Critical Accounting Policies and Estimates

Allowance for Credit Losses

The allowance for credit losses represents the estimate of probable losses associated with the Bank's loan portfolio and commitments to extend credit. The Company utilizes both quantitative and qualitative considerations in establishing the allowance for credit losses believed to be appropriate as of each reporting date.

Quantitative factors include:

• the volume and severity of nonperforming loans and adversely classified credits,

• the level of net charge-offs experienced on previously classified loans,

• the nature and value of collateral securing the loans,

• the trend in loan growth and the percentage of change,

• the level of geographic and/or industry concentration,

• the relationship and trend over the past several years of recoveries in relation to charge-offs, and

• other known factors regarding specific loans.

Qualitative factors include:

• the effectiveness of credit administration,

• the adequacy of loan review,

• the adequacy of loan operations personnel and processes,

• the effect of competitive issues that impact loan underwriting and structure,

• the impact of economic conditions, including interest rate trends,

• the introduction of new loan products or specific marketing efforts,

• large credit exposure and trends, and

Changes in the above factors could significantly affect the determination of the adequacy of the allowance for credit losses. Management performs a full analysis, no less often than quarterly, to ensure that changes in estimated credit loss levels are adjusted on a timely basis.

Goodwill

Another critical accounting policy of the Company is that related to the carrying value of goodwill. Impairment analysis of the fair value of goodwill involves a substantial amount of judgment. Under Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Asset" (SFAS No. 142), the Company ceased amortization of goodwill on January 1, 2002 and periodically tests goodwill for impairment.

The goodwill impairment analysis requires management to make highly subjective judgments in determining if an indicator of impairment has occurred. Events and factors that may significantly affect the analysis include: a significant decline in the Company's expected future cash flows, a substantial increase in the discount factor, a sustained, significant decline in the Company's stock price and market capitalization, a significant adverse change in legal factors or in the business climate. Other factors might include changing competitive forces, customer behaviors and attrition, revenue trends and cost structures, along with specific industry and market conditions, Adverse change in these factors could have a significant impact on the recoverability of intangible assets and could have a material impact on the Company's consolidated financial statements.

The goodwill impairment analysis involves a two-step process. The first step is a comparison of the Company's fair value to its carrying value. Management estimates fair value using a combination of the income approach and market approach with the best information available, including market information and discounted cash flow analysis. The income approach uses a reporting unit's projection of estimated operating results and cash flows that is discounted using a weighted-average cost of capital that reflects current market conditions. For purposes of the goodwill impairment test, the Company was identified as a single reporting unit. The market approach estimates the fair value of a company by examining the price at which similar companies, or shares of similar companies, are exchanged. Based on management's goodwill impairment analysis, it was determined that the Company's carrying value exceeded its fair value and therefore indicated potential impairment under step one of the process.

The amount of impairment is determined by comparing the implied fair value of the reporting unit goodwill to the carrying value of the goodwill in the same manner as if the reporting unit was being acquired in a business combination. Specifically, a company allocates the fair value to all of the assets and liabilities of the reporting unit, including any unrecognized intangible assets, in a hypothetical analysis that would calculate the implied fair value of goodwill. If the implied fair value of goodwill is less than the recorded goodwill, the Company would record an impairment charge for the difference. The analysis performed in the second step indicated that no impairment charge was required since the implied fair value of the Company's goodwill was greater than the carrying value of the goodwill.

Due to the ongoing uncertainty in market conditions, which may continue to negatively impact the performance of the Company as well as the market valuations of financial institutions, including Cowlitz Bancorporation, management will continue to monitor and evaluate the carrying value of goodwill. Goodwill impairment could be recorded in future periods and such impairment could be material to the Company's results of operations.

Income Taxes

The Company uses the asset and liability method of accounting for income taxes. Determination of the deferred and current provision requires analysis by management of certain transactions and the related tax laws and regulations. Management exercises significant judgment in evaluating the amount and timing of recognition of the resulting tax liabilities and assets. Those judgments and estimates are re-evaluated on a continual basis as regulatory and business factors change.

The Company periodically reviews the carrying amount of its deferred tax assets to determine if the establishment of a valuation allowance is necessary. If, based on the available evidence in future periods, it is more likely than not that all or a portion of the Company's deferred tax assets will not be realized, a deferred tax valuation allowance would be established and could be material to its results of operations. Consideration is given to all positive and negative evidence related to the realization of the deferred tax assets.

In evaluating the available evidence, management considers historical financial performance, expectation of future earnings, the ability to carryback losses to recoup taxes previously paid, length of statutory carryforward periods, experience with operating loss and tax credit carryforwards not expiring unused, tax planning strategies and timing of reversals of temporary differences. Significant judgment is required in assessing future earnings trends and the timing of reversals of temporary differences. The Company's evaluation is based on current tax laws as well as management's expectations of future performance based on its strategic initiatives. Changes in existing tax laws and future results that differ from expectations may result in significant changes in the deferred tax asset valuation allowance.

Recent Developments

In December 2008, the Company submitted an application for approval to issue up to three percent of its total risk-weighted assets in preferred stock to the United States Department of the Treasury (Treasury) under the Troubled Asset Relief Program's Capital Purchase Program (TARP-CPP). This application reflected the Company's understanding that an investment by the Treasury though the TARP-CPP might be conditioned on the Company's receipt of a significant amount of private equity capital. On May 1, 2009 the Company submitted a letter to the Federal Reserve, which serves as the primary regulator for the Company, indicating its intention to withdraw its TARP-CPP application. The decision to withdraw the application was based upon a number of factors, including the expectation that private equity co-investment will not be consummated prior to the deadline for the processing of final TARP-CPP investments. The private equity markets for banks have been extremely limited since mid-2008. In the event additional new capital is not available in the near term, the Company may instead take additional steps to preserve capital, including slowing or reducing lending, selling certain assets, and/or increasing loan participations. The Company does not pay cash dividends.

Results of Operations for the Three Months Ended March 31, 2009 and 2008

Overview

The Company's net loss for the first quarter of 2009 was $1,902,000, or ($0.37) per diluted share, compared with net income of $902,000, or $0.18 per diluted share for the first quarter of 2008. Net interest income of $4.2 million was down 22 percent from $5.4 million in the first quarter of 2008

The Company recorded a provision for credit losses of $3,505,000 in the first quarter of 2009, compared with a provision for credit losses of $593,000 in the first quarter of 2008. The higher provision in 2009 primarily reflected the higher level of net charge-offs due to the significant slowdown in the housing industry, affecting the Company's residential land acquisition and development loan portfolio.

Non-interest income was lower by $99,000 in the first quarter of 2009 when compared to first quarter of 2008, primarily due to declines of $137,000 in international trade fees and wire fees of $52,000 that were offset with increases in service charges of $66,000 and fiduciary income of $53,000.

Non-interest expenses totaled $5.1 million in the first quarter of 2009, compared with $4.6 million in the first quarter of 2008. Salaries and benefits decreased $322,000 in the first quarter of 2009 compared with the first quarter of 2008 as the number of full-time equivalent employees at March 31, 2009 decreased 14 percent from the number of full-time equivalent employees at March 31, 2008. FDIC deposit insurance assessments and Washington State public deposit assessments increased $400,000 over the first quarter of 2008, reflecting the FDIC's higher base assessment rate for 2009, expenses related to the FDIC's proposed emergency special assessment and the Company's pro-rata share of the loss of public deposits arising from the failure of the Bank of Clark County.

At March 31, 2009, total assets were $592.8 million, compared with $587.4 at December 31, 2008 and $548.5 million at March 31, 2008. Total loans increased $2.7 million to $418.2 million, from $415.5 million at March 31, 2008, but down from $433.2 million at December 31, 2008. Total deposits increased 12 percent to $529.3 million at March 31, 2009 from $472.3 million at March 31, 2008. The Company continues to be "well-capitalized" under regulatory requirements.

Analysis of Net Interest Income

The primary component of the Company's earnings is net interest income. Net interest income is the difference between interest income, principally from loans and the investment securities portfolio, and interest expense, principally on customer deposits and borrowings. Changes in net interest income, net interest spread, and net interest margin result from changes in asset and liability volume and mix, and to rates earned or paid. Net interest spread refers to the difference between the yield on interest-earning assets and the cost of interest-bearing liabilities. Net interest margin is the ratio of net interest income to total interest-earning assets and is influenced by the volume and relative mix of interest-earning assets and interest-bearing liabilities. Volume refers to the dollar level of interest-earning assets and interest-bearing liabilities.

Interest income from certain of the Company's earning assets is non-taxable. The following tables present interest income and expense, including adjustments for non-taxable interest income, and the resulting tax-adjusted yields earned, rates paid, interest rate spread, and net interest margin for the periods indicated on an annualized basis.

                                                                   For the Quarter Ended March 31,
                                                           2009                                      2008
                                              Average         Interest                  Average         Interest
                                            Outstanding       Earned/     Yield/      Outstanding       Earned/     Yield/
(dollars in thousands)                        Balance           Paid       Rate         Balance           Paid       Rate
Assets
Interest-Earning Assets:
Loans (1) (2) (3)                          $     431,166     $    6,985     6.57 %   $     412,907     $    8,428     8.21 %
Taxable securities                                41,702            545     5.30 %          27,188            364     5.38 %
Non-taxable securities (2)                        21,903            350     6.48 %          24,322            393     6.50 %
Federal funds sold                                44,165             28     0.26 %          13,170             97     2.96 %
Interest-earning balances due from banks
and FHLB stock                                     2,484              1     0.16 %           1,923              8     1.67 %

Total interest-earning assets (2)                541,420          7,909     5.92 %         479,510          9,290     7.79 %

Cash and due from banks                           15,713                                    17,081
Allowance for loan losses                        (13,241 )                                  (5,987 )
Other assets                                      44,465                                    36,093

Total assets                               $     588,357                             $     526,697

Liabilities and Shareholders' Equity
Interest-Bearing Liabilities:
Savings, money market and
interest-bearing demand deposits           $      98,775     $      209     0.86 %   $     121,473     $      599     1.98 %
Certificates of deposit                          364,243          3,257     3.63 %         239,378          2,940     4.94 %
Federal funds purchased                               -              -        -              1,340             11     3.30 %
Junior subordinated debentures                    12,372            109     3.57 %          12,372            193     6.27 %
FHLB and other borrowings                             41              1     8.83 %             114              2     7.06 %

Total interest-bearing liabilities               475,431          3,576     3.05 %         374,677          3,745     4.02 %

Non-interest-bearing deposits                     59,686                                    91,736
Other liabilities                                  4,549                                     4,032

Total liabilities                                539,666                                   470,445
Shareholders' equity                              48,691                                    56,252

Total liabilities and shareholders'
equity                                     $     588,357                             $     526,697

Net interest income (2)                                      $    4,333                                $    5,545

Net interest spread                                                         2.87 %                                    3.77 %

Yield on average interest-earning assets                                    5.92 %                                    7.79 %
Interest expense to average interest-earning assets                         2.68 %                                    3.14 %

Net interest income to average interest-earning assets
(net interest margin)                                                       3.25 %                                    4.65 %

(1) Loans include loans on which the accrual of interest has been discontinued.

(2) Interest earned on non-taxable securities and loans has been computed on a 34 percent tax-equivalent basis.

(3) Loan interest income includes net loan fees of $286,000 and $488,000 for the first quarter of 2009 and 2008, respectively.

Net interest margin as a percentage was 3.25 percent for the first quarter of 2009, compared with 4.65 percent in the first quarter of 2008. Net interest income was $4.2 million in the first quarter of 2009, compared with $5.4 million in the same quarter last year. The Company's net interest margin relative to the first quarter 2008 was affected by several factors, including significant rate reductions by the Federal Reserve in the second half of 2008, interest reversals, continued competitive market pricing on both sides of the balance sheet, a higher level of nonperforming assets and a lower level of non-interest-bearing demand and low-cost money market deposit accounts.

The Company's yield on average earning assets was 5.92 percent in the first quarter of 2009, compared with 7.79 percent in the first quarter of 2008. The Company estimates that interest reversals of $771,000 reduced the first quarter 2009 average yield on earning assets by 58 basis points. The first quarter 2009 average yield on earning assets was also affected by a higher level of federal funds sold as part of the Company's liquidity management. The average rate on interest-bearing liabilities fell to 3.05 percent in the first quarter of 2009 from 4.02 percent in the first quarter a year ago. Average funding costs have improved as deposits issued in the first quarter of 2009 were issued in a lower interest rate environment.

Provision for Credit Losses

The amount of the allowance for credit losses is analyzed by management on a regular basis to ensure that it is adequate to absorb losses inherent in the loan portfolio as of the reporting date. When a provision for credit losses is recorded, the amount is based on the current volume of loans and commitments to extend credit, anticipated changes in loan volumes, past charge-off experience, management's assessment of the risk of loss on current loans, the level of nonperforming and impaired loans, evaluation of future economic trends in the Company's market area, and other factors relevant to the loan portfolio. An internal loan risk grading system is used to evaluate potential losses of individual loans. The Company does not, as part of its analysis, group loans together by loan type to assign risk. See "Allowance for Credit Losses" below for a more detailed discussion.

The Company recorded a provision for credit losses of $3,505,000 in the first quarter of 2009, compared with a $593,000 provision in the first quarter of 2008. The higher provision in 2009 primarily reflected the higher level of net charge-offs in the quarter and the on-going weakness in the regional real estate markets and the economy in general. Net charge-offs of $8.7 million and $158,000 were recorded for the three-month periods ended March 31, 2009 and 2008, respectively.

The Company's approach to the determination of carrying value of its real estate loans is based on the assumption that the only source of repayment will be collateral liquidation. While many loans include personal guarantees of the borrowers, the recovery of material amounts through legal action is considered by management, in most cases, limited.

Non-Interest Income

Non-interest income consists of the following components:



                                                                      Three Months Ended
                                                                          March 31,
(dollars in thousands)                                              2009             2008
Service charges on deposit accounts                               $     230        $     164
International trade fees                                                 63              200
Fiduciary income                                                        226              173
Increase in cash surrender value of bank-owned life insurance           150              152
Wire fees                                                                29               81
Mortgage brokerage fees                                                  60               62
Securities losses                                                       (11 )             -
Other income                                                            116              130

Total noninterest income                                          $     863        $     962

Total non-interest income was $863,000 for the first quarter of 2009, compared with $962,000 for the first quarter of 2008. Service charges increased $66,000 and fiduciary income increased $53,000. Offsetting these increases were declines of $137,000 in international trade fees and $52,000 in wire fees. These decreases related primarily to a planned reduction in the number of non-resident relationships serviced by our Seattle-based international trade department and wire room. There were 193 accounts closed with an average daily balance of approximately $8.3 million.

Non-Interest Expense

Non-interest expense consists of the following components:



                                                    Three Months Ended
                                                        March 31,
            (dollars in thousands)                   2009         2008
            Salaries and employee benefits        $    2,185    $  2,507
            Net occupancy and equipment                  640         617
            Professional services                        570         263
            Data processing and communications           311         215
            Interest rate contracts adjustments          114         228
            Federal deposit insurance                    491          91
            Foreclosed asset expense (income)             60        (162 )
            Other expense                                765         851

            Total noninterest expense             $    5,136    $  4,610

Non-interest expenses in the first quarter of 2009 were $5.1 million, compared with $4.6 million in the first quarter of 2008. Salaries and employee benefits decreased $322,000, or 13 percent, in the first quarter of 2009 compared with the first quarter of 2008. The number of full-time equivalent employees at March 31, 2009 was 14 percent less than the same time a year ago, and reflects management's efforts to streamline operations and reduce overall employee-related costs, while maintaining or improving customer service.

FDIC deposit insurance assessments increased $400,000 over the first quarter of 2008, reflecting the FDIC's higher base assessment rate for 2009, expenses related to the FDIC's proposed emergency special assessment and the Company's pro-rata share of the loss of public deposits arising from the failure of the Bank of Clark County. In February 2009, the FDIC announced a 20 basis point special assessment on deposits as of June 30, 2009, payable September 30, 2009. On May 6, 2009, the U.S. Senate passed a bill increasing the FDIC's Treasury borrowing authority from $30 billion to $100 billion. It is expected that this bill, upon final approval by the U.S. House of Representatives and the President, will reduce the proposed emergency special assessment to 10 basis points. The increase in the FDIC's borrowing authority, combined with other measures the FDIC has taken, could reduce the special assessment to approximately 8 basis points. The rule would also permit the FDIC to impose an additional emergency special assessment after June 30, 2009, of up to 10 basis points. The Company expects to incur additional FDIC insurance costs in the second quarter of 2009.

Professional services increased $307,000 over the same period last year and related primarily to higher legal expenses associated with nonperforming loans, costs related to professional assistance with the Company's capital raising initiative and first-time costs of the independent auditor's review of the Company's internal controls over financial reporting under the Sarbanes-Oxley act. Net costs related to foreclosed assets in the first quarter of 2008 included a $216,500 gain on sale of assets, with no such gains recorded in the first quarter of 2009.

Income Taxes

The effective tax rate for the first quarter of 2009 was 47.0 percent compared with 22.3 percent during the same period of 2008. The Company's effective tax rate for interim periods is based on projections of taxable income or loss for the full year and is affected by the relative amounts of taxable and non-taxable income and the amount of available tax credits.

Financial Condition

Investment Securities

The following table presents the composition and carrying value of the Company's
available for sale investment portfolio:



                                                  March 31,     December 31,
         (dollars in thousands)                     2009            2008
         Agency mortgage-backed securities       $    37,273   $       39,818
         Non-agency mortgage-backed securities         2,451            2,414
         Municipal bonds                              21,909           21,281
         Other securities                                546              551

                                                 $    62,179   $       64,064

Total investment securities as of March 31, 2009 were $62.2 million, compared with $64.1 million at December 31, 2008. The decrease primarily relates to principal reductions of the Company's mortgage-backed securities. The Company's securities, classified as available for sale, are used by management as part of its asset/liability management strategy and may be sold in response to changes in interest rates or significant prepayment risk.

Loans

Total loans outstanding were $418.2 million and $433.2 million at March 31, 2009 and December 31, 2008, respectively. The Company reduced loans $15.0 million, or 3 percent, in the first quarter of 2009. This reduction included $8.7 million of net loan charge-offs. Management currently believes it prudent to reduce loan balances when possible until it is apparent that the economic downturn has run its course. Unfunded loan commitments were $55.6 million at March 31, 2009 and $60.6 million at December 31, 2008. Management believes that the Bank's available resources will be sufficient to fund its commitments in the normal course of business.

The following table presents the composition of the Company's loan portfolio in accordance with bank regulatory guidelines, at the dates indicated:

                                           March 31, 2009           December 31, 2008
     (dollars in thousands)              Amount       Percent      Amount       Percent
     Commercial                         $ 110,748        26.4 %   $ 113,991        26.3 %
     Real estate:
     Construction                          82,797        19.8 %      93,191        21.5 %
     Residential 1-4 family                38,813         9.3 %      36,662         8.4 %
     Multifamily                            2,917         0.7 %       3,028         0.7 %
. . .