Summary of WASHINGTON BANKING CO

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis should be read in conjunction with Item 8- Financial Statements and Supplementary Data.

Recent Developments and Executive Overview

Recent Developments: On January 16, 2009, in exchange for an aggregate purchase price of $26.4 million, the Company issued and sold to the United States Department of the Treasury pursuant to the Trouble Asset Relief Program Capital Purchase Program the following: (i) 26,380 shares of the Company's newly designated Fixed Rate Cumulative Perpetual Preferred Stock, Series A, no par value per share, and liquidation preference $1,000 per share ($26.4 million liquidation preference in the aggregate) and (ii) a warrant to purchase up to 492,164 shares of the Company's common stock, no par value per share, at an exercise price of $8.04 per share, subject to certain anti-dilution and other adjustments. The Warrant may be exercised for up to ten years after it is issued.

In connection with the issuance and sale of the Company's securities, the Company entered into a Letter Agreement including the Securities Purchase Agreement - Standard Terms, dated January 16, 2009, with the United States Department of the Treasury (the "Agreement"). The Agreement contains limitations on the payment of quarterly cash dividends on the Company's common stock in excess of $0.065 per share, and on the Company's ability to repurchase its common stock. The Agreement also grants the holders of the Series A Preferred Stock, the Warrant and the common stock to be issued under the Warrant registration rights, and subjects the Company to executive compensation limitations included in the Emergency Economic Stabilization Act of 2008. Participants in the TARP Capital Purchase Program are required to have in place limitations on the compensation of Senior Executive Officers.

The Series A Preferred Stock will bear cumulative dividends at a rate of 5% per annum for the first five years and 9% per annum thereafter, in each case, applied to the $1,000 per share liquidation preference, but will only be paid when, as and if declared by the Company's Board of Directors out of funds legally available. The Series A Preferred Stock has no maturity date and ranks senior to the Company's common stock with respect to the payment of dividends and distributions and amounts payable upon liquidation, dissolution and winding up of the Company.

On January 13, 2009, the Company's shareholders approved an amendment to the Company's Restated Articles of Incorporation setting the specific terms and conditions of the preferred stock and designating such shares as the Series A Preferred Stock. The amendment was filed with the Secretary of State of the State of Washington on January 13, 2009.

On February 27, 2009, the FDIC announced its board of directors took action to strengthen the Deposit Insurance Fund by proposing a special assessment on insured institutions of 20 basis points (20 cents per $100 of deposits). The assessment is to be collected on September 30, 2009. The FDIC board of directors is also permitted to impose an emergency special assessment of 10 basis points (10 cents per $100 of deposits) after June 30, 2009, if necessary to maintain public confidence in federal deposit insurance. Currently the assessment is under review and has not been finalized. However, if the Company is required to pay the assessment in its current form, it will be approximately $1.6 million.

Executive Overview: 2008 was a unique year for the Company. The Company was relatively unaffected by the slowdown in the housing industry and produced some of the strongest operating results in the banking industry. Results included:

• Net income per diluted share was $0.88 in 2008 compared to $0.99 in 2007. Net income was directly impacted by the Company's decision to increase the provision for loan losses in response to the deterioration on the loan portfolio.

• Return on average equity was 10.82% in 2008 compared to 13.53% in 2007.

• Allowance for loan losses to loans increased to 1.49% of total loans in 2008 from 1.38% of total loans in 2007.

• Net charge-offs to average loans was 0.48% in 2008 compared to 0.25% in 2007.

• Nonperforming assets to total assets was 0.46% in 2008 compared to 0.48% in 2007.

The Company also dealt with some challenges in the past year including:

• The Company's termination of the merger agreement with Frontier Financial Corporation during the second quarter of 2008 and the related impact on the Company operations and management. On November 25, 2008, the Company and Frontier Financial Corporation settled all legal claims concerning the terminated merger agreement, whereby neither company will make any payment under the arrangement.

• The Company's net interest margin, on a tax-equivalent basis, compressed during 2008 to 4.60% compared to 4.89% in 2007. This decrease was due to the impact of the rapid reduction in short term interest rates during 2008.

Summary of Critical Accounting Policies

Significant accounting policies are described in the consolidated financial statements in Note 1- Summary of Significant Accounting Policies. Several of these accounting policies require management to make difficult, subjective or complex judgments or estimates. Management believes that the following accounting policies could be considered critical under the SEC's definition.

Allowance for Loan Losses: The allowance for loan losses is established to absorb known and inherent losses attributable to loans outstanding. The adequacy of the allowance is monitored on a regular basis and is based on management's evaluation of numerous quantitative and qualitative factors. Quantitative factors include our historical loss experience, delinquency and charge-off trends, estimates of, and changes in, collateral values, changes in risk ratings on loans and other factors. Qualitative factors include the general economic environment in our markets and, in particular, the state of the real estate market and specific relevant industries. Other qualitative factors that are considered in our methodology include, size and complexity of individual loans in relation to the lending officer's background and experience levels, loan structure, extent and nature of waivers of existing loan policies, and pace of loan portfolio growth. As the Company adds new products, increase the complexity of the loan portfolio, and expand its geographic coverage, the Company intends to enhance and adapt its methodology to keep pace with the size and complexity of the loan portfolio. Changes in any of the above factors could have a significant effect on the calculation of the allowance for credit losses in any given period. The Company believes that its systematic methodology continues to be appropriate given our size and level of complexity.

Stock-based Compensation: Effective January 1, 2006, the Company adopted the provisions of Statement of Financial Accounting Standards ("SFAS") No. 123R, Share-Based Payment, a revision to the previously issued guidance on accounting for stock options and other forms of equity-based compensation. The Company recognizes in the income statement the grant-date fair value of stock awards issued to employees over the employees' requisite service period (generally the vesting period). The fair value of each stock option grant is estimated as of the grant date using the Black-Scholes option-pricing model. Significant variables are used to estimate the fair value of the stock options granted include volatility, forfeiture rate and expected life. The Company's assumptions utilized at the time of grant impact the fair value of the stock option calculated under the Black-Scholes methodology, and ultimately, the expense that will be recognized over the life of the stock award.

Results of Operations Overview

For the year ended December 31, 2008, net income was $8.3 million, or $0.88 per diluted share, an 11% decrease compared to 2007. The decrease in net income was principally attributable to increased provision for loan losses and decreased noninterest income, partially offset by decreased noninterest expense. On May 29, 2008 the Company terminated the planned merger with Frontier Financial Corporation. The Company incurred merger related expense during the first six months of 2008 and the last three months of 2007.

Additionally in 2008, the Company incurred employee separation expense related to the retirement of the Company's CEO. For the year ended December 31, 2007, net income was $9.4 million, or $0.99 per diluted share compared to $9.5 million or $1.00 per diluted share in 2006. The decrease in net income was principally attributable to increase in noninterest expense and provision for loan losses, partially offset by increases in net interest and noninterest income.

Net Interest Income: One of the Company's key sources of earnings is net interest income. To make it easier to compare results among several periods and the yields on various types of earning assets (some of which are taxable and others which are not), net interest income is presented in this discussion on a "taxable-equivalent basis" (i.e., as if it were all taxable at the same rate). There are several factors that affect net interest income including:

• The volume, pricing, mix and maturity of interest-earning assets and interest-bearing liabilities;
• The volume of free funds (consisting of noninterest-bearing deposits and other liabilities and shareholders' equity);
• The volume of noninterest-earning assets, market interest rate fluctuations, and asset quality.

The following tables set forth various components of the balance sheet that affect interest income and expense, and their respective yields or rates:

                      Net Interest Income Analysis as of:

                                                                              Years Ended December 31
                                                      2008                                  2007                                  2006
                                   Average          Interest    Average     Average       Interest    Average     Average       Interest    Average
(Dollars in thousands)             balance         earned/paid   Yield      balance      earned/paid   yield      balance      earned/paid   yield
Assets
Loans (1) (2)                 $        819,468  $       58,607    7.13%  $   759,242  $       61,911    8.15%  $   682,939  $       54,450    7.97%
Federal funds sold                       2,760              28    1.02%        2,395             121    5.06%        2,686             135    5.02%
Interest-bearing cash                      408               8    1.94%          964              52    5.39%          844              43    5.10%
Investments:
   Taxable                               9,522             397    4.16%       12,198             547    4.48%       12,618             457    3.62%
   Non-taxable (2)                       5,298             301    5.66%        6,497             384    5.91%        7,306             458    6.27%
Interest-earning assets                837,456          59,341    7.07%      781,296          63,015    8.07%      706,393          55,543    7.86%
Noninterest-earning assets              53,133                                55,442                                50,384
   Total assets               $        890,589                           $   836,738                           $   756,777

Liabilities and
   Shareholders' Equity
Deposits:
   Interest-bearing demand
    and money market          $        262,959           4,070    1.54%  $   268,817  $        7,049    2.62%  $   231,316  $        4,521    1.95%
   Saving deposits                      41,662             167    0.40%       46,152             311    0.67%       55,139             432    0.78%
   Time deposits                       352,137          14,205    4.02%      316,308          15,309    4.84%      276,211          11,604    4.20%
Interest-bearing deposits              656,758          18,442    2.80%      631,277          22,669    3.59%      562,666          16,557    2.94%
Fed funds purchased                     12,503             352    2.80%        4,480             242    5.40%        6,850             362    5.29%
Junior subordinated                     25,774           1,254    4.85%       23,061           1,762    7.64%       15,007           1,337    8.91%
debentures
Other interest-bearing
   liabilities                          23,060             786    3.40%        2,493             137    5.49%        4,183             185    4.41%
Interest-bearing liabilities           718,095          20,834    2.89%      661,311          24,810    3.75%      588,706          18,441    3.13%
Noninterest-bearing deposits            91,891                               100,830                               100,267
Other noninterest-bearing
liabilities                              3,605                                 5,109                                 6,004
Total liabilities                      813,591                               767,250                               694,977
Shareholders' equity                    76,998                                69,488                                61,800
   Total liabilities and
   shareholders' equity       $        890,589                           $   836,738                             $ 756,777
Net interest income (2)                         $       38,507                        $       38,205                        $       37,102
Net interest spread                                               4.18%                                 4.32%                                 4.73%
Net interest margin (2)                                           4.60%                                 4.89%                                5.25 %

(1) Of this amount, loan fees accounted for $2,690, $2,406, and $2,001, for the years ended December 31, 2008, 2007 and 2006, respectively. Loan totals include nonaccrual loans.
(2) Interest income on non-taxable assets is presented on a fully tax-equivalent basis using a federal statutory rate of 35.0%, 35.0% and 34.4%, for the years ended December 31, 2008, 2007 and 2006, respectively. These adjustments were $559, $647, and $358, for the years ended December 31, 2008, 2007 and 2006, respectively.

Net interest income on a taxable-equivalent basis totaled $38.5 million at December 31, 2008 compared with $38.2 million in 2007. Changes in net interest income during the year were principally caused by an increase in average interest-earning assets due to strong loan growth, coupled with a decrease in rates paid on average interest-bearing liabilities.

The Company's yields were impacted in 2008 due to the changing interest rate environment. The yield on interest-earning assets was 7.07% for 2008, a decrease of 100 basis points as compared to the same period in 2007. This decrease is primarily attributable to a decrease in the rates charged on new loans and the repricing of variable rate loans. Variable rate loans represented approximately 67.7% of the Company's total loan portfolio at December 31, 2008; the large majority of these variable rate loans did not have interest rate floors in place during 2008. The Company is currently implementing interest rate floors on its variable rate loans when they renew. The yield on interest-bearing liabilities was 2.89%, a decrease of 86 basis points as compared to the same period in 2007. This decrease is primarily attributable to a decrease in rates offered on interest-bearing deposits, lower interest rates on short term borrowings, and the full impact of the Company's refinancing of junior subordinated debentures. Additional information concerning the refinancing of the junior subordinated debentures can be found in the borrowing section of Item 7- Management's Discussion and Analysis of Financial Condition and Results of Operations.

Net interest margin (net interest income as a percentage of average interest-earning assets) on a taxable-equivalent basis was 4.60% for 2008, a decrease of 29 basis points as compared to the same period in 2007. The decrease in net interest margin in 2008 resulted from the increase in average interest-earning assets, coupled with, minimal increase in net interest income.

Net interest income on a tax-equivalent basis totaled $38.2 million at December 31, 2007 compared to $37.1 million in 2006. Changes in net interest income were principally due to an increase in average interest-earning assets due to strong loan growth and higher yields on interest-earning assets.

The yield on interest-earning assets increased 21 basis points to 8.07% at December 31, 2007. This increase was primarily attributable to a increase in the rates charged on new loans and the repricing of variable rate loans. Pricing pressure caused the yield on interest-bearing liabilities to increase 62 basis points during 2007, which was exacerbated by the change in deposit mix towards higher cost time deposit and money market products. As a result, the interest rate spread contracted 41 basis points in 2007 to end the year at 4.32% .

Net interest margin on a taxable-equivalent basis was 4.89% for 2007, a decrease of 36 basis points as compared to the same period in 2006. The decrease in net interest margin in 2007 resulted from a $74.9 million increase in average interest-earning assets, coupled with slower growth in net interest income.

The following table details the effects of the interest changes over the last two years:

                                                   Interest Rate & Volume Analysis

                                    2008 compared to 2007                    2007 compared to 2006
                               Increase (decrease) due to (2)           Increase (decrease) due to (2)
(Dollars in thousands)         Volume          Rate        Total        Volume           Rate      Total
Loans (1) (3)            $          5,699  $  (9,003)  $  (3,304)  $         6,198   $   1,263  $   7,461
Federal funds sold                     22       (115)        (93)             (15)           1       (14)
Interest-earning cash                (21)        (23)        (44)                6           3          9
Securities (1)                      (179)        (54)       (233)             (63)          79         16
      Total interest
income                   $          5,521  $  (9,195)  $  (3,674)  $         6,126   $   1,346  $   7,472
Interest-bearing demand
deposits                 $          (150)  $  (2,829)  $  (2,979)  $           814   $   1,714  $   2,528
Savings deposits                     (28)       (116)       (144)             (65)        (56)      (121)
Time deposits                       2,252     (3,356)     (1,104)            1,810       1,895      3,705
Fed funds purchased                   150        (40)         110            (128)           7      (121)
Junior subordinated
debentures                            242       (750)       (508)              579       (153)        426
Other borrowings                      680        (31)         649            (121)          73       (48)
      Total interest
expense                  $          3,146  $  (7,122)  $  (3,976)  $         2,889   $   3,480  $   6,369

(1) Interest income on non-taxable investments is presented on a fully tax-equivalent basis using the federal statutory rate of 35.0%, 35.0% and 34.4%, for the years ended December 31, 2008, 2007 and 2006, respectively.
(2) The changes attributable to the combined effect of volume and interest rates have been allocated proportionately.
(3) Interest income previously accrued on nonaccrual loans is reversed in the period the loan is placed on nonaccrual status.

Provision for Loan Losses: The provision for loan losses is highly dependent on the Company's ability to manage asset quality and control the level of net charge-offs through prudent underwriting standards. In addition, decline in general economic conditions could increase future provisions for loan loss and materially impact the Company's net income. For further discussion of the Company's asset quality see the Credit Risks and Asset Quality section found in Item 7-Management's Discussion and Analysis of Financial Condition and Results of Operations.

In 2008, the provision for loan losses increased 68% to $5.1 million, compared with $3.0 million in 2007. Changes in the provision were due to higher net charge-offs of $3.9 million in 2008, compared with $1.9 million in 2007 and continued loan portfolio growth and internal downgrades of credit within the portfolio as compared to 2007. At year-end 2008, the allowance for loan losses as a percent of total loans was 1.49% as compared to 1.38% in 2007.

In 2007, the provision for loan losses increased 12% to $3.0 million, compared with $2.7 million in 2006. Changes in the provision were due to higher net charge-offs of $1.9 million in 2007, compared with $1.4 million in 2006 and continued loan portfolio growth as compared to 2006. At year-end 2007, the allowance for loan losses as a percent of total loans was 1.38% as compared to 1.40% in 2006.

Noninterest Income: Noninterest income remains a key focus of the Company. The Company has focused on diversifying the noninterest income mix. The diversification of the noninterest income mix resulted primarily from the introduction of nondeposit investment products consisting primarily of annuity sales, and investment service fees, and income from the Company's Bank Owned Life Insurance ("BOLI"). The following table presents the key components of noninterest income:

                                             Noninterest Income as of:

                                Years Ended December 31              Change        Change
                                                                                   2007 vs.
(Dollars in thousands)      2008         2007         2006        2008 vs. 2007     2006
Service charges and
fees                    $     2,987  $     3,135  $     3,296   $        ( 148)  $  ( 161)
Electronic banking
income                        1,333        1,252        1,052                81        200
Investment products             338          364          344             ( 26)         20
Bank owned life
insurance                       306          587          372            ( 281)        215
Income from sale of SBA
loans                           259          490          597            ( 231)      (107)
Income from sale of
loans                           223          667          709            ( 444)      ( 42)
Other income                  1,440          995          880               445        115
   Total noninterest
expense                 $     6,886  $     7,490  $     7,250  $          (604)  $     240

The changes in noninterest income in 2008 compared to 2007 were related to the following areas:

• Service charges and fees decrease is principally attributable to the decreased volume of transaction deposit accounts.
• Electronic banking income consists primarily of ATM service charges. The increase was principally due to increased ATM transaction volume. Income from electronic banking is likely to decrease in 2009 as consumers reduce nonessential expenditures.
• BOLI income in 2008 was impacted by the performance of the mortgage backed securities market. During the third quarter of 2008, the Company renegotiated with the insurance carrier and investment manager to invest the BOLI assets into more stable investments with a more consistent yield.
• Income from the sale of SBA loans decreased due to lower volumes of SBA loan originations. Additionally, the Company did not sell SBA loans during the third and fourth quarters of 2008 due to unfavorable premiums for SBA loans in the secondary financial market.

• Income from the sale of loans decreased due to lower volumes of loan originations. The level of loan originations was impacted by a slow down in lending on 1-4 family homes during the first nine months of 2008. Additionally, loan originations for the Company were impacted by the terminated merger with Frontier Financial Corporation. Under the proposed merger, the department originating real estate loans for sale was to be closed at the time of the merger.
• Other noninterest income principally increased in 2008 due to a non-recurring loan fee adjustment of $342,000.

The changes in noninterest income in 2007 compared to 2006 were related to the following areas:

Noninterest Expense: The Company continues to focus on controlling noninterest expenses and addressing long term operating expenses. As a result of improving operating efficiencies, the Company continued to successfully manage noninterest expense in 2008 and 2007.

Recent Developments: In February 2009, the FDIC adopted final rules which increase the assessment rates paid on deposits. 2008 Assessment rates, for well capitalized banks, ranged from $0.05 to $0.07 per $100 deposits annually. Assessment rates for 2009 will range from $0.12 to $0.16 per deposits annually. The Company anticipates its FDIC premiums to double in 2009.

The Company's efficiency ratio was relatively stable at 60.90% in 2008 as compared to 62.31% in 2007. As detailed in the table below, noninterest expense was directly impacted by one time charges for employee separation expenses and merger related expenses, respectively. The following table presents the key components of noninterest expense:

                                        Noninterest Expense as of:

                                 Years Ended December 31             Change           Change
(Dollars in thousands)       2008         2007         2006       2008 vs. 2007    2007 vs. 2006
Salaries and benefits    $    17,148  $    19,777  $    19,757  $       (2,629)  $            20
   Less: loan
origination costs            (1,775)      (2,695)      (2,950)              920              255
Net salaries and
benefits (as reported)        15,373       17,082       16,807          (1,709)              275
Occupancy expense              3,762        3,805        3,596             (43)              209
Employee separation
expense                          874            -          575              874            (575)
Consulting and
professional fees                794          735          769               59             (34)
Data processing                  625          663          479            ( 38)              184
Office supplies and
printing                         572          558          640               14             (82)
FDIC premiums                    499          219           81              280              138
Merger related expenses          266          513            -           ( 247)              513
Other                          4,758        4,896        4,613           ( 138)              283
   Total noninterest
expense                  $    27,523  $    28,471  $    27,560  $         (948)  $           911

The changes in noninterest expenses in 2008 compared to 2007 were related to the following areas:

. . .