$	3,546		$	771		$	709		$	2,946		$	8,806

Recorded investment in loans as of September 30, 2014 and 2013 are as follows:

Recorded Investment in Financing Receivables

Dollars in Thousands			Commercial Real		Residential
	Commercial		Estate ("CRE")		Real Estate		Consumer		Unallocated		Total
As of September 30, 2014
Allowance for Credit Losses:
Ending balance: individually evaluated for impairment	$	-	$	-	$	-	$	-	$	-	$	-
Ending balance: collectively evaluated for impairment	$	989	$	3,613	$	747	$	911	$	1,995	$	8,255
Loans:
Ending balance	$	112,873	$	291,004	$	114,655	$	34,787	$	-	$	553,319
Ending balance: individually evaluated for impairment	$	402	$	5,938	$	1,089	$	-	$	-	$	7,429
Ending balance: collectively evaluated for impairment	$	112,471	$	285,066	$	113,566	$	34,787	$	-	$	545,890
Less deferred fees											$	(1,179	)
Ending balance total loans											$	552,140

15

Recorded Investment in Financing Receivables

Dollars in Thousands			Commercial Real		Residential
	Commercial		Estate ("CRE")		Real Estate		Consumer		Unallocated		Total
As of December 31, 2013
Allowance for Credit Losses:
Ending balance: individually evaluated for impairment	$	-	$	-	$	-	$	-	$	-	$	-
Ending balance: collectively evaluated for impairment	$	775	$	3,506	$	675	$	744	$	2,659	$	8,359
Loans:
Ending balance	$	104,111	$	275,682	$	105,282	$	20,728	$	-	$	505,803
Ending balance: individually evaluated for impairment	$	587	$	8,656	$	626	$	53	$	-	$	9,922
Ending balance: collectively evaluated for impairment	$	103,524	$	267,026	$	104,656	$	20,675	$	-	$	495,881
Less deferred fees											$	(1,137	)
Ending balance total loans											$	504,666

Credit Quality Indicators

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

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

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

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

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

16

Credit quality indicators as of September 30, 2014 and December 31, 2013 were as follows:

(Dollars in Thousands)

September 30, 2014			Other Loans
			Especially
	Pass		Mentioned		Substandard		Doubtful		Total
Commercial and agricultural	$	104,073	$	6,648	$	2,152	$	-	$	112,873
Real estate:
Construction and development		24,288		50		1,081		-		25,419
Residential 1-4 family		90,387		448		3,266		-		94,101
Multi-family		20,285		269		-		-		20,554
Commercial real estate — owner occupied		114,120		1,675		6,295		-		122,090
Commercial real estate — non owner occupied		97,102		17,880		5,587		-		120,569
Farmland		21,001		1,878		47		-		22,926
Total real estate		367,183		22,200		16,276		-		405,659
Consumer/Finance		34,692		74		21		-		34,787
Less deferred fees		-		-		-		-		(1,179	)
Total loans	$	505,948	$	28,922	$	18,449	$	-	$	552,140

December 31, 2013			Other Loans
			Especially
	Pass		Mentioned		Substandard		Doubtful		Total
Commercial and agricultural	$	100,262	$	2,858	$	991	$	-	$	104,111
Real estate:
Construction and development		26,587		1,101		1,408		-		29,096
Residential 1-4 family		84,407		554		2,801		-		87,762
Multi-family		17,520		0		0		-		17,520
Commercial real estate — owner occupied		100,612		1,019		3,963		-		105,594
Commercial real estate — non owner occupied		98,044		16,752		2,498		-		117,294
Farmland		20,228		2,464		1,006		-		23,698
Total real estate		347,398		21,890		11,676		-		380,964
Consumer/Finance		20,570		62		96		-		20,728
Less deferred fees		-		-		-		-		(1,137	)
Total loans	$	468,230	$	24,810	$	12,763	$	-	$	504,666

17

Impaired Loans

Impaired loans by type as of September 30, 2014, and interest income recognized for the three and nine months ended September 30, 2014, were as follows:

(Dollars in Thousands)							3 Month		9 Month		3 Month		9 Month
	Unpaid						Average		Average		Interest		Interest
	Principal		Recorded		Related		Recorded		Recorded		Income		Income
	Balance		Investment		Allowance		Investment		Investment		Recognized		Recognized
September 30, 2014
With no Related Allowance:
Commercial	$	440	$	402	$	-	$	407	$	455	$	4	$	15
Consumer						-		26		53		-		-
Residential real estate		1,425		1,089		-		932		815		18		43
Commercial real estate:
CRE — owner occupied		1,640		1,640		-		1,650		1,732		-		-
CRE — non owner occupied		3,589		3,217		-		3,557		4,064		17		28
Farmland						-		478		716		-		225
Construction and development		3,139		1,081		-		1,177		1,260		15		48
Total	$	10,233	$	7,429	$	-	$	8,227	$	9,095	$	54	$	359
With a Related Allowance:
Consumer/Finance	$	-	$	-	$	-	$	-	$	-	$	-	$	-
Residential real estate		-		-		-		-		-		-		-
Total	$	-	$	-	$	-	$	-	$	-	$	-	$	-
Total Impaired Loans:
Commercial	$	440	$	402	$	-	$	407	$	455	$	4	$	15
Consumer						-		26		53		-		-
Residential real estate		1,425		1,089		-		932		815		18		43
Commercial real estate:
CRE — owner occupied		1,640		1,640		-		1,650		1,732		-		-
CRE — non owner occupied		3,589		3,217		-		3,557		4,064		17		28
Farmland						-		478		716		-		225
Construction and development		3,139		1,081		-		1,177		1,260		15		48
Total Impaired Loans	$	10,233	$	7,429	$	-	$	8,227	$	9,095	$	54	$	359

18

Impaired loans by type as of September 30, 2013, and interest income recognized for the three and nine months ended September 30, 2013, were as follows:

(Dollars in Thousands)							3 Month		9 Month		3 Month		9 Month
	Unpaid						Average		Average		Interest		Interest
	Principal		Recorded		Related		Recorded		Recorded		Income		Income
	Balance		Investment		Allowance		Investment		Investment		Recognized		Recognized
September 30, 2013
With no Related Allowance:
Commercial	$	766	$	766	$	-	$	984	$	1,440	$	1	$	6
Consumer		-		-		-		-		-		-		-
Residential real estate		1,102		871		-		1,233		1,150		9		19
Commercial real estate:
CRE — owner occupied		1,787		1,787		-		2,327		2,674		-		24
CRE — non owner occupied		6,791		4,591		-		4,584		5,349		9		32
Farmland		955		955		-		955		960		20		60
Construction and development		3,685		1,413		-		1,435		1,626		-		-
Total	$	15,086	$	10,383	$	-	$	11,518	$	13,199	$	39	$	141
With a Related Allowance:
Consumer	$	-	$	-	$	-	$	5	$	2	$	-	$	-
Residential real estate		-		-		-		100		50		-		1
Total	$		$		$		$	105	$	52	$		$	1
Total Impaired Loans:
Commercial	$	766	$	766	$	-	$	984	$	1,440	$	1	$	6
Consumer								5		2		-		-
Residential real estate		1,102		871				1,333		1,200		9		20
Commercial real estate:
CRE — owner occupied		1,787		1,787		-		2,327		2,674				24
CRE — non owner occupied		6,791		4,591		-		4,584		5,349		9		32
Farmland		955		955		-		955		960		20		60
Construction and development		3,685		1,413		-		1,435		1,626		-		-
Total Impaired Loans	$	15,086	$	10,383	$	-	$	11,623	$	13,251	$	39	$	142

19

Aging Analysis

The following tables summarize the Company’s loans past due, both accruing and nonaccruing, by type as of September 30, 2014 and December 31, 2013:

(Dollars in Thousands)
					Greater
	30-59 Days		60-89 Days		Than			Total Past		Non-accrual					Total
	Past Due		Past Due		90 Days			Due		Loans		Current			Loans
September 30, 2014:
Commercial and agricultural	$	7	$	-	$	-		$	7	$	113	$	112,753		$	112,873
Real estate:
Construction and development		-		-		-			-		1,081		24,338			25,419
Residential 1-4 family		251		-		-			251		714		93,136			94,101
Multi-family		-		-		-					-		20,554			20,554
Commercial real estate — owner occupied		-		-		409			409		1,586		120,095			122,090
Commercial real estate — non owner occupied		2,612		-		-			2,612		1,163		116,794			120,569
Farmland		-		-		-			-		-		22,926			22,926
Total real estate		2,863				409			3,272		4,544		397,843			405,659
Consumer/Finance		2		-		-			2		154		34, 631			34,787
Less deferred fees		-		-		-			-		-		(1,179	)		(1,179	)
Total	$	2,872			$		$409	$	3,281	$	4,811	$	544,048		$	552,140
December 31, 2013:
Commercial and agricultural	$	14	$	-	$	-		$	14	$	286	$	103,811		$	104,111
Real estate:
Construction and development		-		-		-			-		1,408		27,688			29,096
Residential 1-4 family		333		-		-			333		400		87,029			87,762
Multi-family		-		-		-			-		-		17,520			17,520
Commercial real estate — owner occupied		-		-		-			-		1,659		103,935			105,594
Commercial real estate — non owner occupied		-		-		-			-		2,482		114,812			117,294
Farmland		875		-		-			875		955		21,868			23,698
Total real estate		1,208		-		-			1,208		6,904		372,852			380,964
Consumer/Finance		165		3		-			168		53		20,507			20,728
Less deferred fees		-		-		-			-		-		(1,137	)		(1,137	)
Total	$	1,387	$	3	$	-		$	1,390	$	7,243	$	496,033		$	504,666

Modifications

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

Loans modified in a TDR are considered impaired loans and typically already on non-accrual status. Partial charge-offs have in some cases already been taken against the outstanding loan balance.  Loans modified in a TDR for the Company may have the financial effect of increasing the specific allowance associated with the loan.  An allowance for impaired loans that have been modified in a TDR is measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s observable market price, or the estimated fair value of the collateral, less any selling costs, if the loan is collateral dependent.  The Company’s practice is to re-appraise collateral dependent loans every six to nine months. During the nine months ended September 30, 2014, there was no impact on the allowance from TDRs during the period, as the loans classified as TDRs during the period did not have a specific reserve and were already considered impaired loans at the time of modification and no further impairment was required upon modification. The Company had no commitments to lend additional funds for loans classified as TDRs at September 30, 2014.

20

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

The following table presents TDRs for the nine months ended September 30, 2014 and 2013, all of which were modified due to financial stress of the borrower.

Restructured loans by type current and subsequently defaulted

(Dollars in Thousands)

	September 30, 2014
	Current Restructured Loans						Subsequently Defaulted Restructured Loans
	Number of Loans		Pre-TDR Outstanding Recorded Investment		Post-TDR Outstanding Recorded Investment		Number of Loans		Pre-TDR Outstanding Recorded Investment		Post-TDR Outstanding Recorded Investment
Commercial and agriculture		1	$	335	$	288		-	$	-	$	-
Construction and development		2		2,764		1,081		-		-		-
Residential real estate		2		272		221		-		-		-
CRE — owner occupied		1		59		54		-		-		-
CRE — non owner occupied		1		2,180		2,054		-		-		-
Total restructured loans (1)		7	$	5,610	$	3,698		-	$	-	$	-

	September 30, 2013
	Current Restructured Loans						Subsequently Defaulted Restructured Loans
	Number of Loans		Pre-TDR Outstanding Recorded Investment		Post-TDR Outstanding Recorded Investment		Number of Loans		Pre-TDR Outstanding Recorded Investment		Post-TDR Outstanding Recorded Investment
Commercial and agriculture		1	$	335	$	306		-	$	-	$	-
Construction and development		3		2,972		1,413		-		-		-
Residential real estate		2		272		227		-		-		-
CRE — owner occupied		1		59		56		-		-		-
CRE — non owner occupied		1		2,180		2,110		-		-		-
Total restructured loans (1)		8	$	5,818	$	4,112		-	$	-	$	-

(1) The period end balances are inclusive of all partial paydowns and charge-offs since the modification date.

The following table summarizes the Company’s troubled debt restructured loans by type and geographic region as of September 30, 2014:

Restructured loans by type and geographic region

(Dollars in Thousands)

	September 30, 2014
	Restructured Loans
	Central Western Washington		Southwestern Washington		Northern Washington		Oregon		Totals		Number of Loans
Commercial and agriculture	$	-	$	-	$	288	$	-	$	288		1
Construction and development						841		240		1,081		2
Residential real estate		-		-		-		221		221		2
CRE — owner occupied		54		-		-		-		54		1
CRE — non owner occupied		-		-		2,054		-		2,054		1
Total restructured loans	$	54	$	-	$	3,183	$	461	$	3,698		7

21

The following table presents troubled debt restructurings by accrual or nonaccrual status as of September 30, 2014 and 2013:

Restructured loans by accrual or nonaccrual status

(Dollars in Thousands)

	September 30, 2014
	Restructured loans
	Accrual Status		Non-accrual Status		Total Modifications
Commercial and agriculture	$	288	$	-	$	288
Construction and development		-		1,081		1,081
Residential real estate		221		-		221
CRE — owner occupied		54		-		54
CRE — non owner occupied		2,054		-		2,054
Total restructured loans	$	2,617	$	1,081	$	3,698

	September 30, 2013
	Restructured loans
	Accrual Status		Non-accrual Status		Total Modifications
Commercial and agriculture	$	306	$	-	$	306
Construction and development		-		1,413		1,413
Residential real estate		227		-		227
CRE — owner occupied		56		-		56
CRE — non owner occupied		2,110		-		2,110
Total restructured loans	$	2,699	$	1,413	$	4,112

22

NOTE 5 – ACCUMULATED OTHER COMPREHENSIVE INCOME/(LOSS)

The following table presents the changes in each component of accumulated other comprehensive income/(loss), net of tax, for the nine months ended September 30, 2014 and 2013:

(Dollars in Thousands)	Net Unrealized
	Gains and Losses
	On Investment			Defined Benefit
	Securities			Plans			Total
Balance, January 1, 2014	$	(919	)	$	(450	)	$	(1,369	)
Other comprehensive gain before reclassifications		946			87			1,033
Amounts reclassified from AOCI		(26	)		-			(26	)
Net Current period other comprehensive income (loss)		920			87			1,007
Balance, September 30, 2014	$	1		$	(363	)	$	(362	)

	Net Unrealized
	Gains and Losses
	On Investment			Defined Benefit
	Securities			Plans			Total
Balance, January 1, 2013	$	956		$	(535	)	$	421
Other comprehensive gain before reclassifications		(1,254	)		84			(1,170	)
Amounts reclassified from AOCI		(240	)		-			(240	)
Net Current period other comprehensive income (loss)		(1,494	)		84			(1,410	)
Balance, September 30, 2013	$	(538	)	$	(451	)	$	(989	)

23

The following table presents the amounts reclassified out of each component of accumulated other comprehensive income (“AOCI”) for the three and nine months ended September 30, 2014 and 2013:

(Dollars in Thousands)
Details about Accumulated Other Comprehensive Income Components	Amounts Reclassified from AOCI						Affected Line Item in the Statement Where Net Income is Presented
	Three Months			Nine Months
	Ended September			Ended September
	30, 2014			30, 2014
Net Unrealized Gains and Losses	$	(38	)	$	(88	)	(Gain)/loss on sales of investments available for sale
on Investment Securities		-			48		Net OTTI losses
		13			14		Income tax expense
	$	(25	)	$	(26	)	Unrealized gain on investment securities net of tax

(Dollars in Thousands)
Details about Accumulated Other Comprehensive Income Components	Amounts Reclassified from AOCI						Affected Line Item in the Statement Where Net Income is Presented
	Three Months			Nine Months
	Ended September			Ended September
	30, 2013			30, 2013
Net Unrealized Gains and Losses	$	(14	)	$	(401	)	(Gain) on sales of investments available for sale
on Investment Securities		4			38		Net OTTI losses
		3			123		Income tax expense
	$	(7	)	$	(240	)	Unrealized gain on investment securities net of tax

24

The following table presents the components of other comprehensive income (loss) for the three and nine months ended September 30, 2014 and 2013:

(Dollars in Thousands)
	Before Tax			Tax Effect			Net of Tax
Three months ended September 30, 2014
Net unrealized losses on investment securities:
Net unrealized gains arising during the period	$	(26	)	$	(9	)	$	(17	)
Less: reclassification adjustments for net gains realized in net income		(38	)	$	(13	)		(25	)
Net unrealized losses on investment securities	$	(64	)	$	(22	)	$	(42	)
Net unrealized losses on investment securities:
Amortization of unrecognized prior service costs and net  actuarial gains/losses	$	44		$	15		$	29
Other Comprehensive Income (Loss)	$	(20	)	$	(7	)	$	(13	)
Nine months ended September 30, 2014
Net unrealized losses on investment securities:
Net unrealized gains arising during the period	$	1,433		$	487		$	946
Less: reclassification adjustments for net gains realized in net income		(40	)	$	(14	)		(26	)
Net unrealized losses on investment securities	$	1,393		$	473		$	920
Net unrealized losses on investment securities:
Amortization of unrecognized prior service costs and net actuarial gains/losses	$	132		$	45		$	87
Other Comprehensive Income (Loss)	$	1,525		$	518		$	1,007

25

(Dollars in Thousands)
	Before Tax			Tax Effect			Net of Tax
Three months ended September 30, 2013
Net unrealized losses on investment securities:
Net unrealized losses arising during the period	$	781		$	265		$	516
Less: reclassification adjustments for net gains realized in net income		(10	)	$	(3	)		(7	)
Net unrealized losses on investment securities	$	771		$	262		$	509
Net unrealized losses on investment securities:
Amortization of unrecognized prior service costs and net  actuarial gains/losses	$	43		$	15		$	28
Other Comprehensive Income (Loss)	$	814		$	277		$	537
Nine months ended September 30, 2013
Net unrealized losses on investment securities:
Net unrealized losses arising during the period	$	(1,901	)	$	(647	)	$	(1,254	)
Less: reclassification adjustments for net gains realized in net income		(363	)		(123	)		(240	)
Net unrealized losses on investment securities	$	(2,264	)	$	(770	)	$	(1,494	)
Net unrealized losses on investment securities:
Amortization of unrecognized prior service costs and net actuarial gains/losses	$	128		$	44		$	84
Other Comprehensive Income (Loss)	$	(2,136	)	$	(726	)	$	(1,410	)

NOTE 6 – STOCK BASED COMPENSATION

The Company’s 2011 Equity Incentive Plan, as amended (the “2011 Plan”), provides for the issuance of up to 900,000 shares in connection with incentive and nonqualified stock options, restricted stock, restricted stock units and other equity-based awards. Prior to adoption of the 2011 Plan, the Company made equity-based awards under the Company’s 2000 Stock Incentive Plan, which expired January 1, 2011.

Stock Options

The 2011 Plan authorizes the issuance of incentive and non-qualified stock options, as defined under current tax laws, to key personnel. Options granted under the 2011 Plan either become exercisable ratably over five years or in a single installment five years from the date of grant.

The Company uses the Black-Scholes option pricing model to calculate the fair value of stock option awards based on assumptions 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, 2014	6.5 years		2.11	%		23.24	%		3.27	%	$	1.02
September 30, 2013	6.5 years		1.35	%		23.04	%		4.14	%	$	0.57

26

A summary of stock option activity as of September 30, 2014 and 2013, 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, 2014
Outstanding beginning of period		625,495		$	9.53
Granted		22,500			6.13
Exercised		-			-
Forfeited		-			-
Expired		(70,400	)		15.17
Outstanding end of period		577,595		$	8.71		5.2	$	227,900
Exercisable end of period		295,495		$	11.43		3.3	$	42,875

	Shares			Weighted Average Exercise Price		Weighted Average Remaining Contractual Term (Years)		Aggregate Intrinsic Value
September 30, 2013
Outstanding beginning of period		537,107		$	11.28
Granted		183,500			5.03
Exercised		-			-
Forfeited		(33,275	)		9.25
Expired		(64,337	)		11.36
Outstanding end of period		622,995		$	9.54		5.4	$	114,450
Exercisable end of period		313,245		$	13.25		2.7	$	4,443

A summary of the status of the Company’s non-vested options as of September 30, 2014 and 2013 and changes during the nine months then ended, are presented below:

	September 30, 2014					September 30, 2013
	Shares			Weighted Average Fair Value		Shares			Weighted Average Fair Value
Non-vested beginning of period		296,650		$	0.47		147,280		$	0.31
Granted		22,500			1.02		183,500			0.57
Vested		(37,050	)		0.59		(2,275	)		0.65
Forfeited		-			-		(18,755	)		0.40
Non-vested end of period		282,100		$	0.50		309,750		$	0.45

27

The Company accounts for stock based compensation in accordance with GAAP, which requires measurement of compensation cost for all stock-based awards based on grant date fair value and recognition of compensation cost over the service period of each award.

Stock-based compensation expense
(Unaudited)
(Dollars in Thousands)
Nine months ended September 30, 2014	Before Tax		Tax Effect		Net of Tax
Recognized compensation expense	$	32	$	11	$	21

Nine months ended September 30, 2013	Before Tax		Tax Effect		Net of Tax
Recognized compensation expense	$	38	$	13	$	25

	September 30, 2014		September 30, 2013
Future compensation expense  (1)	$	70	$	90
Weighted Average Remaining Contractual Term (Years)		1.7		1.8

(1) related to non-vested stock options

28

Restricted Stock Units

The Company grants restricted stock units (“RSU”) to employees qualifying for awards under the Company’s Annual Incentive Compensation Plan. Recipients of RSUs will be issued a specified number of shares of common stock under the 2011 Plan upon the lapse of applicable restrictions. Outstanding RSUs are subject to forfeiture if the recipient’s employment terminates prior to the expiration of three years from the date of grant.

The following table summarizes RSU activity during the nine months ended September 30, 2014 and 2013:

	September 30, 2014
	Shares			Weighted Average Grant Price		Weighted Average Remaining Contractual terms (in years)
Outstanding, January 1, 2014		50,024
Granted		11,673		$	6.45
Exercised		(476	)		-
Forfeited		(944	)	$	5.27
Non-vested end of period		60,277					1.7

	September 30, 2013
	Shares			Weighted Average Grant Price		Weighted Average Remaining Contractual terms (in years)
Outstanding, January 1, 2013		16,059
Granted		35,476		$	4.93
Exercised		-
Forfeited		(1,511	)	$	-
Non-vested end of period		50,024					2.2

29

The following table summarizes RSU compensation expense during the nine months ended September 30, 2014 and 2013:

RSU compensation expense
(Unaudited)
(Dollars in Thousands)
Nine months ended September 30, 2014	Before Tax		Tax Effect		Net of Tax
RSU recognized compensation expense	$	74	$	25	$	49

Nine months ended September 30, 2013	Before Tax		Tax Effect		Net of Tax
RSU recognized compensation expense	$	46	$	16	$	30

	September 30, 2014		September 30, 2013
Future compensation expense  (1)	$	174	$	193

(1) related to non-vested RSU's

NOTE 7 – COMMITMENTS AND CONTINGENCIES

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

The Bank’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amount of those instruments. The Bank uses the same credit policies in making commitments and conditional obligations as they do for on-balance-sheet instruments. A summary of the Bank’s off-balance sheet commitments at September 30, 2014 and December 31, 2013 is as follows:

(Dollars in Thousands)
	September 30, 2014		December 31, 2013
Commitments to extend credit	$	96,817	$	106,017
Standby letters of credit	$	1,351	$	1,733

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

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

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

30

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

NOTE 8 – FAIR VALUE MEASUREMENTS

Fair Value Hierarchy

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

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

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

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

Investment Securities Available-for-Sale

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

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

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

On a quarterly basis, management reviews the pricing information received from the third party-pricing service through a combination of procedures that include an evaluation of methodologies used by the pricing service, analytical reviews and performance analyses of the prices against statistics and trends and maintenance of an investment watch list. Based on this review, management determines whether the current placement of the security in the fair value hierarchy is appropriate or whether transfers may be warranted. As necessary, the Company compares prices received from the pricing service to discounted cash flow models or through performing independent valuations of inputs and assumptions similar to those used by the pricing service in order to ensure prices represent a reasonable estimate of fair value. Although the Company does identify differences from time to time as a result of these validation procedures, the Company did not make any significant adjustments as of September 30, 2014 or December 31, 2013.

31

The following table presents the balances of assets measured at fair value on a recurring basis at September 30, 2014 and December 31, 2013.

(Dollars in Thousands)	Fair Value Measurements
	At September 30, 2014
Description	Fair Value 09/30/2014		Quoted Prices in Active Markets for Identical Assets (Level 1)		Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Available-for-sale securities:
Collateralized mortgage obligations: agency issued	$	40,039	$	-	$	40,039	$	-
Collateralized mortgage obligations: non agency		579		-		579		-
Mortgage-backed securities: agency issued		12,499		-		12,499		-
U.S. Government agency securities		8,655		-		8,655		-
State and municipal securities		27,556		-		26,198		1,358
Total assets measured at fair value	$	89,328	$		$	87,970	$	1,358

	Fair Value Measurements
	At December 31, 2013
Description	Fair Value 12/31/2013		Quoted Prices in Active Markets for Identical Assets (Level 1)		Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Available-for-sale securities:
Collateralized mortgage obligations: agency issued	$	38,791	$	-	$	38,791	$	-
Collateralized mortgage obligations: non agency		2,011		-		2,011		-
Mortgage-backed securities: agency issued		13,389		-		13,389		-
U.S. Government agency securities		8,811		-		8,811		-
State and municipal securities		32,160		-		30,741		1,419
Corporate bonds		982		-		982		-
Total assets measured at fair value	$	96,144	$		$	94,725	$	1,419

As of September 30, 2014 and December 31, 2013, the Company had three investments classified as Level 3 investments which consist of local non-rated municipal bonds for which the Company is the sole owner of the entire bond issue. The valuation of these securities is supported by analysis prepared by an independent third party. Their approach to determining fair value involves using recently executed transactions and market quotations for similar securities. As these securities are not rated by the rating agencies and there is no trading volume, management determined that these securities should be classified as Level 3 within the fair value hierarchy. Additionally, these securities are considered sensitive to changes in credit given the unobserved assumed credit ratings.

The following table presents a reconciliation of assets that are measured at fair value on a recurring basis using significant unobservable inputs (Level 3) during the three and nine months ended September 30, 2014 and 2013, respectively. There were no transfers of assets into or out of Level 1, 2 or 3 for the three and nine months ended September 30, 2014.

(Dollars in Thousands)	Three months ended September 30,						Nine months ended September 30,
	2014			2013			2014			2013
Balance beginning of period	$	1,394		$	1,491			1,419		$	1,614
Principal paydowns		(61	)		(61	)		(92	)		(90	)
Change in FV (included in other comprehensive income)		25			(3	)		31			(97	)
Balance end of period	$	1,358		$	1,427			1,358		$	1,427

32

Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis

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

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

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

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

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

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

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

33

The following table presents the Company’s assets that were held at the end of each period that were measured at fair value on a nonrecurring basis during the nine months ended September 30, 2014 and year ended December 31, 2013:

(Dollars in Thousands)	Fair Value Measurements
	As of September 30, 2014
Description	Fair Value 09/30/2014		Quoted Prices in Active Markets for Identical Assets (Level 1)	Other Observable Inputs (Level 2)	Significant Unobservable Inputs (Level 3)
Other real estate owned and foreclosed assets	$	291	$	$	$	291
Loans measured for impairment, net of specific reserves		441				441
Total impaired assets measured at fair value	$	732	$	$	$	732

	Fair Value Measurements
	As of December 31, 2013
Description	Fair Value 12/31/2013		Quoted Prices in Active Markets for Identical Assets (Level 1)	Other Observable Inputs (Level 2)	Significant Unobservable Inputs (Level 3)
Other real estate owned and foreclosed assets	$	1,960	$	$	$	1,960
Loans measured for impairment, net of specific reserves		162				162
Total impaired assets measured at fair value	$	2,122	$	$	$	2,122

Other real estate owned with a pre-foreclosure loan balance of $652,000 was acquired during the nine months ended September 30, 2014. Upon foreclosure, write downs totaling $127,000 were applied to the allowance for credit losses during the period related to these assets.

The following table presents quantitative information about Level 3 inputs for financial instruments measured at fair value on a nonrecurring basis at September 30, 2014:

(Dollars in Thousands)
Description	Fair Value 09/30/2014		Valuation Technique	Significant Unobservable Inputs	Range (Weighted Average)
Other real estate owned and foreclosed assets	$	291	Appraised value	Adjustment for		0-10% (1.6%)
				market conditions
Loans measured for impairment, net of specific reserves	$	441	Appraised value	Adjustment for  market conditions		0-20% (2.8%)

Fair Value of Financial Instruments

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

Cash and due from banks, interest bearing deposits in banks, and certificates held for investment

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

Investment securities available-for-sale and held-to-maturity

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

34

Federal Home Loan Bank Stock

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

Pacific Coast Bankers’ Bancshares Stock

PCBB stock is carried at cost which approximates fair value and equals its par value based on the price per share paid at the capital offering concluded during the current quarter.

Loans, net and loans held for sale

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

Deposits

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

Borrowings

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

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.

35

The estimated fair value of the Company’s financial instruments at September 30, 2014 and December 31, 2013 is as follows:

(Dollars in Thousands)
	As of September 30, 2014
	Carrying Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total Fair Value
Financial assets:
Cash and cash equivalents	$	40,781	$	40,781	$	-	$	-	$	40,781
Interest-bearing certificates of deposit (original maturities greater than 90 days)		2,727		2,727		-		-		2,727
Investment securities available-for-sale		89,328		-		87,970		1,358		89,328
Investment securities held-to-maturity		1,857		-		1,874		-		1,874
Federal Home Loan Bank stock		2,926		-		2,926		-		2,926
Loans held-for-sale		8,161		-		8,161		-		8,161
Loans		543,885		-		-		517,498		517,498
Financial liabilities:
Deposits	$	644,004	$		$	644,518	$	-	$	644,518
Short-term borrowings		-		-		-		-		-
Long-term borrowings		11,491		-		10,145		-		10,145
Junior subordinated debentures		13,403		-		-		7,541		7,541

	As of December 31, 2013
	Carrying Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total Fair Value
Financial assets:
Cash and cash equivalents	$	35,948	$	35,948	$	-	$	-	$	35,948
Interest-bearing certificates of deposit (original maturities greater than 90 days)		2,727		2,727		-		-		2,727
Investment securities available-for-sale		96,144		-		94,725		1,419		96,144
Investment securities held-to-maturity		2,132		-		2,158		-		2,158
Federal Home Loan Bank stock		3,013		-		3,013		-		3,013
Loans held-for-sale		7,765		-		7,765		-		7,765
Loans		496,307		-		-		473,224		473,224
Financial liabilities:
Deposits	$	607,347	$		$	606,654	$	-	$	606,654
Short-term borrowings		-		-		-		-		-
Long-term borrowings		10,000		-		10,195		-		10,195
Junior subordinated debentures		13,403		-		-		7,646		7,646

NOTE 9 – JUNIOR SUBORDINATED DEBENTURES

At September 30, 2014, two wholly-owned subsidiary grantor trusts established by the Company had outstanding $13.0 million of 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 of trust preferred securities 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 mandatorily 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, at a redemption price specified in the indentures plus any accrued but unpaid interest to the redemption date.

36

The Debentures issued by the Company to the grantor trusts totaling $13.0 million 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 $403,000 in the consolidated balance sheet at September 30, 2014 for the common capital securities issued by the issuer trusts.

As of September 30, 2014, regular accrued interest on junior subordinated debentures totaled $40,000 and is included in accrued interest payable on the balance sheet. Following are the terms of the junior subordinated debentures as of September 30, 2014.

(Dollars in Thousands)
		Issued			Maturity
Trust Name	Issue Date	Amount		Rate	Date
Pacific Financial Corporation	December				March
Statutory Trust I	2005	$	5,000	LIBOR + 1.45% (1)	2036
Pacific Financial Corporation	June				July
Statutory Trust II	2006		8,000	LIBOR + 1.60% (2)	2036
		$	13,000

⁽¹⁾ Pacific Financial Corporation Statutory Trust I securities incurred interest at the fixed rate of 6.39% until mid March 2011, at which the rate changed to a variable rate of 3-month LIBOR (0.234% at September 11, 2014) plus 1.45% or 1.68%, adjusted quarterly, through the final maturity date in March 2036.

⁽²⁾ Pacific Financial Corporation Statutory Trust II securities incur interest at a variable rate of 3-month LIBOR (0.234% at July 11, 2014) plus 1.60% or 1.83%, adjusted quarterly, through the final maturity date in July 2036.

NOTE 10 – RECENTLY ISSUED ACCOUNTING STANDARDS

In June 2014, the FASB issued ASU No. 2014-11, Transfers and Servicing (Topic 860): Repurchase-to-Maturity Transactions, Repurchase Financings, and Disclosures. ASU 2014-11 changes the accounting for repurchase-to-maturity transactions and repurchase financing arrangements. It also requires additional disclosures about repurchase agreements and other similar transactions. The new guidance aligns the accounting for repurchase-to-maturity transactions and repurchase agreements executed as a repurchase financing with the accounting for other typical repurchase agreements. Going forward, these transactions would all be accounted for as secured borrowings. The ASU also requires new and expanded disclosures. This ASU is effective for the first interim or annual period beginning after December 15, 2014. The adoption of ASU No. 2014-11 is not expected to have a material impact on the Company's consolidated financial statements.

In June 2014, the FASB issued ASU No. 2014-12, Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved after the Requisite Service Period. ASU 2014-12 requires that a performance target that affects vesting and that could be achieved after the requisite service period be treated as a performance condition. A reporting entity should apply existing guidance in Topic 718, Compensation - Stock Compensation, as it relates to awards with performance conditions that affect vesting to account for such awards. The performance target should not be reflected in estimating the grant-date fair value of the award. Compensation cost should be recognized in the period in which it becomes probable that the performance target will be achieved and should represent the compensation cost attributable to the period(s) for which the requisite service has already been rendered. The amendments in this ASU can be applied prospectively or retrospectively and are effective for annual periods and interim periods within those annual periods beginning after December 15, 2015 with early adoption permitted. The Company is currently reviewing the requirements of ASU No. 2014-12, but does not expect the ASU to have a material impact on the Company's consolidated financial statements.

In May 2014, the FASB issued Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers (ASU 2014-09), which supersedes nearly all existing revenue recognition guidance under U.S. GAAP. The core principle of ASU 2014-09 is to recognize revenues when promised goods or services are transferred to customers in an amount that reflects the consideration to which an entity expects to be entitled for those goods or services. ASU 2014-09 defines a five step process to achieve this core principle and, in doing so, more judgment and estimates may be required within the revenue recognition process than are required under existing U.S. GAAP. The standard is effective for annual periods beginning after December 15, 2016, and interim periods therein, using either of the following transition methods: (i) a full retrospective approach reflecting the application of the standard in each prior reporting period with the option to elect certain practical expedients, or (ii) a retrospective approach with the cumulative effect of initially adopting ASU 2014-09 recognized at the date of adoption (which includes additional footnote disclosures). We are currently evaluating the impact of our pending adoption of ASU 2014-09 on our consolidated financial statements and have not yet determined the method by which we will adopt the standard in 2017.

37

In July 2013, FASB issued ASU No. 2013-11, "Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists." The provisions of ASU No. 2013-11 require an entity to present an unrecognized tax benefit, or portion thereof, in the statement of financial position as a reduction to a deferred tax asset for a net operating loss carryforward or a tax credit carryforward, with certain exceptions related to availability. ASU No. 2013-11 is effective for interim and annual reporting periods beginning after December 15, 2013. The adoption of ASU No. 2013-11 has not had a material impact on the Company's Consolidated Financial Statements.

NOTE 11 – BUSINESS COMBINATION

On January 28, 2013, the Bank and Sterling Savings Bank, a Washington state-chartered bank (“Sterling”), entered into a Purchase and Assumption Agreement (the “Agreement”) pursuant to which the Bank agreed to purchase from Sterling three branches located in Aberdeen, Washington; Astoria, Oregon; and Seaside, Oregon; including certain deposit liabilities, loans and other assets and liabilities associated with such branch locations.  The actual amount of loans and deposits, the value of other assets and liabilities transferred to the Bank and the actual price paid were determined at the time of the closing of the transaction on September 1, 2013, in accordance with the terms of the Agreement.  The purchase price was $976,000 and exceeded the estimated fair value of tangible net assets acquired by approximately $1.1 million, which was recorded as goodwill and intangible assets.

Cash flow information relative to the agreement is as follows (in thousands):

Fair value of tangible net assets acquired	$	37,533
Cash paid for deposit premium		(976	)
Liabilities assumed		(37,684	)
Goodwill and intangible assets recorded	$	1,127

The primary purposes of the acquisition are to expand the Company’s market share in the northern Oregon coast, to provide existing customers with added convenience and service, and to provide our new customers with the opportunity to enjoy the outstanding personalized service and commitment of our community-based bank.

Fair value adjustments and related goodwill were recorded in the statement of financial condition of the Company.  The following is a condensed balance sheet disclosing the estimated fair value amounts of the acquired branches of Sterling assigned to the major consolidated asset and liability captions at the acquisition date (in thousands):

Cash and cash equivalents	$	31,941
Loans receivable		3,989
Premises and equipment		604
Goodwill and intangible assets		1,127
Other assets		23
Total assets	$	37,684
Deposits and accrued interest payable	$	37,636
Deferred tax liability		47
Other liabilities		1
Total liabilities and shareholders’ equity	$	37,684

The core deposit intangible asset that was recognized as part of the business combination was $242,000 and will be amortized over its estimated useful life of approximately ten years utilizing an accelerated method. The goodwill of $885,000 will not be amortized for financial statement purposes; instead, it will be reviewed annually for impairment.

38

The fair value of savings and transaction deposit accounts acquired from Sterling was assumed to approximate the carrying value as these accounts have no stated maturity and are payable on demand.  Certificates of deposit were valued by comparing the contractual cost of the portfolio to an identical portfolio bearing current market rates.  The projected cash flows from maturing certificates were calculated based on contractual rates.  The fair value of certificates of deposit was calculated by discounting their contractual cash flows at a market rate for a certificate of deposit with a corresponding maturity.

Direct costs related to the Sterling acquisition were expensed as incurred in the year ended December 31, 2013.  These acquisition and integration expenses included salaries and benefits, technology and communications, occupancy and equipment, professional services and other noninterest expenses.  For the year ended December 31, 2013, the Company incurred $615,000 of expenses related to acquisition costs.

NOTE 12 – GOODWILL

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

During the second quarter of 2014, the Company initiated its annual goodwill impairment test to determine whether an impairment of its goodwill asset exists. The test was completed during the current quarter. The goodwill impairment test involves a two-step process.  The first step is a comparison of the reporting unit’s fair value to its carrying value. If the reporting unit’s fair value is less than its carrying value, the Company is required to progress to the second step. In the second step the Company calculates the implied fair value of its reporting unit and, in accordance with applicable GAAP standards, compares the implied fair value of goodwill to the carrying amount of goodwill on the Company’s balance sheet.  If the carrying amount of the goodwill is greater than the implied fair value of that goodwill, an impairment loss must be recognized in an amount equal to that excess.  The implied fair value of goodwill is determined in the same manner as goodwill recognized in a business combination.  The estimated fair value of the Company is allocated to all of the Company’s individual assets and liabilities, including any unrecognized identifiable intangible assets, as if the Company had been acquired in a business combination and the estimated fair value of the Company is the price paid to acquire it. The allocation process is performed only for purposes of determining whether a goodwill impairment exists and the amount of any such impairment. No assets or liabilities are written up or down, nor are any additional unrecognized identifiable intangible assets recorded as a part of this process.

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

As part of our process for performing the step one impairment test of goodwill, the Company estimated the fair value of the reporting unit utilizing the income approach and the market approach in order to derive an enterprise value of the Company. In determining the discount rate for the discounted cash flow model, the Company used a modified capital asset pricing model that develops a rate of return utilizing a risk-free rate and equity risk premium resulting in a discount rate of 12.0%. This approach also includes adjustments for the industry the Company operates in and size of the Company. In addition, assumptions used by the Company in its discounted cash flow model (income approach) included an average annual revenue growth rate that approximated 23%; an asset growth of 4.4% in years one through five; net interest margin ranging from 4.02% in the base year to 4.24% in year five; and a return on assets that ranged from 0.62% to 1.24%.

In applying the market approach method, the Company considered all banks that announced a sale between January 1, 2013 and September 30, 2014, with total assets under $5 billion and a return on assets greater than zero. This resulted in selecting 24 institutions which fit these criteria.  After selecting these institutions, the Company derived the fair value of the reporting unit by completing a comparative analysis of the relationship between their financial metrics listed above and their market values utilizing various market multiples.  Focus was placed on the price to tangible book value of equity multiple as this multiple generally reflects returns on the capital employed within the industry and is generally correlated with the profitability of each individual company.

39

The Company concluded its reporting unit had a fair value of $8.50 per share, or $86.6 million, after giving similar consideration to the values derived from 1) the market approach of $8.20 per share weighted at 80%, and 2) the income approach of $9.67 per share million weighted at 20%. This estimate compares to a carrying value of its reporting unit of $70.9 million. Accordingly, following step one of the Company’s goodwill impairment test, the Company concluded that its reporting unit’s fair value exceeded its carrying value and no goodwill impairment existed.

Even though the Company determined that there was no goodwill impairment, a future impairment charge may be necessary if our stock price declines, market values of others in the financial industry decrease, the Bank’s revenue falls, or there are significant adverse changes in the operating environment for the financial industry. It is also possible that changes in circumstances existing now or in the future, or in the numerous estimates, judgments, and assumptions made by management in assessing the fair value of our goodwill, could result in a future goodwill impairment. If the Company records an impairment charge, its financial position and results of operations would be adversely affected; however, such an impairment charge would have no impact on liquidity, day-to-day operations or regulatory capital.

NOTE 13 – INCOME TAXES

The Company recorded an income tax provision for the three months ended September 30, 2014, June 31, 2014 and September 30, 2013. The amount of the provision for each period was commensurate with the estimated tax liability associated with the net income earned during the period. As of September 30, 2014, the Company maintained a deferred tax asset balance of $4.1 million. The Company believes it will be fully utilized in the normal course of business, thus no valuation allowance is maintained against this asset.

The Company's provision for income taxes includes both federal and state income taxes and reflects the application of federal and state statutory rates to the Company's income before taxes. The principal difference between statutory tax rates and the Company's effective tax rate is the benefit derived from investing in tax-exempt securities and bank owned life insurance.

Income taxes are accounted for using the asset and liability method. Under this method a deferred tax asset or liability is determined based on the enacted tax rates which will be in effect when the differences between the financial statement carrying amounts and tax basis of existing assets and liabilities are expected to be reported in the Company’s income tax returns. The effect on deferred taxes of a change in tax rates is recognized in income in the period that includes the enactment date. Valuation allowances are established to reduce the net carrying amount of deferred tax assets if it is determined to be more likely than not, that all or some portion of the potential deferred tax asset will not be realized.

The Company applies the provisions of FASB ASC 740, Income Taxes, relating to the accounting for uncertainty in income taxes. The Company periodically reviews its income tax positions based on tax laws and regulations, and financial reporting considerations, and records adjustments as appropriate. This review takes into consideration the status of current taxing authorities’ examinations of the Company’s tax returns, recent positions taken by the taxing authorities on similar transactions, if any, and the overall tax environment. The Company’s uncertain tax positions were nominal in amount as of September 30, 2014.

40

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

The following discussion should be read in conjunction with the audited consolidated financial statements and related notes to those statements of Pacific Financial Corporation (“Company”) that appear under the heading “Financial Statements and Supplementary Data” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2013 (“2013 10-K”), as well as the unaudited consolidated financial statements for the current quarter found under Item 1 above.

DISCLOSURE REGARDING FORWARD LOOKING STATEMENTS

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," “will”, "expects," "anticipates," "intends," "plans," "estimates" or similar expressions.

Any forward-looking statements in this document are subject to the risks of our business, including risk factors described in our 2013 10-K, as well as risks relating to, among other things, the following:

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

· economic or business conditions, nationally and in the regions in which we do business that may result in, among other things, reduced demand for credit and other banking services, lower credit quality and additional workout and other real estate owned (“OREO”) expenses;

· 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;

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

· 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; and

· integration of three bank branches and related assets acquired from Sterling that may cost more or be less beneficial to us than expected.

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.

Third Quarter 2014 Highlights (as of, or for the period ended September 30, 2014, except as noted):

• Earnings per share (“EPS”) declined by 7% to $0.13, compared to $0.14 in second quarter 2014, primarily due more shares outstanding reflecting the exercise of warrants during the quarter. EPS grew 44% from $0.09 in third quarter 2013. Year-to-date, EPS increased 28% to $0.37, from $0.29 for the same period in 2013.

• Net interest income increased $86,000, or 1%, to $6.9 million, compared to $6.8 million in second quarter 2014, and grew $867,000, or 14%, from $6.0 million in third quarter 2013. For the first nine months of 2014, net interest income increased $2.7 million, or 15%, to $20.2 million, from $17.5 million for the like period in 2013.

41

• Net interest margin (NIM) was 4.13%, compared to 4.28% for the preceding quarter, and 3.88% for third quarter 2013. Year-to-date, net interest margin expanded 23 basis points to 4.22%, compared to 3.99% for the first nine months of 2013.

• Gross loans grew to $552.1 million, an increase of $4.8 million, or 1% from $547.3 million at June 30, 2014, and up 13% from $486.7 million at September 30, 2013.

• Nonperforming assets declined to $6.4 million, or 0.86% of total assets, down from $7.4 million, or 1.03% of total assets, at June 30, 2014 and $12.4 million, or 1.73% of total assets at September 30, 2013.

• Classified loans increased to $18.4 million, or 3.33% of gross loans, up from $16.0 million, or 2.91% of gross loans, at June 30, 2014, and $13.7 million, or 2.82% of gross loans at September 30, 2013.

• Net charge-offs totaled $160,000, compared to $73,000 in second quarter 2014 and $156,000 for third quarter 2013. Year-to-date, net charge-offs were $304,000, compared to $102,000 for the first nine months of 2013.

• Capital levels exceeded regulatory requirements for a well-capitalized financial institution, with a total risk-based capital ratio of 14.06% and a leverage ratio of 10.09% at quarter end.

OPERATING RESULTS

Net Interest Income

Net interest income for the quarter and nine months ended September 30, 2014, increased from the quarter and nine months ended September 30, 2013. This increase was primarily due to the growth in earning assets, along with changes in the balance sheet mix. Loan balances increased due to the production generated predominately in Western Washington. Investment securities and federal funds sold decreased as a proportion of the balance sheet due to the strong loan demand during the past several quarters. Funding costs remained low due to the shift in mix toward non-interest bearing and lower-cost deposits, and continued historically low interest rates.

Net interest income for the current quarter increased from the second quarter of 2014, reflecting higher loan balances and lower levels of investments. While funding costs declined slightly when comparing the periods, given the lengthy period of very low interest rates over the past several years, additional reductions in funding costs are becoming more difficult to achieve as renewing certificates of deposit are receiving rates that are similar to those granted at previous renewals.

Certain reclassifications have been made to the June 31, 2014 and September 30, 2013 financial table presentations to conform to current year presentations. These reclassifications have no effect on previously reported net income per share.

42

INCOME STATEMENT OVERVIEW

(Unaudited)

(Dollars in Thousands, Except for Income per Share Data)

	For the Three Months Ended September 30, 2014		For the Three Months Ended June 30, 2014		$ Change			% Change			For the Three Months Ended September 30, 2013		$ Change			% Change
Interest and dividend income	$	7,400	$	7,337	$	63			1	%	$	6,605	$	795			12	%
Interest expense		518		541		(23	)		-4	%		590		(72	)		-12	%
Net interest income		6,882		6,796		86			1	%		6,015		867			14	%
Loan loss provision		100		100		-			0	%		-		100			100	%
Non-interest income		2,274		2,176		98			5	%		2,232		42			2	%
Non-interest expense		7,133		7,066		67			1	%		7,089		44			1	%
INCOME BEFORE PROVISION FOR INCOME TAXES		1,923		1,806		117			6	%		1,158		765			66	%
PROVISION FOR INCOME TAXES		549		403		146			36	%		249		300			120	%
NET INCOME	$	1,374	$	1,403	$	(29	)		-2	%	$	909	$	465			51	%
INCOME PER COMMON SHARE:
BASIC (1)	$	0.13	$	0.14	$	(0.01	)		-7	%	$	0.09	$	0.04			44	%
DILUTED (2)	$	0.13	$	0.14	$	(0.01	)		-7	%	$	0.09	$	0.04			44	%
Average common shares outstanding - basic (1)		10,281,745		10,189,386		92,359			1	%		10,121,853		159,892			2	%
Average common shares outstanding - diluted (2)		10,379,166		10,275,628		103,538			1	%		10,194,826		184,340			2	%

	For the Nine Months Ended September 30, 2014		For the Nine Months Ended September 30, 2013			$ Change			% Change
Interest and dividend income	$	21,821		19,476			2,345			12	%
Interest expense		1,589		1,927			(338	)		-18	%
Net interest income		20,232		17,549			2,683			15	%
Loan loss provision		200		(450	)		650			-144	%
Non-interest income		6,058		8,033			(1,975	)		-25	%
Non-interest expense		21,028		22,380			(1,352	)		-6	%
INCOME BEFORE PROVISION FOR INCOME TAXES		5,062		3,652			1,410			39	%
PROVISION FOR INCOME TAXES		1,257		710			547			77	%
NET INCOME	$	3,805		2,942			863			29	%
INCOME PER COMMON SHARE:
BASIC (1)	$	0.37		0.29			0.08			28	%
DILUTED (2)	$	0.37		0.29			0.08			28	%
Average common shares outstanding - basic (1)		10,218,103		10,121,853			96,250			1	%
Average common shares outstanding - diluted (2)		10,309,436		10,179,928			129,508			1	%

The following tables provide reconciliations of net income to pre-tax, pre-credit cost operating income and to tax equivalent pretax income (each non-GAAP financial measures) for the periods presented:

Reconciliation of Non-GAAP Measure:
Non-GAAP Operating Income
(Dollars in Thousands)
For The Three Months Ended	September 30, 2014		June 30, 2014		$ Change			% Change			September 30, 2013		$ Change			% Change
Net income	$	1,374	$	1,403	$	(29	)		-2	%	$	909	$	465			51	%
Provision for loan losses		100		100		0			0	%		-		100			100	%
Other real estate owned write-downs		1		54		(53	)		-98	%		176		(175	)		-99	%
Other real estate owned operating costs		100		30		70			233	%		67		33			49	%
Provision for income taxes		549		403		146			36	%		249		300			120	%
Pre-tax, pre-credit cost operating income*	$	2,124	$	1,990	$	134			7	%	$	1,401	$	723			52	%

For The Nine Months Ended	September 30, 2014		September 30, 2013			$ Change			% Change
Net income	$	3,805	$	2,942		$	863			29	%
Provision for loan losses		200		(450	)		650			-144	%
Other real estate owned write-downs		67		636			(569	)		-89	%
Other real estate owned operating costs		191		276			(85	)		-31	%
Provision for income taxes		1,257		710			547			77	%
Pre-tax, pre-credit cost operating income*	$	5,520	$	4,114		$	1,406			34	%

43

Reconciliation of Non-GAAP Measure:

Tax Equivalent Income

(Dollars in Thousands)

For the Three Months ended	September 30, 2014			June 30, 2014			$ Change			% Change			September 30, 2013			$ Change			% Change
Net interest income	$	6,882		$	6,796		$	86			1	%	$	6,015		$	867			14	%
Tax equivalent adjustment for municipal loan interest		45			46			(1	)		-2	%		46			(1	)		-2	%
Tax equivalent adjustment for municipal bond interest		94			120			(26	)		-22	%		121			(27	)		-22	%
Tax equivalent net interest income		7,021			6,962			59			1	%		6,182			839			14	%
Provision for loan losses		100			100			-			0	%		-			100			100	%
Non-interest income		2,274			2,176			98			5	%		2,232			42			2	%
Non-interest expense		7,133			7,066			67			1	%		7,089			44			1	%
Tax equivalent income before income taxes*		2,062			1,972			90			5	%		1,325			737			56	%
Provision for income taxes		549			403			146			36	%		249			300			120	%
Accumulative tax adjustment		(139	)		(166	)		27			-16	%		(167	)		28			-17	%
Common stock dividends		-			-			-			0	%		-			-			0	%
Net income	$	1,374		$	1,403		$	(29	)		-2	%	$	909		$	465			51	%

For the Nine Months ended	September 30, 2014			September 30, 2013			$ Change			% Change
Net interest income	$	20,232		$	17,549		$	2,683			15	%
Tax equivalent adjustment for municipal loan interest		138			163			(25	)		-15	%
Tax equivalent adjustment for municipal bond interest		332			392			(60	)		-15	%
Tax equivalent net interest income		20,702			18,104			2,598			14	%
Provision for loan losses		200			(450	)		650			-144	%
Non-interest income		6,058			8,033			(1,975	)		-25	%
Non-interest expense		21,028			22,380			(1,352	)		-6	%
Tax equivalent income before income taxes*		5,532			4,207			1,325			31	%
Provision for income taxes		1,257			710			547			77	%
Accumulative tax adjustment		(470	)		(555	)		85			-15	%
Common stock dividends		-			-			-			0	%
Net income	$	3,805		$	2,942		$	863			29	%

*Pre-tax, pre-credit cost operating income and tax equivalent income before income taxes are non-GAAP financial measures. Non-GAAP financial measures have inherent limitations and are not required to be uniformly applied. Management believes that presentation of these non-GAAP financial measures provides useful information that is frequently used by shareholders and analysts in the evaluation of financial institutions. Non-GAAP financial measures have limitations as analytical tools and should not be considered in isolation or as a substitute for information reported in accordance with GAAP.

Noninterest Income

Noninterest income for third quarter 2014 grew compared to both the preceding and year ago quarters, reflecting increases in gains from sales of loans over the preceding quarter. Gains on sale of residential mortgage loans and related fee income rose in third quarter 2014 compared to second quarter 2014, and was similar to that earned in third quarter 2013. The recent rebound in home purchases throughout many of our markets is fueling new residential mortgage originations. In addition, fee income from annuity sales increased in the current quarter compared to the second quarter of 2013, but was down slightly from the prior quarter due to seasonal factors. Losses on sale of other real estate owned (“OREO”) were higher in the current period as compared to the prior quarter and were in contrast to a small gain in third quarter in 2013, reflecting a more aggressive approach to pricing in order to reduce the levels of OREO. In addition, gains on our securities available for sale portfolio in third quarter 2014 and third quarter 2013 were taken to improve the credit quality of securities in the portfolio and to reduce interest rate risk.

Noninterest income for the first nine months of 2014 was down from the same period in 2013, reflecting the declines in gains on sale of residential mortgage loans due to the slowdown in refinancing activity that occurred in the second half of 2013 and higher losses on sale of OREO.

44

Noninterest income

(Unaudited)

(Dollars in Thousands)

For The Three Months Ended
	September 30, 2014			June 30, 2014			$ Change			% Change			September 30, 2013			$ Change			% Change
Service charges on deposit accounts	$	450		$	474		$	(24	)		-5	%	$	440		$	10			2	%
Net (loss) on sale of other real estate owned		(85	)		(57	)		(28	)		49	%		18			(103	)		-572	%
Net gains from sales of loans		1,120			968			152			16	%		1,128			(8	)		-1	%
Net gains on sales of securities available for sale		38			(2	)		40			-2000	%		14			24			171	%
Net other-than-temporary impairment (net of $0, $0, and $7, respectively recognized other comprehensive income before taxes)		-			(3	)		3			-100	%		(4	)		4			-100	%
Earnings on bank owned life insurance		127			140			(13	)		-9	%		105			22			21	%
Other operating income
Fee income		498			442			56			13	%		421			77			18	%
Income from other real estate owned		6			17			(11	)		-65	%		22			(16	)		-73	%
Other non-interest income		120			197			(77	)		-39	%		88			32			36	%
Total non-interest income	$	2,274		$	2,176		$	98			5	%	$	2,232		$	42			2	%

For The Nine Months Ended
	September 30, 2014			September 30, 2013			$ Change			% Change
Service charges on deposit accounts	$	1,359		$	1,281		$	78			6	%
Net (loss) on sale of other real estate owned		(179	)		43			(222	)		-516	%
Net gains from sales of loans		2,717			4,306			(1,589	)		-37	%
Net gains on sales of securities available for sale		88			401			(313	)		-78	%
Net other-than-temporary impairment (net of $15, and $2, respectively recognized other comprehensive income before taxes)		(48	)		(38	)		(10	)		26	%
Earnings on bank owned life insurance		378			342			36			11	%
Other operating income
Fee income		1,304			1,392			(88	)		-6	%
Income from other real estate owned		34			51			(17	)		-33	%
Other non-interest income		405			255			150			59	%
Total non-interest income	$	6,058		$	8,033		$	(1,975	)		-25	%

Noninterest Expense

Noninterest expense for third quarter of 2014 was virtually unchanged as compared to the second quarter of 2014. Decreases in OREO write-downs were offset by increased operating costs associated with acquisitions into OREO during the current quarter.

Noninterest expense for third quarter 2014 was virtually unchanged compared to the year ago quarter. Salary and benefits expense increased with the addition of loan production personnel and branch staff for the new branch that opened in the fourth quarter of 2013. Total costs associated with OREO and related third-party loan expenses decreased due to the decline in OREO balances and stabilization of valuations. Other non-interest expenses also declined primarily due to a decrease in loan origination and appraisal expense associated with a decline in mortgage origination activity.

Noninterest expense for the first nine months of 2014 was down as compared to the same period in 2013, because of the $471,000 savings generated from reduction in mortgage lending staff initiated in first quarter 2014 prompted by the decline in residential mortgage loan refinance activity. Also, in second quarter 2013 the Bank incurred one-time expenses of $395,000 in data processing conversion costs relating to three branches acquired from Sterling Savings Bank in June 2013. In addition, OREO write-downs and expenses and loan origination and appraisal expense were down as compared to the prior period for reasons noted above.

45

Noninterest expense

(Unaudited)

(Dollars in Thousands)

For The Three Months Ended
	September 30, 2014		June 30, 2014		$ Change			% Change			September 30, 2013		$ Change			% Change
Salaries and employee benefits	$	4,286	$	4,283	$	3			0	%	$	4,098	$	188			5	%
Occupancy		483		504		(21	)		-4	%		473		10			2	%
Equipment		261		263		(2	)		-1	%		233		28			12	%
Data processing		492		462		30			6	%		449		43			10	%
Professional services		220		201		19			9	%		198		22			11	%
Other real estate owned write-downs		1		54		(53	)		-98	%		176		(175	)		-99	%
Other real estate owned operating costs		100		30		70			233	%		67		33			49	%
State taxes		110		107		3			3	%		110		0			0	%
FDIC and state assessments		119		129		(10	)		-8	%		129		(10	)		-8	%
Other non-interest expense:
Director fees		80		72		8			11	%		48		32			67	%
Communication		65		53		12			23	%		42		23			55	%
Advertising		73		76		(3	)		-4	%		76		(3	)		-4	%
Professional liability insurance		24		19		5			26	%		21		3			14	%
Amortization		99		98		1			1	%		116		(17	)		-15	%
Other non-interest expense		720		715		5			1	%		853		(133	)		-16	%
Total non-interest expense	$	7,133	$	7,066	$	67			1	%	$	7,089	$	44			1	%

For The Nine Months Ended
	September 30, 2014		September 30, 2013		$ Change			% Change
Salaries and employee benefits	$	12,624	$	12,983	$	(359	)		-3	%
Occupancy		1,494		1,338		156			12	%
Equipment		775		619		156			25	%
Data processing		1,387		1,688		(301	)		-18	%
Professional services		606		696		(90	)		-13	%
Other real estate owned write-downs		67		636		(569	)		-89	%
Other real estate owned operating costs		191		276		(85	)		-31	%
State taxes		314		360		(46	)		-13	%
FDIC and state assessments		381		395		(14	)		-4	%
Other non-interest expense:
Director fees		208		164		44			27	%
Communication		155		130		25			19	%
Advertising		227		222		5			2	%
Professional liability insurance		65		67		(2	)		-3	%
Amortization		291		311		(20	)		-6	%
Other non-interest expense		2,243		2,495		(252	)		-10	%
Total non-interest expense	$	21,028	$	22,380	$	(1,352	)		-6	%

46

SUMMARY BALANCE SHEET OVERVIEW

(Unaudited)

(Dollars in Thousands)

	September			June						%			September						%
	30, 2014			30, 2014			$ Change			Change			30, 2013			$ Change			Change
Assets:
Cash and cash equivalents	$	40,781		$	17,694		$	23,087			130	%	$	69,657		$	(28,876	)		-41	%
Interest-bearing certificates of deposit		2,727			2,727			0			0	%		1,735			992			57	%
Federal Home Loan Bank stock, at cost		2,926			2,956			(30	)		-1	%		3,041			(115	)		-4	%
Pacific Coast Bankers' Bank stock, at cost		1,000			0			1,000			-			0			1,000			-
Investment securities		91,185			90,583			602			1	%		94,129			(2,944	)		-3	%
Loans held-for-sale		8,161			7,632			529			7	%		7,266			895			12	%
Gross loans, net of deferred fees		552,140			547,283			4,857			1	%		486,700			65,440			13	%
Allowance for loan losses		(8,255	)		(8,315	)		60			-1	%		(8,806	)		551			-6	%
Net loans		543,885			538,968			4,917			1	%		477,894			65,991			14	%
Other assets		58,382			58,912			(530	)		-1	%		62,026			(3,644	)		-6	%
Total assets	$	749,047		$	719,472		$	29,575			4	%	$	715,748		$	33,299			5	%
Liabilities and shareholders' equity
Total deposits	$	644,004		$	619,301		$	24,703			4	%	$	618,918		$	25,086			4	%
Accrued interest payable		141			151			(10	)		-7	%		182			(41	)		-23	%
Borrowings		24,894			23,743			1,151			5	%		23,403			1,491			6	%
Other liabilities		6,751			5,417			1,334			25	%		4,909			1,842			38	%
Shareholders' equity		73,257			70,860			2,397			3	%		68,336			4,921			7	%
Total liabilities and shareholders' equity	$	749,047		$	719,472		$	29,575			4	%	$	715,748		$	33,299			5	%

Cash and Cash Equivalents and Investment Securities

(Unaudited)

(Dollars in Thousands)

	September 30, 2014		% of Total			June 30, 2014		% of Total			$ Change			% Change			September 30, 2013		% of Total			$ Change			% Change
Cash and due from banks	$	15,284		11	%	$	17,455		15	%	$	(2,171	)		-12	%	$	15,494		9	%	$	(210	)		-1	%
Cash equivalents:
Interest-bearing deposits		25,497		18	%		239		0	%		25,258			10568	%		54,163		32	%		(28,666	)		-53	%
Interest-bearing certificates of deposit		2,727		2	%		2,727		2	%		-			0	%		1,735		1	%		992			57	%
Total cash equivalents and certificate of deposits		43,508		31	%		20,421		18	%		23,087			113	%		71,392		42	%		(27,884	)		-39	%
Investment securities:
Collateralized mortgage obligations: agency issued		40,039		29	%		38,822		34	%		1,217			3	%		34,482		20	%		5,557			16	%
Collateralized mortgage obligations: non-agency issued		579		0	%		604		1	%		(25	)		-4	%		2,179		1	%		(1,600	)		-73	%
Mortgage-backed securities: agency issued		12,630		9	%		12,059		11	%		571			5	%		12,972		8	%		(342	)		-3	%
U.S. Government and agency securities		8,655		6	%		8,721		8	%		(66	)		-1	%		8,859		5	%		(204	)		-2	%
State and municipal securities		29,282		21	%		30,377		27	%		(1,095	)		-4	%		35,042		21	%		(5,760	)		-16	%
Corporate bonds		-		0	%		-		0	%		-			0	%		595		0	%		(595	)		-100	%
FHLB Stock		2,926		2	%		2,956		3	%		(30	)		-1	%		3,041		2	%		(115	)		-4	%
Pacific Coast Bankers' Bank stock, at cost		1,000		1	%		-		0	%		1,000			100	%		-		0	%		1,000			100	%
Total investment securities		95,111		69	%		93,539		82	%		1,572			2	%		97,170		58	%		(2,059	)		-2	%
Total cash equivalents and investment securities	$	138,619		100	%	$	113,960		100	%	$	24,659			22	%	$	168,562		100	%	$	(29,943	)		-18	%
Total cash equivalents and investment securities as a % of total assets				19	%				16	%										24	%

47

Investment securities and interest-bearing certificates of deposit

(Unaudited)
(Dollars in Thousands)
For the Three Months Ended	September 30, 2014			June 30, 2014			$ Change			% Change			September 30, 2013			$ Change			% Change
Balance beginning of period	$	96,266		$	102,951		$	(6,685	)		-6	%	$	94,855		$	1,411			1	%
Principal purchases		7,482			3,806			3,676			97	%		10,772			(3,290	)		-31	%
Proceeds from sales		(3,927	)		(8,979	)		5,052			-56	%		(3,067	)		(860	)		28	%
Principal paydowns, maturities, and calls		(1,673	)		(2,144	)		471			-22	%		(4,266	)		2,593			-61	%
Gains on sales of securities		94			159			(65	)		-41	%		57			37			65	%
Losses on sales of securities		(56	)		(161	)		105			-65	%		(43	)		(13	)		30	%
OTTI loss writedown		-			(3	)		3			-100	%		13			(13	)		-100	%
Change in unrealized gains (loss) before tax		(64	)		903			(967	)		-107	%		770			(834	)		-108	%
Amortization and accretion of discounts and premiums		(284	)		(266	)		(18	)		7	%		(186	)		(98	)		53	%
Total investment portfolio	$	97,838		$	96,266		$	1,572			2	%	$	98,905		$	(1,067	)		-1	%

Liquidity remains strong based on the current levels of cash equivalents and investment securities. The Company maintains unsecured lines of credit totaling $16.0 million with correspondent banks, all of which are currently available. In addition, it has a secured borrowing facility with the Federal Home Loan Bank of Seattle of $143.8 million, of which $11.5 million is currently outstanding. In an effort to fund pending loan demand, cash equivalents were increased during the current quarter. In addition, some restructuring of the investment portfolio was conducted to reduce the impact of interest rate risk on securities valuation, resulting in a lowering of portfolio yields. The expected modified duration (adjusted for calls, consensus pre-payment speeds and rate adjustment dates) of the investment portfolio was 4.3 years at September 30, 2014, 4.5 years at June 30, 2014 and 4.4 years at September 30, 2013.

LOANS

Loan portfolio growth continues to be well diversified and generated predominately within our Washington and Oregon markets. This is despite a payoff of a $5.7 million non-owner occupied commercial real estate relationship during the current quarter. The portfolio includes $36.3 million in purchased government-guaranteed commercial and commercial real estate loans. In addition, the loan portfolio contains $25.3 million in indirect consumer loans to individuals with high credit scores to finance luxury and classic cars as a part of a strategy to diversify the loan portfolio.

Our ability to continue loan growth will be dependent on many factors, including the effects of competition, economic conditions in our markets, retention of key personnel and valued customers, and our ability to close loans in the pipeline. The Company manages new loan origination volume using concentration limits that establish maximum exposure levels by designated industry segment, real estate product types, geography, and single borrower limits.

Loans by category

(Unaudited)	September 30,			% of			June 30,			% of			$						September			% of			$
(Dollars in Thousands)	2014			Gross Loans			2014			Gross Loans			Change			% Change			30, 2013			Gross Loans			Change			% Change
Commercial and agricultural	$	112,873			20	%	$	109,368			20	%	$	3,505			3	%	$	94,471			19	%	$	18,402			19	%
Real estate:
Construction and development		25,419			5	%		32,071			6	%		(6,652	)		-21	%		29,538			6	%		(4,119	)		-14	%
Residential 1-4 family		94,101			17	%		90,549			17	%		3,552			4	%		85,625			18	%		8,476			10	%
Multi-family		20,554			4	%		20,110			4	%		444			2	%		13,846			3	%		6,708			48	%
Commercial real estate — owner occupied		122,090			22	%		117,203			21	%		4,887			4	%		106,670			22	%		15,420			14	%
Commercial real estate — non owner occupied		120,569			22	%		124,929			23	%		(4,360	)		-3	%		115,290			24	%		5,279			5	%
Farmland		22,926			4	%		23,900			4	%		(974	)		-4	%		24,002			5	%		(1,076	)		-4	%
Consumer		34,787			6	%		30,241			6	%		4,546			15	%		18,366			4	%		16,421			89	%
Gross loans		553,319			100	%		548,371			100	%		4,948			1	%		487,808			100	%		65,511			13	%
Less: allowance for loan losses		(8,255	)					(8,315	)					60						(8,806	)					551
Less: deferred fees		(1,179	)					(1,088	)					(91	)					(1,108	)					(71	)
Loans, net	$	543,885					$	538,968					$	4,917					$	477,894					$	65,991

The table provided below summarizes the Bank’s level of concentrations in commercial real estate as of September 30, 2014, December 31, 2013 and September 30, 2013, respectively, as defined in the Interagency Guidelines for Real Estate Lending and the Commercial Real Estate Lending Joint Guidance policy. The results displayed support the Company’s efforts to manage CRE concentrations in the loan portfolio.

48

Commercial Real Estate ("CRE")
Portfolio Policy Concentrations
	September 30, 2014			December 31, 2013			September 30, 2013			Guideline
Total Regulatory CRE1		224	%		231	%		226	%		300	%
Construction & Land Development CRE2		39	%		44	%		39	%		100	%

As a percent of total risk based capital ("TRBC")

¹Consists of CRE Const, CRE Residential SFR 1-4 Const, CRE Land Dev & Other Land, CRE NOO Term, C&I Loans not RE Secured to Finance CRE Activities

²Consists of CRE Const, CRE Residential SFR 1-4 Const, CRE Land Dev & Other Land

Commercial real estate markets continue to be vulnerable to financial and valuation pressures that may limit refinance options and negatively impact borrowers’ ability to perform under existing loan agreements. Declines in the value of commercial real estate or higher market interest rates may have a further adverse impact on the ability of borrowers with maturing loans to satisfy loan to value ratios required to renew such loans.

At September 30, 2014, the Bank had outstanding loan advances of $3.7 million to persons serving as directors, executive officers, principal stockholders and their related interests. This compares to $66,000 and $254,000 at December 31, 2013 and September 30, 2013, respectively. These loans were made in the ordinary course of business on substantially the same terms, including interest rates, maturities and collateral, as comparable loans made to customers not related to the Bank. None of these loans were on nonaccrual, past due or restructured as of September 30, 2014.

DEPOSITS

Total deposits were up at September 30, 2014, compared to the second quarter of this year and the third quarter a year ago. Non-interest bearing deposits grew due to seasonal inflows associated with increased business activity in our local markets with economies focused on summer tourism. Recent success in acquiring business deposit relationships in conjunction with the growth in lending achieved over the past year has also contributed to deposit growth. The combination of our efforts to reduce higher-cost time deposits through lowering interest rates paid and offering non-insured deposit products, when appropriate, reduced the average rate paid on total deposits in third quarter 2014 from third quarter 2013.

Total brokered deposits were $22.6 million at September 30, 2014, which included $2.5 million via reciprocal deposit arrangements. This compares to $22.9 million and $24.1 million at June 30, 2014 and September 30, 2013, respectively. In addition, the Company’s funding structure contains $11.5 million in borrowings from the Federal Home Loan Bank. The Company views the prudent use of brokered deposits and borrowings to be an appropriate funding tool to support interest rate risk mitigation strategies.

Deposits
(Unaudited)
(Dollars in Thousands)	September 30, 2014		Percent of Total			June 30, 2014		Percent of Total			$ Change			September 30, 2013		Percent of Total			$ Change
Interest-bearing demand and money market	$	266,863		41	%	$	268,480		43	%	$	(1,617	)	$	253,895		41	%	$	12,968
Savings		76,661		12	%		74,336		12	%		2,325			72,880		12	%		3,781
Time deposits		118,221		18	%		119,531		19	%		(1,310	)		135,979		22	%		(17,758	)
Total interest-bearing deposits		461,745		72	%		462,347		75	%		(602	)		462,754		75	%		(1,009	)
Non-interest bearing demand		182,259		28	%		156,954		25	%		25,305			156,164		25	%		26,095
Total deposits	$	644,004		100	%	$	619,301		100	%	$	24,703		$	618,918		100	%	$	25,086

49

Deposits and Borrowings

The following table summarizes the quarterly average dollar amount in each of the deposit and borrowing categories during the three months ended September 30, 2014, June 31, 2014 and September 30, 2013 as well as the nine months ended September 30, 2014 and 2013:

AVERAGE DEPOSITS AND BORROWINGS

(Unaudited)
(Dollars in Thousands)
Averages for the Three Months Ended	September 30, 2014		% of Total			June 30, 2014		% of Total			$ Change			% Change			September 30, 2013		% of Total			$ Change			% Change
Non-interest bearing demand deposits	$	170,560		26	%	$	150,776		24	%	$	19,784			2	%	$	138,875		22	%	$	31,685			4	%
Interest bearing demand		268,922		41	%		270,702		42	%		(1,780	)		-1	%		251,400		40	%		17,522			1	%
Savings		74,282		11	%		74,414		12	%		(132	)		-1	%		71,206		11	%		3,076			0	%
Time deposits		120,515		18	%		122,134		19	%		(1,619	)		-1	%		138,762		22	%		(18,247	)		-4	%
Total average interest bearing deposits		463,719		70	%		467,250		73	%		(3,531	)		-3	%		461,368		74	%		2,351			-4	%
Total average deposits	$	634,279				$	618,026				$	16,253					$	600,243				$	34,036
Average rate on total average deposits
Federal Home Loan Bank borrowings	$	10,878		2	%	$	10,000		2	%	$	878			0	%	$	10,000		2	%	$	878			0	%
Short term borrowings		587		0	%		6		0	%		581			0	%		-		0	%		587			0	%
Junior subordinated debentures		13,403		2	%		13,403		2	%		-			0	%		13,403		2	%		-			0	%
Total average borrowings	$	24,868		4	%	$	23,409		4	%	$	1,459					$	23,403		4	%	$	1,465			0	%
Total average interest-bearing liabilities	$	488,587				$	490,659				$	(2,072	)				$	484,771				$	3,816
Total average deposits and borrowings	$	659,147		100	%	$	641,435		100	%	$	17,712					$	623,646		100	%	$	35,501

Averages for the Nine Months Ended	September 30, 2014		% of Total			September 30, 2013		% of Total			$ Change			% Change
Non-interest bearing demand deposits	$	154,213		24	%	$	123,868		21	%	$	30,345			3	%
Interest bearing demand		267,060		42	%		244,141		41	%		22,919			1	%
Savings		74,473		12	%		67,651		11	%		6,822			1	%
Time deposits		123,140		19	%		136,863		23	%		(13,723	)		-4	%
Total average interest bearing deposits		464,673		72	%		448,655		75	%		16,018			-3	%
Total average deposits	$	618,886				$	572,523				$	46,363
Average rate on total average deposits
Federal Home Loan Bank borrowings	$	10,296		2	%	$	10,066		2	%	$	230			0	%
Short term borrowings		200		0	%		-		0	%		200			0	%
Junior subordinated debentures		13,403		2	%		13,403		2	%		-			0	%
Total average borrowings	$	23,899		4	%	$	23,469		4	%	$	430
Total average interest-bearing liabilities	$	488,572				$	472,124				$	16,448
Total average deposits and borrowings	$	642,785		100	%	$	595,992		100	%	$	46,793

Two wholly-owned subsidiary grantor trusts established by the Company had issued and outstanding $13.4 million of trust preferred securities and accrued interest. For additional information regarding these securities see the discussion under the subheadings “Junior Subordinated Debentures” included in Note 10 of the Company’s audited financial statements as presented in its 2013 Form10-K.

CAPITAL

Pacific Financial Corporation, and its subsidiary Bank of the Pacific, continue to meet the thresholds to be considered “well-capitalized” under regulatory requirements. Capital ratios increased slightly as compared to the prior quarter primarily due to earnings retention. Also, $1.2 million of additional capital was supplied via the exercise at a price of $6.50 per share of warrants to purchase 185,000 shares of common stock originally issued in conjunction with a private capital raise conducted in 2009. In general, capital ratios declined from September 30, 2013 due to the successful execution of the Company’s growth strategy and shift in the balance sheet mix to higher risk-weighted loan assets. However, the tangible common equity ratio grew due to the additional capital supplied via exercise of warrants, as previously mentioned.

50

The Board of Governors of the Federal Reserve System (“Federal Reserve”) and the FDIC have established minimum requirements for capital adequacy for bank holding companies and state non-member banks. For more information on these topics, see the discussions under the subheading “Capital Adequacy” in the section “Business” included in Item 1, of the Company’s 2013 Form 10-K. The following table summarizes the capital measures of the Company and the Bank, respectively, at the dates listed below.

The total risk based capital ratios of the Company include $13.4 million of junior subordinated debentures, all of which qualified as Tier 1 capital at September 30, 2014, under guidance issued by the Federal Reserve. The Company expects to continue to rely on these junior subordinated debentures as part of its regulatory capital.

	September 30, 2014			June 30, 2014			Change			September 30, 2013			Change			Regulatory Minimum to be "Well Capitalized"
																greater than or equal to
Pacific Financial Corporation
Total risk-based capital ratio		14.09	%		13.76	%		0.33			14.84	%		(0.75	)		10	%
Tier 1 risk-based capital ratio		12.83	%		12.51	%		0.32			13.59	%		(0.76	)		6	%
Leverage ratio		10.09	%		10.04	%		0.05			10.04	%		0.05			5	%
Tangible common equity ratio		8.11	%		8.11	%		-			7.79	%		0.32			n/a
Bank of the Pacific
Total risk-based capital ratio		13.87	%		13.73	%		0.14			14.85	%		(0.98	)		10	%
Tier 1 risk-based capital ratio		12.61	%		12.48	%		0.13			13.59	%		(0.98	)		6	%
Leverage ratio		9.91	%		10.01	%		(0.10	)		10.04	%		(0.13	)		5	%

51

FINANCIAL PERFORMANCE OVERVIEW
(Unaudited)
(Dollars in Thousands, Except per Share Data)
For The Three Months Ended
	September 30, 2014			June 30, 2014			Change			September 30, 2013			Change
Selective quarterly performance ratios
Return on average assets, annualized		0.74	%		0.79	%		(0.05	)		0.52	%		0.22
Return on average equity, annualized		7.55	%		8.04	%		(0.49	)		5.33	%		2.22
Efficiency ratio (1)		77.91	%		78.76	%		(0.85	)		85.96	%		(8.05	)
Share and per share information
Average common shares outstanding - basic		10,281,745			10,189,386			92,359			10,121,853			159,892
Average common shares outstanding - diluted		10,379,166			10,275,628			103,538			10,194,826			184,340
Basic income per common share		0.13			0.14			(0.01	)		0.09			0.04
Diluted income per common share		0.13			0.14			(0.01	)		0.09			0.04
Book value per common share (2)		7.07			6.94			0.13			6.75			0.32
Tangible book value per common share (3)		5.75			5.60			0.15			5.46			0.29

For The Nine Months Ended
	September 30, 2014			September 30, 2013			Change
Selective quarterly performance ratios
Return on average assets, annualized		0.71	%		0.59	%		0.12
Return on average equity, annualized		7.26	%		5.81	%		1.45
Efficiency ratio (1)		79.98	%		87.48	%		(7.50	)
Share and per share information
Average common shares outstanding - basic		10,218,103			10,121,853			96,250
Average common shares outstanding - diluted		10,309,436			10,179,928			129,508
Basic income per common share		0.37			0.29			0.08
Diluted income per common share		0.37			0.29			0.08

⁽¹⁾ Non-interest expense divided by net interest income plus non-interest income.

⁽²⁾ Book value is calculated as the total common equity divided by the period ending number of common shares outstanding.

⁽³⁾ Tangible book value is calculated as the total common equity less total intangible assets and liabilities divided by the period ending number of common shares outstanding.

Net Interest Margin

Net interest margin declined compared to second quarter of 2014, as reductions in investment securities and loan yields offset declines in deposit costs. Declines in yields on investment securities were primarily due to portfolio restructuring. Loan yield declines resulted from increased competition for high quality borrowing relationships in the marketplace. Net interest margin improved when compared to third quarter of 2013, predominantly due to a shift in the mix of earning assets toward higher-yielding loans and the lower cost of interest bearing liabilities. The growth in the proportion of noninterest bearing deposits over the past several quarters has supported the improvement in net interest margin as well. In second quarter 2014, loan yields and net interest margin were enhanced by 9 and 7 basis points, respectively, due to the collection of $115,000 in non-accrual interest during the period. There was no similar collection of non-accrual interest during the third quarter of 2014 or 2013.

The improvement in yields on investment securities also enhanced net interest margin between the nine months ending September 30, 2014 and the same period in 2013. This was primarily the result of reducing the proportion of lower yielding cash-equivalent investments to fund loan growth and increasing the proportion of relatively higher-yielding federal government guaranteed mortgage-backed securities.

52

NET INTEREST MARGIN

(Annualized, tax-equivalent basis)
(Unaudited)
For The Three Months Ended
	September 30, 2014			June 30, 2014			Change			September 30, 2013			Change
Selective quarterly performance ratios
Yield on average gross loans (1)		4.95	%		5.04	%		(0.09	)		4.99	%		(0.04	)
Yield on average investment securities (1)		2.02	%		2.54	%		(0.52	)		1.70	%		0.32
Cost of average interest bearing deposits		0.34	%		0.37	%		(0.03	)		0.41	%		(0.07	)
Cost of average borrowings		1.83	%		1.90	%		(0.07	)		1.97	%		(0.14	)
Cost of average total deposits and borrowings		0.31	%		0.34	%		(0.03	)		0.38	%		(0.07	)
Cost of average interest-bearing liabilities		0.42	%		0.44	%		(0.02	)		0.48	%		(0.06	)
Yield on average interest-earning assets		4.44	%		4.61	%		(0.17	)		4.25	%		0.19
Cost of average interest-bearing liabilities		0.42	%		0.44	%		(0.02	)		0.48	%		(0.06	)
Net interest spread		4.02	%		4.17	%		(0.15	)		3.77	%		0.25
Net interest margin (1)		4.13	%		4.28	%		(0.15	)		3.88	%		0.25

For The Nine Months Ended
	September 30, 2014			September 30, 2013			Change
Selective quarterly performance ratios
Yield on average gross loans (1)		5.04	%		5.09	%		(0.05	)
Yield on average investment securities (1)		2.30	%		1.83	%		0.47
Cost of average interest bearing deposits		0.36	%		0.47	%		(0.11	)
Cost of average borrowings		1.90	%		2.02	%		(0.12	)
Cost of average total deposits and borrowings		0.33	%		0.43	%		(0.10	)
Cost of average interest-bearing liabilities		0.43	%		0.55	%		(0.12	)
Yield on average interest-earning assets		4.55	%		4.42	%		0.13
Cost of average interest-bearing liabilities		0.43	%		0.55	%		(0.12	)
Net interest spread		4.12	%		3.87	%		0.25
Net interest margin (1)		4.22	%		3.99	%		0.23

⁽¹⁾ Tax-exempt income has been adjusted to a tax equivalent basis at a 34% rate.

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

53

Average Interest Earning Balances:	For the Three Months Ended
	September 30, 2014								June 30, 2014								September 30, 2013
	Average Balance			Interest Income or Expense		Average Yields or Rates			Average Balance			Interest Income or Expense		Average Yields or Rates			Average Balance			Interest Income or Expense		Average Yields or Rates
(Dollars in Thousands)
ASSETS:
Interest bearing certificate of deposit	$	2,727		$	11		1.60	%	$	2,727		$	10		1.47	%	$	1,871		$	6		1.27	%
Interest bearing deposits in banks		23,928			14		0.23	%		12,552			9		0.29	%		46,665			29		0.25	%
Investments - taxable		63,751			298		1.85	%		65,964			343		2.09	%		61,924			221		1.42	%
Investments - nontaxable		27,646			277		3.98	%		31,607			352		4.47	%		32,058			355		4.39	%
Gross loans (1)		549,280			6,870		4.96	%		532,490			6,718		5.06	%		483,459			6,090		5.00	%
Loans held for sale		7,068			69		3.87	%		7,685			71		3.71	%		6,642			72		4.30	%
Total interest earning assets		674,400			7,539		4.44	%		653,025			7,503		4.61	%		632,619			6,773		4.25	%
Cash and due from banks		14,169								13,135								12,362
Bank premises and equipment (net)		16,615								16,703								16,167
Other real estate owned		940								2,088								4,070
Deferred fees		(1,113	)							(1,068	)							(1,045	)
Allowance for loan losses		(8,342	)							(8,271	)							(8,917	)
Other assets		40,757								40,705								40,955
Total assets	$	737,426							$	716,317							$	696,211
LIABILITIES AND SHAREHOLDERS' EQUITY:
Interest-bearing deposits	$	343,204			134		0.15	%	$	345,116			140		0.16	%	$	322,606			167		0.21	%
Time deposits		120,515			269		0.89	%		122,134			290		0.95	%		138,762			307		0.88	%
FHLB borrowings		10,878			61		2.22	%		10,000			60		2.41	%		10,000			62		2.46	%
Short term borrowings		587			-		0.00	%		6			-		0.00	%		-			-		0.00	%
Junior subordinated debentures		13,403			54		1.60	%		13,403			51		1.53	%		13,403			54		1.60	%
Total interest bearing liabilities		488,587			518		0.42	%		490,659			541		0.44	%		484,771			590		0.48	%
Non-interest-bearing deposits		170,560								150,776								138,875
Other liabilities		6,055								4,928								4,957
Equity		72,224								69,954								67,608
Total liabilities and shareholders' equity	$	737,426							$	716,317							$	696,211
Net interest income (3)				$	7,021							$	6,962							$	6,183
Net interest spread							4.02	%							4.17	%							3.77	%
Average yield on investments							2.02	%							2.54	%							1.70	%
Average yield on earning assets (2) (3)							4.44	%							4.61	%							4.25	%
Interest expense to earning assets							0.31	%							0.33	%							0.37	%
Net interest income to earning assets (2) (3)							4.13	%							4.28	%							3.88	%
Reconciliation of Non-GAAP measure:
Tax Equivalent Net Interest Income
Net interest income				$	6,882							$	6,796							$	6,015
Tax equivalent adjustment for municipal loan interest					45								46								46
Tax equivalent adjustment for municipal bond interest					94								120								121
Tax equivalent net interest income				$	7,021							$	6,962							$	6,182

Non-GAAP financial measures have inherent limitations, are not required to be uniformly applied, and are not audited.

Management believes that presentation of this non-GAAP measure provides useful information frequently used by shareholders in the evaluation of a company.

Non-GAAP financial measures have limitations as analytical tools and should not be considered in isolation or as a substitute for analyses of results as reported under GAAP.

(1) Non-accrual loans of approximately $4.8 million at 09/30/14, $6.4 million at 06/30/2014, and $7.8 million for 09/30/2013 are included in the average loan balances.

(2) Loan interest income includes loan fee income of $152,000, $180,000, and $169,000 for the three months ended 09/30/2014, 06/30/2014, and 09/30/2013, respectively.

(3) Tax-exempt income has been adjusted to a tax equivalent basis at a 34% effective rate. The amount of such adjustment was an addition to recorded pre-tax income of $139,000, $166,000, and $167,000 for the three months ended September 30, 2014, June 30, 2014, and September 30, 2013, respectively.

54

	For the Three Months Ended									For the Three Months Ended
	September 30, 2014 vs. June 30, 2014									September 30, 2014 vs. September 30, 2013
	Increase (Decrease) Due To									Increase (Decrease) Due To
(Dollars in Thousands)							Net									Net
	Volume			Rate			Change			Volume			Rate			Change
ASSETS:
Interest bearing certificate of deposit	$	-		$	1		$	1		$	3		$	2		$	5
Interest bearing deposits in banks		8			(3	)		5			(14	)		(1	)		(15	)
Investments - taxable		(12	)		(33	)		(45	)		6			71			77
Investments - nontaxable		(44	)		(31	)		(75	)		(48	)		(30	)		(78	)
Gross loans		212			(60	)		152			821			(41	)		780
Loans held for sale		(6	)		4			(2	)		5			(8	)		(3	)
Total interest earning assets	$	158		$	(122	)	$	36		$	773		$	(7	)	$	766
LIABILITIES AND SHAREHOLDERS' EQUITY:
Interest-bearing deposits	$	(1	)	$	(5	)	$	(6	)	$	11		$	(44	)	$	(33	)
Time deposits		(4	)		(17	)		(21	)		(40	)		2			(38	)
FHLB borrowings		5			(4	)		1			5			(6	)		(1	)
Short-term borrowings		-			-			-			-			-			-
Long-term borrowings		-			3			3			-			-			-
Total interest bearing liabilities		0			(23	)		(23	)		(24	)		(48	)		(72	)
Net increase (decrease) in net interest income	$	158		$	(99	)	$	59		$	797		$	41		$	838

55

Average Interest Earning Balances:	For the Nine Months Ended
	September 30, 2014								September 30, 2013
	Average Balance			Interest Income or Expense		Average Yields or Rates			Average Balance			Interest Income or Expense		Average Yields or Rates
(Dollars in Thousands)
ASSETS:
Interest bearing certificate of deposit	$	2,727		$	31		1.52	%	$	2,312		$	20		1.16	%
Interest bearing deposits in banks		18,167			33		0.24	%		37,359			66		0.24	%
Investments - taxable		65,789			980		1.99	%		51,861			472		1.22	%
Investments - nontaxable		30,656			977		4.26	%		33,557			1,153		4.59	%
Gross loans (1)		531,517			20,081		5.05	%		471,702			18,071		5.12	%
Loans held for sale		6,348			189		3.98	%		9,709			249		3.43	%
Total interest earning assets		655,204			22,291		4.55	%		606,500			20,031		4.42	%
Cash and due from banks		13,106								11,478
Bank premises and equipment (net)		16,707								15,547
Other real estate owned		1,858								4,086
Deferred fees		(1,106	)							(1,008	)
Allowance for loan losses		(8,334	)							(9,218	)
Other assets		40,862								40,925
Total assets	$	718,297							$	668,310
LIABILITIES AND SHAREHOLDERS' EQUITY:
Interest-bearing deposits	$	341,533			415		0.16	%	$	311,792			547		0.23	%
Time deposits		123,140			835		0.91	%		136,863			1,026		1.00	%
FHLB borrowings		10,296			181		2.35	%		10,066			186		2.47	%
Short term borrowings		200			-		0.00	%		-			-		0.00	%
Junior subordinated debentures		13,403			158		1.58	%		13,403			168		1.68	%
Total interest bearing liabilities		488,572			1,589		0.43	%		472,124			1,927		0.55	%
Non-interest-bearing deposits		154,213								123,868
Other liabilities		5,396								4,596
Equity		70,116								67,722
Total liabilities and shareholders' equity	$	718,297							$	668,310
Net interest income (3)				$	20,702							$	18,104
Net interest spread							4.12	%							3.87	%
Average yield on investments							2.30	%							1.83	%
Average yield on earning assets (2) (3)							4.55	%							4.42	%
Interest expense to earning assets							0.33	%							0.43	%
Net interest income to earning assets (2) (3)							4.22	%							3.99	%
Reconciliation of Non-GAAP measure:
Tax Equivalent Net Interest Income
Net interest income				$	20,232							$	17,549
Tax equivalent adjustment for municipal loan interest					138								163
Tax equivalent adjustment for municipal bond interest					332								392
Tax equivalent net interest income				$	20,702							$	18,104

Non-GAAP financial measures have inherent limitations, are not required to be uniformly applied, and are not audited.

Management believes that presentation of this non-GAAP measure provides useful information frequently used by shareholders in the evaluation of a company.

Non-GAAP financial measures have limitations as analytical tools and should not be considered in isolation or as a substitute for analyses of results as reported under GAAP.

(1) Non-accrual loans of approximately $4.8 million at 09/30/14 and $7.8 million for 09/30/2013 are included in the average loan balances.

(2) Loan interest income includes loan fee income of $482,000 and $396,000 for the nine months ended 09/30/2014 and 09/30/2013, respectively.

(3) Tax-exempt income has been adjusted to a tax equivalent basis at a 34% effective rate. The amount of such adjustment was an addition to recorded pre-tax income of $470,000 and $555,000 for the nine months ended September 30, 2014 and September 30, 2013, respectively.

56

	For the Nine Months Ended
	September 30, 2014 vs. September 30, 2013
	Increase (Decrease) Due To
(Dollars in Thousands)							Net
	Volume			Rate			Change
ASSETS:
Interest bearing certificate of deposit	$	2		$	9		$	11
Interest bearing deposits in banks		(23	)		(10	)		(33	)
Investments - taxable		84			424			508
Investments - nontaxable		(66	)		(110	)		(176	)
Gross loans		1,519			491			2,010
Loans held for sale		(57	)		(3	)		(60	)
Total interest earning assets	$	1,459		$	801		$	2,260
LIABILITIES AND SHAREHOLDERS' EQUITY:
Interest-bearing deposits	$	34		$	(166	)	$	(132	)
Time deposits		(68	)		(123	)		(191	)
FHLB borrowings		3			(8	)		(5	)
Short-term borrowings		-			-			-
Long-term borrowings		-			(10	)		(10	)
Total interest bearing liabilities		(31	)		(307	)		(338	)
Net increase (decrease) in net interest income	$	1,490		$	1,108		$	2,598

57

SUMMARY AVERAGE BALANCE SHEETS

(Unaudited)
(Dollars in Thousands)
Averages for the Three Months Ended	September 30,			June 30,									September 30,
	2014			2014			$ Change			% Change			2013			$ Change			% Change
Assets:
Cash and due from banks	$	14,169		$	13,135		$	1,034			8	%	$	12,362		$	1,807			15	%
Interest-bearing deposits in banks		23,928			12,552			11,376			91	%		46,665			(22,737	)		-49	%
Interest bearing certificate of deposit		2,727			2,727			0			0	%		1,871			856			46	%
Investment securities		91,397			97,571			(6,174	)		-6	%		93,982			(2,585	)		-3	%
Loans, net of deferred loan fees		555,235			539,106			16,129			3	%		489,056			66,179			14	%
Allowance for loan losses		(8,342	)		(8,271	)		(71	)		1	%		(8,917	)		575			-6	%
Net loans		546,893			530,835			16,058			3	%		480,139			66,754			14	%
Other assets		58,312			59,497			(1,185	)		-2	%		61,191			(2,879	)		-5	%
Total assets	$	737,426		$	716,317		$	21,109			3	%	$	696,210		$	41,216			6	%
Liabilities:
Total deposits	$	634,279		$	618,026		$	16,253			3	%	$	600,242		$	34,037			6	%
Borrowings		24,868			23,409			1,459			6	%		23,403			1,465			6	%
Other liabilities		6,055			4,928			1,127			23	%		4,957			1,098			22	%
Total liabilities		665,202			646,363			18,839			3	%		628,602			36,600			6	%
Equity:
Common equity		72,224			69,954			2,270			3	%		67,608			4,616			7	%
Total equity		72,224			69,954			2,270			3	%		67,608			4,616			7	%
Total liabilities and shareholders' equity	$	737,426		$	716,317		$	21,109			3	%	$	696,210		$	41,216			6	%

Averages for the Nine Months Ended	September 30,			September 30,
	2014			2013			$ Change			% Change
Assets:
Cash and due from banks	$	13,106		$	11,478		$	1,628			14	%
Interest-bearing deposits in banks		18,167			37,359			(19,192	)		-51	%
Interest bearing certificate of deposit		2,727			2,312			415			18	%
Investment securities		96,445			85,418			11,027			13	%
Loans, net of deferred loan fees		536,759			480,404			56,355			12	%
Allowance for loan losses		(8,334	)		(9,218	)		884			-10	%
Net loans		528,425			471,186			57,239			12	%
Other assets		59,427			60,557			(1,130	)		-2	%
Total assets	$	718,297		$	668,310		$	49,987			7	%
Liabilities:
Total deposits	$	618,886		$	572,523		$	46,363			8	%
Borrowings		23,899			23,469			430			2	%
Other liabilities		5,396			4,596			800			17	%
Total liabilities		648,181			600,588			47,593			8	%
Equity:
Common equity		70,116			67,722			2,394			4	%
Total equity		70,116			67,722			2,394			4	%
Total liabilities and shareholders' equity	$	718,297		$	668,310		$	49,987			7	%

AVERAGE INTEREST EARNING ASSETS

(Unaudited)
(Dollars in Thousands)			% of					% of			$			%					% of			$			%
Averages for the Three Months Ended	September 30, 2014		Total			June 30, 2014		Total			Change			Change			September 30, 2013		Total			Change			Change
Interest-bearing certificate of deposits	$	2,727		0	%	$	2,727		0	%	$	0			0	%	$	1,871		0	%	$	856			0	%
Interest-bearing deposits in banks		23,928		4	%		12,552		2	%		11,376			2	%		46,665		7	%		(22,737	)		-3	%
Investments		91,397		14	%		97,571		15	%		(6,174	)		-1	%		93,982		15	%		(2,585	)		-1	%
Gross loans		549,280		81	%		532,490		82	%		16,790			-1	%		483,459		76	%		65,821			5	%
Loans held for sale		7,068		1	%		7,685		1	%		(617	)		0	%		6,642		1	%		426			0	%
Total average interest-earning assets	$	674,400		100	%	$	653,025		100	%	$	21,375					$	632,619		100	%	$	41,781

			% of					% of			$			%
Averages for the Nine Months Ended	September 30, 2014		Total			September 30, 2013		Total			Change			Change
Interest-bearing certificate of deposits	$	2,727		0	%	$	2,312		0	%	$	415			0	%
Interest-bearing deposits in banks		18,167		3	%		37,359		6	%		(19,192	)		-3	%
Investments		96,445		15	%		85,418		14	%		11,027			1	%
Gross loans		531,517		81	%		471,702		78	%		59,815			3	%
Loans held for sale		6,348		1	%		9,709		2	%		(3,361	)		-1	%
Total average interest-earning assets	$	655,204		100	%	$	606,500		100	%	$	48,704

58

ASSET QUALITY

At September 30, 2014, total adversely classified loans increased in dollars and as a percentage of gross loans from the preceding and year ago quarters. This is the result of designating a $4.7 million commercial and commercial real estate relationship as adversely classified during the current quarter. Total loans on accruing status 30-89 days past due continue to remain below 1.00% of gross loans, mirroring the improvement in overall credit quality noted previously. Past due loans increased in the current period primarily from a $2.6 million commercial real estate relationship scheduled to be paid off. We monitor delinquencies, defined as loans on accruing status 30-89 days past due, as an indicator of future adversely classified loans.

At September 30, 2014, total nonperforming loans were down compared to June 30, 2014 and September 30, 2013. Nonperforming assets also declined during this period as a percentage of total assets, despite the increase in OREO during the current quarter. This was primarily due to the payoff of a $1.0 million non-accrual commercial real estate loan during the current quarter. Nonperforming loans consist primarily of commercial real estate loans.

Adversely classified loans

(Unaudited)

(Dollars in Thousands)

	September 30, 2014			June 30, 2014			$ Change			% Change			September 30, 2013			$ Change			% Change
Rated substandard or worse, but not impaired	$	11,020		$	6,938		$	4,082			59	%	$	3,365		$	7,655			227	%
Impaired		7,429			9,025			(1,596	)		-18	%		10,383			(2,954	)		-28	%
Total adversely classified loans*	$	18,449		$	15,963		$	2,486			16	%	$	13,748		$	4,701			34	%
Gross loans	$	553,319		$	548,371		$	4,948			1	%	$	487,808		$	65,511			13	%
Adversely classified loans to gross loans		3.33	%		2.91	%		0.42	%					2.82	%		0.51	%
Allowance for loan losses	$	8,255		$	8,315		$	(60	)		-1	%	$	8,806		$	(551	)		-6	%
Allowance for loan losses as a percentage of adversely classified loans		44.74	%		52.09	%		-7.35	%					64.05	%		-19.31	%
Allowance for loan losses to total impaired loans		111.12	%		92.13	%		18.99	%					84.81	%		26.31	%

* Adversely classified loans are defined as loans having a well-defined weakness or weaknesses related to the borrower's financial capacity or to pledged collateral that may jeopardize the repayment of the debt. They are characterized by the possibility that the Bank may sustain some loss if the deficiencies giving rise to the substandard classification are not corrected. Note that any loans internally rated worse than substandard are included in the impaired loan totals.

30-89 Days Past Due by type

(Unaudited)

(Dollars in Thousands)

	September 30, 2014			% of Category			June 30, 2014			% of Category			$ Change			% Change			September 30, 2013			% of Category			$ Change			% Change
Commercial and agricultural	$	7			0.2	%	$	23			16.5	%	$	(16	)		-70	%	$	52			6.7	%	$	(45	)		-87	%
Real estate:
Construction and development					0.0	%		-			0.0	%		-			0	%		-			0.0	%		-			0	%
Residential 1-4 family		251			8.7	%		53			38.1	%		198			374	%		590			76.5	%		(339	)		-57	%
Multi-family					0.0	%		-			0.0	%		-			0	%		-			0.0	%		-			0	%
Commercial real estate — owner occupied					0.0	%		0			0.0	%		0			0	%		87			11.3	%		(87	)		-100	%
Commercial real estate — non owner occupied		2,612			90.9	%		0			0.0	%		2,612			100	%		-			0.0	%		2,612			100	%
Farmland								-			0.0	%		-			0	%		37			4.8	%		(37	)		-100	%
Total real estate	$	2,863					$	53					$	2,810			5302	%	$	714					$	2,149
														-
Consumer		2			0.1	%		63			45.3	%		(61	)		-97	%		5			0.6	%		(3	)		-60	%
Total loans 30-89 days past due, not in nonaccrual status	$	2,872			100.0	%	$	139			100.0	%	$	2,733			1966	%	$	771			100.0	%	$	2,101			273	%
Delinquent loans to total loans, not in nonaccrual status		0.60	%					0.03	%											0.17	%

59

Non-performing assets

(Unaudited)

(Dollars in Thousands)	September 30, 2014			June 30, 2014			$ Change			% Change			September 30, 2013			$ Change			% Change
Loans on nonaccrual status	$	4,811		$	6,388		$	(1,577	)		-25	%	$	7,829		$	(3,018	)		-39	%
Loans past due greater than 90 days but not on nonaccrual status		409			-			409			100	%		221			188			85	%
Total non-performing loans		5,220			6,388			(1,168	)		-18	%		8,050			(2,830	)		-35	%
Other real estate owned and foreclosed assets		1,210			991			219			22	%		4,334			(3,124	)		-72	%
Total nonperforming assets	$	6,430		$	7,379		$	(949	)		-13	%	$	12,384		$	(5,954	)		-48	%
Percentage of nonperforming assets to total assets		0.86	%		1.03	%								1.73	%

OREO increased during third quarter 2014, but declined significantly year-over-year. One commercial income property was taken into the OREO portfolio during the quarter. OREO valuation adjustments continued to be minimal. At September 30, 2014, the OREO portfolio consisted of 7 properties, down from both second quarter 2014 and third quarter 2013. The largest balances in the OREO portfolio at the end of the quarter were attributable to commercial properties, followed by residential properties, all of which are located within our market area.

Other real estate owned and foreclosed assets

(Unaudited)

(Dollars in Thousands)

For the Three Months Ended	September 30, 2014			% of Category			June 30, 2014			% of Category			$ Change			% Change			September 30, 2013			% of Category			$ Change			% Change
Other real estate owned, beginning of period	$	991			82	%	$	2,386			241	%	$	(1,395	)		-58	%	$	3,451			80	%	$	(2,460	)		-71	%
Transfers from outstanding loans		525			43	%		206			21	%		319			155	%		1,382			32	%		(857	)		-62	%
Improvements and other additions		-			0	%		-			0	%		-			0	%		-			0	%		-			0	%
Proceeds from sales		(219	)		-18	%		(1,490	)		-150	%		1,271			-85	%		(341	)		-8	%		122			-36	%
Net gain (loss) on sales		(86	)		-7	%		(57	)		-6	%		(29	)		51	%		18			0	%		(104	)		-578	%
Impairment charges		(1	)		0	%		(54	)		-5	%		53			-98	%		(176	)		-4	%		175			-99	%
Total other real estate owned	$	1,210			100	%	$	991			100	%	$	219			22	%	$	4,334			100	%	$	(3,124	)		-72	%

For the Nine Months Ended	September 30, 2014			% of Category			September 30, 2013			% of Category			$ Change			% Change
Other real estate owned, beginning of period	$	2,771			229	%	$	4,678			108	%	$	(1,907	)		-41	%
Transfers from outstanding loans		842			70	%		1,591			37	%		(749	)		-47	%
Improvements and other additions		-			0	%		-			0	%		-			0	%
Proceeds from sales		(2,157	)		-178	%		(1,342	)		-31	%		(815	)		61	%
Net gain (loss) on sales		(179	)		-15	%		43			1	%		(222	)		-516	%
Impairment charges		(67	)		-6	%		(636	)		-15	%		569			-89	%
Total other real estate owned	$	1,210			100	%	$	4,334			100	%	$	(3,124	)		-72	%

Other real estate owned and foreclosed assets by type

(Unaudited)

(Dollars in Thousands)

	September 30, 2014		# of Properties		June 30, 2014		# of Properties		$ Change			% Change			September 30, 2013		# of Properties		$ Change			% Change
Construction, Land Dev & Other Land	$	35		1	$	46		2	$	(11	)		-24	%	$	787		7	$	(752	)		-96	%
1-4 Family Residential Properties		86		2		317		4		(231	)		-73	%		868		6		(782	)		-90	%
Nonfarm Nonresidential Properties		1,089		4		628		4		461			73	%		2,679		13		(1,590	)		-59	%
Total OREO by type	$	1,210		7	$	991		10	$	219			22	%	$	4,334		26	$	(3,124	)		-72	%

ALLOWANCE FOR LOAN LOSSES

The allowance for loan losses continues to decline in relation to total loans in concert with the general trend of improvement in relevant credit metrics. As such, loss factors used in estimates to establish reserve levels have declined commensurately. A provision was made to the allowance for loan losses in the current and prior quarter, corresponding to recent growth in the loan portfolio. No provision was made in third quarter 2013.

60

For the quarter ended September 30, 2014, total net loan charge-offs were up compared to the quarter ended June 30, 2014, but virtually unchanged versus the quarter ended September 30, 2013. The charge-offs incurred in the third quarter 2014 were primarily centered in one commercial real estate loan, which was written down $127,000 prior to transfer to OREO. The ratio of net loan charge-offs to average gross loans (annualized) for the current quarter was up compared to the prior quarter, but unchanged from the third quarter one year ago.

The overall risk profile of the loan portfolio continues to improve, as stated above, but more slowly than in recent periods. However, the trend of future provision for loan losses will depend primarily on economic conditions, growth in the loan portfolio, level of adversely-classified assets, and changes in collateral values.

61

Allowance for Loan Losses

(Unaudited)

(Dollars in Thousands)

For the Three Months Ended	September 30, 2014			June 30, 2014			$ Change			% Change			September 30, 2013			$ Change			% Change
Gross loans outstanding at end of period	$	553,319		$	548,371		$	4,948			1	%	$	487,808		$	65,511			13	%
Average loans outstanding, gross	$	549,280		$	532,490		$	16,790			3	%	$	483,459		$	65,821			14	%
Allowance for loan losses, beginning of period	$	8,315		$	8,288		$	27			0	%	$	8,962		$	(647	)		-7	%
Commercial		0			(9	)		9			-100	%		(40	)		40			-100	%
Commercial Real Estate		(127	)		(389	)		262			-67	%		(37	)		(89	)		241	%
Residential Real Estate		(61	)		(4	)		(57	)		1425	%		(29	)		(32	)		110	%
Consumer		(12	)		(29	)		17			-59	%		(79	)		67			-85	%
Total charge-offs		(200	)		(431	)		231			-54	%		(185	)		(14	)		8	%
Commercial		7			1			6			600	%		20			(13	)		-65	%
Commercial Real Estate		29			347			(318	)		-92	%		5			23			460	%
Residential Real Estate		4			9			(5	)		-56	%		3			0			0	%
Consumer		-			1			1			100	%		1			0			0	%
Total recoveries		40			358			(318	)		-89	%		29			10			34	%
Net charge-offs		(160	)		(73	)		(87	)		119	%		(156	)		(4	)		3	%
Provision charged to income		100			100			-			0	%		-			100			100	%
Allowance for loan losses, end of period	$	8,255		$	8,315		$	(60	)		-1	%	$	8,806		$	(551	)		-6	%
Ratio of net loans charged-off to average gross loans outstanding, annualized		0.12	%		0.05	%		0.07	%		140	%		0.13	%		-0.01	%		-8	%
Ratio of allowance for loan losses to  gross loans outstanding		1.49	%		1.52	%		-0.03	%		-2	%		1.81	%		-0.32	%		-18	%

For the Nine Months Ended	September 30, 2014			September 30, 2013			$  Change			% Change
Gross loans outstanding at end of period	$	553,319		$	487,808		$	65,511			13	%
Average loans outstanding, gross	$	531,517		$	471,702		$	59,815			13	%
Allowance for loan losses, beginning of period	$	8,359		$	9,358		$	(999	)		-11	%
Commercial		(26	)		(40	)		14			-35	%
Commercial Real Estate		(523	)		(83	)		(440	)		530	%
Residential Real Estate		(105	)		(95	)		(10	)		11	%
Consumer		(59	)		(145	)		86			-59	%
Total charge-offs		(713	)		(363	)		(349	)		96	%
Commercial		9			35			(26	)		-74	%
Commercial Real Estate		381			220			161			73	%
Residential Real Estate		17			4			13			325	%
Consumer		2			2			-			0	%
Total recoveries		409			261			148			57	%
Net charge-offs		(304	)		(102	)		(202	)		198	%
Provision charged to income		200			(450	)		650			-144	%
Allowance for loan losses, end of period	$	8,255		$	8,806		$	(551	)		-6	%
Ratio of net loans charged-off to average gross loans outstanding, annualized		0.08	%		0.03	%		0.05	%		167	%
Ratio of allowance for loan losses to gross loans outstanding		1.49	%		1.81	%		-0.32	%		-18	%

An allowance for loan losses has been established based on management’s best estimate, as of the balance sheet date, of probable losses inherent in the loan portfolio. For more information regarding the Company’s allowance for loan losses and net loan charge-offs, see the discussion under the subheadings “Loans Receivable” and “Allowance for Credit Losses” included in Note 1 – Summary of Significant Accounting Policies and “Loans” included in Note 4 of the Company’s interim financials as presented in this Form 10-Q and audited financial statements as presented in its 2013 10-K.

62

Overall, we believe that the allowance for loan losses is adequate to absorb probable losses in the loan portfolio at September 30, 2014. there can be no assurance that future loan losses will not exceed our current estimates. The process for determining the adequacy of the allowance for loan losses is significant to our financial results. Please refer to Item 1A “Risk Factors”, together with our discussion of our critical accounting policies in our 2013 Form 10-K for further information.

Liquidity and Sources of Funds

The Bank’s sources of funds include core deposits, loan repayments, advances from the FHLB or the Federal Reserve Bank discount window, brokered deposits, maturities of investment securities, sales of “Available-for-Sale” securities, loan and OREO sales, net income and the use of Federal Funds markets. Stated maturities of investment securities, loan repayments from maturities and core deposits are a relatively stable source of funds, while brokered deposit inflows, unscheduled loan prepayments, and loan and OREO sales are not. Deposit inflows, sales of securities, loan and OREO properties, and unscheduled loan prepayments may, amongst other factors, be influenced by general interest rate levels, interest rates available on other investments, competition, pricing considerations, and general economic conditions.

Deposits are our primary source of funds. Our loan to deposit ratio has increased as a result of loan demand due to the improvement of economic conditions in our region and customer dissatisfaction at other financial institutions from recent merger activity. The increase in loan balances has resulted in increased demands on our liquidity. As such, our current approach to managing our liquidity is directed toward increasing non-interest bearing core deposits from businesses and consumers. We continued to reduce higher cost time deposits during the most recent quarter.

The following table summarizes the primary (on-balance sheet) liquidity, short-term funds availability, net non-core funding dependency, and loan to deposit ratios of the Bank. The primary liquidity ratio represents the sum of net interest-bearing cash/federal funds sold, short-term and readily marketable assets divided by total assets. The short-term funds availability ratio consists of the sum of net interest-bearing cash/federal funds sold, short-term and readily marketable assets and available capacity under borrowing facilities divided by assets. The net non-core funding dependency ratio is non-core liabilities less short-term investments divided by long-term assets. Despite the increase in the loan to deposit ratio due to the loan growth, as previously discussed, the Bank’s primary liquidity, short-term funds availability, and net non-core funding dependency ratios remained strong at quarter end.

	September			December			September
	30, 2014			31, 2013			30, 2013
Primary liquidity		12.8	%		16.3	%		22.1	%
Short term funds availability		25.0	%		29.4	%		30.7	%
Net non-core funding dependency		3.4	%		3.2	%		6.4	%
Gross loans to deposits		85.9	%		80.7	%		78.8	%

An analysis of liquidity should encompass a review of the changes that appear in the consolidated statements of cash flow for the nine months ended September 30, 2014 and 2013. The statement of cash flows includes operating, investing, and financing categories.

At September 30, 2014, the Bank had $11.5 million in outstanding borrowings against its $143.8 million in established borrowing capacity with the FHLB. The Bank had $10.0 million outstanding in borrowings at December 31, 2013 and September 30, 2013. The borrowing capacity at the FHLB was $143.1 million and $137.2 million at December 31, 2013 and September 30, 2013, respectively. The Bank’s borrowing facility with the FHLB is subject to collateral and stock ownership requirements. The Bank also had an available discount window primary credit line with the Federal Reserve Bank of San Francisco of approximately $53.6 million, subject to collateral requirements, and $16.0 million from correspondent banks with no balance outstanding on any of these facilities.

Off-Balance Sheet Arrangements

At September 30, 2014, the Bank had commitments to extend credit and standby letters related to extensions of credit of $97.9 million compared to $107.7 million at December 31, 2013 and $102.1 million at September 30, 2013. Such commitments represented 17.7%, 21.3% and 21.9% of total net loans as of September 30, 2014, December 31, 2013 and September 30, 2013, respectively. Please refer to Note 7 – “Commitments and Contingencies” in the accompanying financial statements for further information.

63

Critical Accounting Policies

Management has identified the calculation of our allowance for loan losses, goodwill, investment valuation and Other-Than-Temporary-Impairment (OTTI), valuation of OREO, and estimates relating to income taxes as critical accounting policies. Each of these policies are discussed in our 2013 10-K under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operation – Critical Accounting Policies.”

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Market risk is the risk of loss from adverse changes in market prices and rates. The Company’s market risk arises principally from interest rate risk in its lending, deposit and borrowing activities. Management actively monitors and manages its interest rate risk exposure. Although the Company manages other risks, such as credit quality and liquidity risk, in the normal course of business, Management considers interest rate risk to be a significant market risk, which could have a material effect on the Company’s financial condition and results of operations. Other types of market risks, such as foreign currency exchange rate risk and commodity price risk, do not arise in the normal course of the Company’s business activities. The Company did not experience a significant change in market risk at September 30, 2014, as compared to December 31, 2013.

The Company attempts to monitor interest rate risk from the perspective of changes in the economic value of equity, also referred to as net portfolio value (NPV), and changes in net interest income. Changes to the NPV and net interest income are simulated using instant and permanent rates up and down shocks of various increments. It is the Company’s policy to manage interest rate risk to maximize long-term profitability under the range of likely interest-rate scenarios. For additional information, refer to “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Asset and Liability Management” in the Company’s 2013 10-K.

ITEM 4. CONTROLS AND PROCEDURES

EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES

As of the end of the period covered by this report, Pacific Financial Corporation’s Management, with the participation of our Chief Executive Officer and Chief Financial Officer, carried out an evaluation of the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934). Based upon that evaluation, Management, including our Chief Executive Officer and Chief Financial Officer, has concluded that our disclosure controls and procedures were effective, including in timely alerting them to information relating to us that is required to be included in our periodic SEC filings.

CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING

There have not been any changes in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934) during our most recent quarter ended September 30, 2014, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II – OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

From time to time, in the normal course of business, Pacific Financial may become party to various legal actions. Management is unaware of any existing legal actions against the Company or its subsidiaries that Management believes will have a materially adverse impact on our business, financial condition or results of operations.

ITEM 1A. RISK FACTORS

There were no material changes in the risk factors presented in the Company’s 2013 10-K.

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

(a) Between August 4 and September 30, 2014, the Company sold 139,000 shares of common stock at a price of $6.50 per share upon exercise of certain warrants originally issued in a private placement transaction completed in 2009.  Total proceeds from the exercise of warrants were $903,500, all of which will be used for general working capital purposes.  The Company completed the sales pursuant to the exemption from the registration requirements of the Securities Act of 1933, as amended, provided by Section 4(a)(2) of the Securities Act.

(b) [Not applicable.]

(c) [None.]

64

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

(a) [Not applicable.]

(b) [Not applicable.]

ITEM 4. MINE SAFETY DISCLOSURES

(a) [Not applicable.]

ITEM 5. OTHER INFORMATION

(a) [None.]

65

ITEM 6. EXHIBITS

EXHIBIT NO.	EXHIBIT
31.1	Certification of CEO under Rule 13a – 14(a) of the Exchange Act.
31.2	Certification of CFO under Rule 13a – 14(a) of the Exchange Act.
32.1	Certification of CEO under 18 U.S.C. Section 1350.
32.2	Certification of CFO under 18 U.S.C. Section 1350.
101.	INS XBRL Instance Document
101.	SCH XBRL Taxonomy Extension Schema Document
101.	CAL XBRL Taxonomy Extension Calculation Linkbase Document
101.	DEF XBRL Taxonomy Extension Definition Linkbase Document
101.	LAB XBRL Taxonomy Extension Label Linkbase Document
101.	PRE XBRL Taxonomy Extension Presentation Linkbase Document

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.

DATED: November 14, 2014

Pacific Financial Corporation

/s/ Dennis A. Long 

Dennis A. Long, President and Chief Executive Officer

/s/ Douglas N. Biddle 

Douglas N. Biddle, Executive Vice President and Chief Financial Officer

66