Quarterly Report (10-q)

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 June 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 July 31, 2014 was 10,225,984.

Form 10-Q

Table of Contents

Part I FINANCIAL INFORMATION

Item I.	FINANCIAL STATEMENTS (UNAUDITED)	2

	CONDENSED CONSOLIDATED BALANCE SHEETS JUNE 30, 2014 AND DECEMBER 31, 2013	2

	CONDENSED CONSOLIDATED STATEMENTS OF INCOME THREE AND SIX MONTHS ENDED JUNE 30, 2014 AND 2013	3

	CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME THREE AND SIX MONTHS ENDED JUNE 30, 2014 AND 2013	4

	CONDENSED CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY SIX MONTHS ENDED JUNE 30, 2014 AND 2013	5

	CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS SIX MONTHS ENDED JUNE 30, 2014 AND 2013	6

	NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS	7

Item 2.	MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	35

Item 3.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	56

Item 4.	CONTROLS AND PROCEDURES	56

Part II OTHER INFORMATION

Item 1.	LEGAL PROCEEDINGS	56

Item 1A.	RISK FACTORS	56

Item 2.	UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS	56

Item 3.	DEFAULTS UPON SENIOR SECURITIES	57

Item 4.	MINE SAFETY DISCLOSURES	57

Item 5.	OTHER INFORMATION	57

Item 6.	EXHIBITS	58

SIGNATURES		59

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

PACIFIC FINANCIAL CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(Dollars in Thousands, except per share data)

(UNAUDITED)

	June 30,			December 31,
	2014			2013
ASSETS
Cash and cash equivalents:
Cash and due from banks	$	17,455		$	12,214
Interest-bearing deposits in banks		239			23,734
Total cash and cash equivalents		17,694			35,948
Interest-bearing certificates of deposit (original maturities greater than 90 days)		2,727			2,727
Federal Home Loan Bank stock, at cost		2,956			3,013
Investment securities:
Investment securities available-for-sale, at fair market value		88,712			96,144
Investment securities held-to-maturity, at amortized cost (fair value of $1,894, $2,158, and $6,985)		1,871			2,132
Total investment securities		90,583			98,276

Loans held-for-sale		7,632			7,765
Loans, net of deferred loan fees		547,283			504,666
Allowance for loan losses		(8,315	)		(8,359	)
Loans, net		538,968			496,307

Premises and equipment, net of accumulated depreciation and amortization		16,660			16,790
Other real estate owned and foreclosed assets		991			2,771
Accrued interest receivable		2,277			2,307
Cash surrender value of life insurance		18,488			18,237
Goodwill		12,168			12,168
Other intangible assets		1,460			1,481
Other assets		6,868			7,249

TOTAL ASSETS	$	719,472		$	705,039

LIABILITIES AND SHAREHOLDERS' EQUITY
LIABILITIES
Deposits:
Demand	$	156,954		$	145,028
Interest-bearing demand and savings		342,816			336,260
Time deposits		119,531			126,059
Total deposits		619,301			607,347
Accrued interest payable		151			167
Short-term borrowings		340			-
Long-term borrowings		10,000			10,000
Junior subordinated debentures		13,403			13,403
Other liabilities		5,417			6,985
Total liabilities		648,612			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, 10,185,755 shares issued and outstanding at 06/30/2014 and 10,182,083 at 12/31/2013		10,213			10,182
Additional paid-in-capital		42,058			41,817
Retained earnings		18,938			16,507
Accumulated other comprehensive income/(loss)		(349	)		(1,369	)
Total shareholders' equity		70,860			67,137
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY	$	719,472		$	705,039

See accompanying notes.

PACIFIC FINANCIAL CORPORATION

CONSOLIDATED STATEMENTS OF INCOME

(Dollars in Thousands, Except per Share Data)

(UNAUDITED)

	For the Three Months Ended						For the Six Months Ended
	June 30,			June 30,			June 30,			June 30,
	2014			2013			2014			2013
INTEREST AND DIVIDEND INCOME
Loans	$	6,743		$	6,169		$	13,238		$	12,042
Deposits in banks and federal funds sold		18			23			38			51
Investment securities:
Taxable		343			146			682			250
Tax-exempt		232			262			462			528
FHLB dividends		1			-			2			-

Total interest and dividend income		7,337			6,600			14,422			12,871

INTEREST EXPENSE
Deposits:
Interest-bearing demand and savings		140			181			281			381
Time		290			351			566			718
Long-term borrowings		51			54			104			114
Junior subordinated debentures		60			62			120			124

Total interest expense		541			648			1,071			1,337

Net interest income		6,796			5,952			13,351			11,534

LOAN LOSS PROVISION		100			(450	)		100			(450	)

Net interest income after loan loss provision		6,696			6,402			13,251			11,984

NON-INTEREST INCOME
Service charges on deposit accounts		474			431			909			841
Net gains (loss) on sale of other real estate owned		(57	)		45			(93	)		25
Net gains from sales of loans		968			1,669			1,596			3,178
Net gains (loss) on sales of securities available for sale		(2	)		329			50			387
Net other-than-temporary impairment (net of $0, $3, $15, $3 respectively recognized in other comprehensive income before taxes)		(3	)		(34	)		(48	)		(34	)
Earnings on bank owned life insurance		140			116			251			237
Other operating income		656			619			1,119			1,167

Total non-interest income		2,176			3,175			3,784			5,801

NON-INTEREST EXPENSE
Salaries and employee benefits		4,283			4,499			8,338			8,885
Occupancy		504			452			1,010			865
Equipment		263			195			515			386
Data processing		462			809			895			1,239
Professional services		201			236			386			498
Other real estate owned write-downs		54			108			66			460
Other real estate owned operating costs		30			125			91			209
State taxes		107			133			204			250
FDIC and state assessments		129			130			263			266
Other non-interest expense		1,033			1,185			2,128			2,233

Total non-interest expense		7,066			7,872			13,896			15,291

INCOME BEFORE PROVISION FOR INCOME TAXES		1,806			1,705			3,139			2,494

PROVISION FOR INCOME TAXES		403			373			708			461

NET INCOME APPLICABLE TO COMMON SHAREHOLDERS	$	1,403		$	1,332		$	2,431			2,033

EARNINGS PER COMMON SHARE:
BASIC	$	0.14		$	0.13		$	0.24			0.20
DILUTED	$	0.14		$	0.13		$	0.24			0.20

WEIGHTED AVERAGE SHARES OUTANDING:
BASIC		10,189,386			10,121,853			10,185,755			10,121,853
DILUTED		10,275,628			10,182,524			10,273,994			10,172,356

See accompanying notes.

PACIFIC FINANCIAL CORPORATION

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Dollars in Thousands)

(UNAUDITED)

	For the Three Months Ended					For the Six Months Ended
	June 30,		June 30,			June 30,		June 30,
	2014		2013			2014		2013

NET INCOME	$	1,403	$	1,332		$	2,431	$	2,033
OTHER COMPREHENSIVE INCOME (LOSS), NET OF TAX:
Change in fair value of securities available-for-sale		596		(1,874	)		962		(2,003	)
Defined benefit plan		29		28			58		56
Total other comprehensive income (loss), net of tax		625		(1,846	)		1,020		(1,947	)
COMPREHENSIVE INCOME	$	2,028	$	(514	)	$	3,451	$	86

See accompanying notes.

PACIFIC FINANCIAL CORPORATION

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY

(Dollars in Thousands, Except Share Amounts)

(UNAUDITED)

									Accumulated
	Common Stock								Other			Total
	Shares		Amount		Additional Paid-in Capital		Retained Earnings		Comprehensive Income/(Loss)			Shareholders' Equity
BALANCE - December 31, 2012		10,121,853	$	10,122	$	41,366	$	14,812	$	421		$	66,721
Net income		-		-				2,033		-			2,033
Other comprehensive income, net of tax
Unrealized holding loss on securities less reclassification adjustments for net gains included in net income		-		-		-		-		(2,003	)		(2,003	)
Amortization of unrecognized prior service costs and net gains/(losses)		-		-		-		-		56			56
Issuance of common stock		-		-		-		-		-			-
Stock-based compensation expense		-		-		42		-		-			42
BALANCE - June 30, 2013		10,121,853	$	10,122	$	41,408	$	16,845	$	-1,526		$	66,849

BALANCE - December 31, 2013		10,182,083	$	10,182	$	41,817	$	16,507	$	(1,369	)	$	67,137
Net income		-		-				2,431		-			2,431
Other comprehensive income, net of tax
Unrealized holding gain on securities less reclassification adjustments for net gains included in net income		-		-		-		-		962			962
Amortization of unrecognized prior service costs and net gains/(losses)		-		-		-		-		58			58
Issuance of common stock		31,251		31		172		-		-			203
Stock-based compensation expense		-		-		69		-		-			69
BALANCE - June 30, 2014		10,213,334	$	10,213	$	42,058	$	18,938	$	(349	)	$	70,860

See accompanying notes.

PACIFIC FINANCIAL CORPORATION AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in Thousands)

(UNAUDITED)

	For the Six Months Ended
	June 30,			June 30,
	2014			2013
CASH FLOWS FROM OPERATING ACTIVITIES
Net Income	$	2,431		$	2,033
Adjustments to reconcile net income to net cash from operating activities
Provision for credit losses		100			(450	)
Depreciation and amortization		1,297			1,176
Originations of loans held for sale		(66,287	)		(155,116	)
Proceeds from sales of loans held for sale		68,016			160,325
Net gains on sales of loans		(1,596	)		(3,178	)
Net gain (loss) on sales of securities available for sale		(50	)		(387	)
Net OTTI recognized in earnings		48			34
(Gain) loss on sales of other real estate owned		93			(25	)
(Gain) loss on sale of premises and equipment		5			16
Earnings on bank owned life insurance		(251	)		(237	)
(Increase) decrease in accrued interest receivable		30			(157	)
Increase (decrease) in accrued interest payable		(16	)		(30	)
Other real estate owned write-downs		66			460
(Increase) decrease in prepaid expenses		(72	)		2,106
Other — net		404			970

Net cash provided by operating activities		4,218			7,540

CASH FLOWS FROM INVESTING ACTIVITIES
Net decrease in interest bearing balances with banks		23,495			6,602
Purchase of certificates of deposits held for investment, net		-			750
Activity in securities available for sale:
Sales		13,828			4,158
Maturities, prepayments and calls		3,891			5,598
Purchases		(9,297	)		(38,369	)
Activity in securities held to maturity:
Maturities, prepayments and calls		261			3,928
Purchases		-			-
(Increase) decrease in loans made to customers, net of principal collections		(42,335	)		(22,650	)
Purchases of premises and equipment		(533	)		(1,280	)
Proceeds from sales of other real estate owned		1,244			1,002
Proceeds from sales of premises and equipment		8			-
Cash received in acquisition, net of cash paid		-			31,941

Net cash provided by (used in) investing activities		(9,438	)		(8,320	)

CASH FLOWS FROM FINANCING ACTIVITIES
Net increase in deposits		11,954			5,270
Net decrease in short-term borrowings		340			(3,000	)
Proceeds from issuance of long-term debt		-			2,500
Stock options exercised		203			-
Cash dividends paid		(2,036	)		-

Net cash provided by financing activities		10,461			4,770

NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS		5,241			3,990
CASH AND DUE FROM BANKS - BEGINNING OF THE PERIOD		12,214			14,168
CASH AND DUE FROM BANKS - END OF THE PERIOD	$	17,455		$	18,158

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash paid for interest	$	1,087		$	1,365
Cash paid for taxes	$	-		$	130

SUPPLEMENTAL SCHEDULE OF NON CASH INVESTING AND
FINANCING ACTIVITIES
Change in fair value of securities available-for-sale, net of tax	$	962		$	(2,003	)
Transfer of loans held for sale to loans held for investment	$	-		$	64
Other real estate owned acquired in settlement of loans	$	(317	)	$	(209	)
Financed sale of other real estate owned	$	694		$	-

See accompanying notes.

PACIFIC FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

As of and for the 6 months ended June 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 bank, 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 16 branches located in communities in Grays Harbor, Pacific, Whatcom, Skagit and Wahkiakum counties in the state of Washington and three in Clatsop County, Oregon. In addition, the Bank operates three loan production offices in Burlington, Dupont and Vancouver, 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 Pacific Financial Corporation ("Pacific" or 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 six months ended June 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 Bank of the Pacific 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 June 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.

Cash dividends – No cash dividends were declared in the quarter ended June 30, 2014.

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				Six Months Ended
	June 30,				June 30,
	2014		2013		2014		2013
Basic:
Net income	$	1,403	$	1,332	$	2,431	$	2,033
Weighted average shares outstanding		10,189,386		10,121,853		10,185,755		10,121,853
Basic earnings per share	$	0.14	$	0.13	$	0.24	$	0.20

Diluted:
Net income	$	1,403	$	1,332	$	2,431	$	2,033
Weighted average shares outstanding		10,189,386		10,121,853		10,185,755		10,121,853
Effect of dilutive stock options		86,242		60,671		88,239		50,503
Weighted average shares outstanding assuming dilution		10,275,628		10,182,524		10,273,994		10,172,356
Diluted earnings per share	$	0.14	$	0.13	$	0.24	$	0.20

	June 30, 2014		June 30, 2013
Shares subject to outstanding options		365,095		468,865
Shares subject to outstanding warrants		410,542		699,642

As of June 30, 2014 and 2013, the shares subject to outstanding options and 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.

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).

Investment securit ies at June 30, 2014 and December 31, 2013 consisted of the following:

(Dollars in Thousands)

	June 30, 2014
			Gross		Gross
	Amortized		unrealized		unrealized		Fair
		cost		gains		losses		value
Available-for-sale:
Collateralized mortgage obligations: agency issued	$	39,336	$	221	$	735	$	38,822
Collateralized mortgage obligations: non-agency		614		-		10		604
Mortgage-backed securities: agency issued		11,980		57		118		11,919
U.S. Government and agency securities		8,674		80		33		8,721
State and municipal securities		28,043		826		223		28,646
Corporate bonds		-		-		-		-

Total available-for-sale	$	88,647	$	1,184	$	1,119	$	88,712

Held-to-maturity:
Mortgage-backed securities: agency issued	$	140	$	13	$	-	$	153
State and municipal securities		1,731		10		-		1,741

Total held-to-maturity	$	1,871	$	23	$	-	$	1,894

	December 31, 2013
			Gross		Gross
	Amortized		unrealized		unrealized		Fair
	cost		gains		losses		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

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 June 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 June 30, 2014	Fair Value		Losses		Fair Value		Losses		Fair Value		Losses
Available-for-sale:
Collateralized mortgage obligations: agency issued	$	13,594	$	99	$	15,987	$	635	$	29,581	$	734
Collateralized mortgage obligations: non agency		-		-		227		10		227		10
Mortgage-backed securities: agency issued		510		2		7,863		117		8,373		119
U.S. Government agency securities		-		-		3,627		33		3,627		33
State and municipal securities		1,674		7		8,916		216		10,590		223
Corporate bonds		-		-		-		-		-		-
Total	$	15,778	$	108	$	36,620	$	1,011	$	52,398	$	1,119

	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 June 30, 2014, there were 64 investment securities in an unrealized loss position, of which 47 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 June 30, 2014.

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 six months ended June 30, 2014, no non-agency MBS was determined to be other-than-temporarily-impaired. For the six months ended June 30, 2013, one non-agency MBS was determined to be other-than-temporarily-impaired. This security was sold in the current quarter, incurring a loss of $69,000. The Company recorded $48,000 and $34,000 in impairments related to credit losses through earnings for the six months ended June 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 six months ended June 30, 2014 and 2013:

Investment securities gross gains and losses

(Dollars in Thousands)

	For the Three Months Ended					For the Six Months Ended
	June 30, 2014			June 30, 2013		June 30, 2014			June 30, 2013
Gross realized gain on sale of securities	$	159		$	329	$	221		$	387
Gross realized loss on sale of securities		(161	)		-		(171	)		-
Net realized gain (loss) on sale of securities	$	(2	)	$	329	$	50		$	387

Proceeds from sale of securities	$	8,979		$	1,171	$	13,828		$	4,158

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 June 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.

At June 30, 2014

(Dollars in Thousands)

	Held-to-maturity				Available-for-sale
	Amortized				Amortized
	Cost		Fair Value		Cost		Fair Value

Due in one year or less	$		$		$	1,084	$	1,086
Due after one year through five years		-		-		7,027		7,022
Due after five years through ten years		888		898		12,673		12,930
Due after ten years		843		842		15,915		16,328
Mortgage-backed securities		140		154		51,948		51,346

Total investment securities	$	1,871	$	1,894	$	88,647	$	88,712

At June 30, 2014, investment securities with an estimated fair value of $69.0 million were pledged to secure public deposits, certain nonpublic deposits and borrowings.

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 June 30, 2014, the Company held approximately $3.0 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 six month periods ended June 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 June 30, 2014, and believes that it will ultimately recover the par value of its investment in this stock.

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

Loans

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

Loans as of June 30, 2014 and December 31, 2013 consisted of the following:

(Dollars in Thousands)	June 30, 2014			December 31, 2013

Commercial and agricultural	$	109,368		$	104,111
Real estate:
Construction and development		32,071			29,096
Residential 1-4 family		90,549			87,762
Multi-family		20,110			17,520
Commercial real estate — owner occupied		117,203			105,594
Commercial real estate — non owner occupied		124,929			117,294
Farmland		23,900			23,698
Consumer/Finance		30,241			20,728
Gross loans		548,371			505,803
Less: deferred fees		(1,088	)		(1,137	)

Portfolio Loans	$	547,283		$	504,666

Allowance for 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 “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 “Accounting for Contingencies.”

Additionally, impaired loans are evaluated for loss potential on an individual basis in accordance with “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 six months ended June 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 June 30, 2014

Beginning balance	$	774		$	3,603		$	674		$	774		$	2,463		$	8,288
Charge-offs and concessions		(9	)		(389	)		(4	)		(29	)		-			(431	)
Recoveries		1			347			9			1			-			358
Provision / (recapture)		138			246			23			136			(443	)		100

Ending balance	$	904		$	3,807		$	702		$	882		$	2,020		$	8,315

For the six months ended June 30, 2014

Beginning balance	$	775		$	3,506		$	675		$	744		$	2,659		$	8,359
Charge-offs and concessions		(26	)		(396	)		(44	)		(47	)		-			(513	)
Recoveries		2			352			13			2			-			369
Provision / (recapture)		153			345			58			183			(639	)		100

Ending balance	$	904		$	3,807		$	702		$	882		$	2,020		$	8,315

Allowance for Credit Losses

Dollars in Thousands				Commercial Real			Residential
	Commercial			Estate ("CRE")			Real Estate			Consumer			Unallocated			Total

For the three months ended June 30, 2013

Beginning balance	$	711		$	3,743		$	787		$	542		$	3,565		$	9,348
Charge-offs and concessions		-			(41	)		(56	)		(55	)		-			(152	)
Recoveries		5			210			1			-			-			216
Provision / (recapture)		93			(498	)		81			151			(277	)		(450	)

Ending balance	$	809		$	3,414		$	813		$	638		$	3,288		$	8,962

For the six months ended June 30, 2013

Beginning balance	$	923		$	4,098		$	829		$	531		$	2,977		$	9,358
Charge-offs and concessions		-			(46	)		(66	)		(66	)		-			(178	)
Recoveries		15			215			1			1			-			232
Provision / (recapture)		(129	)		(853	)		49			172			311			(450	)

Ending balance	$	809		$	3,414		$	813		$	638		$	3,288		$	8,962

Recorded investment in loans as of June 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 June 30, 2014

Allowance for Credit Losses:
Ending balance: individually evaluated for impairment	$	-	$	-	$	-	$	-	$	-	$	-

Ending balance: collectively evaluated for impairment	$	904	$	3,807	$	702	$	882	$	2,020	$	8,315

Loans:
Ending balance	$	109,368	$	298,103	$	110,659	$	30,241	$	-	$	548,371
Ending balance: individually evaluated for impairment	$	411	$	7,785	$	776	$	53	$	-	$	9,025
Ending balance: collectively evaluated for impairment	$	108,957	$	290,318	$	109,883	$	30,188	$	-	$	539,346

Less deferred fees											$	(1,088	)

Ending balance total loans											$	547,283

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.

(Dollars in Thousands)

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

June 30, 2014			Other Loans
			Especially
	Pass		Mentioned		Substandard		Doubtful		Total

Commercial and agricultural	$	101,018	$	7,581	$	769	$	-	$	109,368
Real estate:
Construction and development		30,748		50		1,273		-		32,071
Residential 1-4 family		87,049		759		2,741		-		90,549
Multi-family		19,839		271		-		-		20,110
Commercial real estate — owner occupied		109,489		3,885		3,829		-		117,203
Commercial real estate — non owner occupied		94,940		23,717		6,272		-		124,929
Farmland		20,474		2,422		1,004		-		23,900
Total real estate		362,539		31,104		15,119		-		408,762

Consumer/Finance		30,106		60		75		-		30,241

Less deferred fees		-		-		-		-		(1,088	)

Total loans	$	493,663	$	38,745	$	15,963	$	-	$	547,283

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

Impaired Loans

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

(Dollars in Thousands)							3 Month		6 Month		3 Month		6 Month
	Unpaid						Average		Average		Interest		Interest
	Principal		Recorded		Related		Recorded		Recorded		Income		Income
	Balance		Investment		Allowance		Investment		Investment		Recognized		Recognized
June 30, 2014

With no Related Allowance:
Commercial	$	449	$	411	$	-	$	415	$	472	$	4	$	11
Consumer		53		53		-		53		53		-		-
Residential real estate		1,042		776		-		774		724		14		25
Commercial real estate:
CRE — owner occupied		1,661		1,661		-		1,788		1,763		-		-
CRE — non owner occupied		4,267		3,896		-		4,229		4,346		3		11
Farmland		955		955		-		955		955		115		225
Construction and development		3,331		1,273		-		1,275		1,320		18		33
Total	$	11,758	$	9,025	$	-	$	9,489	$	9,633	$	154	$	305

With a Related Allowance:
Consumer/Finance	$	-	$	-	$	-	$	-	$	-	$	-	$	-
Residential real estate		-		-		-		-		-		-		-
Total	$	-	$	-	$	-	$	-	$	-	$	-	$	-

Total Impaired Loans:
Commercial	$	449	$	411	$	-	$	415	$	472	$	4	$	11
Consumer		53		53		-		53		53		-		-
Residential real estate		1,042		776		-		774		724		14		25
Commercial real estate:
CRE — owner occupied		1,661		1,661		-		1,788		1,763		-		-
CRE — non owner occupied		4,267		3,896		-		4,229		4,346		3		11
Farmland		955		955		-		955		955		115		225
Construction and development		3,331		1,273		-		1,275		1,320		18		33
Total Impaired Loans	$	11,758	$	9,025	$	-	$	9,489	$	9,633	$	154	$	305

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

(Dollars in Thousands)							3 Month		6 Month		3 Month		6 Month
	Unpaid						Average		Average		Interest		Interest
	Principal		Recorded		Related		Recorded		Recorded		Income		Income
	Balance		Investment		Allowance		Investment		Investment		Recognized		Recognized
June 30, 2013

With no Related Allowance:
Commercial	$	1,199	$	1,202	$	-	$	1,388	$	1,665	$	3	$	5
Consumer		-		-		-		-		-		-		-
Residential real estate		1,865		1,595		-		1,430		1,243		6		10
Commercial real estate:
CRE — owner occupied		2,866		2,866		-		2,888		2,970		12		24
CRE — non owner occupied		6,773		4,576		-		5,505		5,601		6		23
Farmland		3,728		1,457		-		1,649		1,696		20		40
Construction and development		955		955		-		955		962		-		-
Total	$	17,386	$	12,651	$	-	$	13,815	$	14,137	$	47	$	102

With a Related Allowance:
Consumer	$	9	$	9	$	9	$	5	$	3	$	-	$	-
Residential real estate		199		199		57		100		66		1		1
Total	$	208	$	208	$	66	$	105	$	69	$	1	$	1

Total Impaired Loans:
Commercial	$	1,199	$	1,202	$	-	$	1,388	$	1,665	$	3	$	5
Consumer		9		9		9		5		3		-		-
Residential real estate		2,064		1,794		57		1,530		1,309		7		11
Commercial real estate:
CRE — owner occupied		2,866		2,866		-		2,888		2,970		12		24
CRE — non owner occupied		6,773		4,576		-		5,505		5,601		6		23
Farmland		3,728		1,457		-		1,649		1,696		20		40
Construction and development		955		955		-		955		962		-		-
Total Impaired Loans	$	17,594	$	12,859	$	66	$	13,920	$	14,206	$	48	$	103

Aging Analysis

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

Commercial and agricultural	$	23	$	-	$	-	$	23	$	117	$	109,228		$	109,368
Real estate:
Construction and development		-		-		-		-		1,273		30,798			32,071
Residential 1-4 family		53		-		-		53		554		89,942			90,549
Multi-family		-		-		-		-		-		20,110			20,110
Commercial real estate — owner occupied		-		-		-		-		1,607		115,596			117,203
Commercial real estate — non owner occupied		-		-		-		-		1,829		123,100			124,929
Farmland		-		-		-		-		955		22,945			23,900
Total real estate		53				-		53		6,218		402,491			408,762

Consumer/Finance		63		-		-		63		53		30,125			30,241

Less deferred fees		-		-		-		-		-		(1,088	)		(1,088	)

Total	$	139	$		$	-	$	139	$	6,388	$	540,756		$	547,283

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 typically already on non-accrual status and 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 six months ended June 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 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 six months ended June 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)

	June 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	$	293		-	$	-	$	-
Construction and development		2		2,764		1,273		-		-		-
Residential real estate		2		272		222		-		-		-
CRE — owner occupied		1		59		54		-		-		-
CRE — non owner occupied		1		2,180		2,067		-		-		-
Total restructured loans (1)		7	$	5,610	$	3,909		-	$	-	$	-

	June 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	$	310		-	$	-	$	-
Construction and development		3		2,972		1,415		-		-		-
Residential real estate		2		272		228		-		-		-
CRE — owner occupied		1		59		57		-		-		-
CRE — non owner occupied		1		2,180		2,124		-		-		-
Total restructured loans (1)		8	$	5,818	$	4,134		-	$	-	$	-

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

There were no loans modified as a TDR within the previous 12 months that subsequently defaulted during the three and six months ended June 30, 2014. Loans classified as TDRs are considered impaired loans. The Company had no commitments to lend additional funds for loans classified as TDRs at June 30, 2014.

The following tables summarize the Company’s troubled debt restructured loans by type and geographic region as of June 30, 2014:

Restructured loans by type and geographic region

(Dollars in Thousands)

	June 30, 2014
	Restructured Loans
	Central Western Washington		Southwestern Washington		Northern Washington		Oregon		Totals		Number of Loans
Commercial and agriculture	$	-	$	-	$	293	$	-	$	293		1
Construction and development						841		432		1,273		2
Residential real estate		-		-		-		222		222		2
CRE — owner occupied		54		-		-		-		54		1
CRE — non owner occupied		-		-		2,067		-		2,067		1
Total restructured loans	$	54	$	-	$	3,201	$	654	$	3,909		7

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

Restructured loans by accrual or nonaccrual status

(Dollars in Thousands)

	June 30, 2014
	Restructured loans
	Accrual Status		Non-accrual Status		Total Modifications
Commercial and agriculture	$	293	$	-	$	293
Construction and development		-		1,273		1,273
Residential real estate		222		-		222
CRE — owner occupied		54		-		54
CRE — non owner occupied		2,067		-		2,067
Total restructured loans	$	2,636	$	1,273	$	3,909

	June 30, 2013
	Restructured loans
	Accrual Status		Non-accrual Status		Total Modifications
Commercial and agriculture	$	310	$	-	$	310
Construction and development		-		1,415		1,415
Residential real estate		228		-		228
CRE — owner occupied		57		-		57
CRE — non owner occupied		2,124		-		2,124
Total restructured loans	$	2,719	$	1,415	$	4,134

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 six months ended June 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 net of tax		963			58			1,021
Amounts reclassified from AOCI		(1	)		-			(1	)
Net Current period other comprehensive income (loss)		962			58			1,020

Balance, June 30, 2014	$	43		$	(392	)	$	(349	)

	Net Unrealized
	Gains and Losses
	On Investment			Defined Benefit
	Securities			Plans			Total
Balance, January 1, 2013	$	956		$	(535	)	$	421

Other comprehensive gain before reclassifications net of tax		(1,770	)		56			(1,714	)
Amounts reclassified from AOCI		(233	)		-			(233	)
Net Current period other comprehensive income (loss)		(2,003	)		56			(1,947	)

Balance, June 30, 2013	$	(1,047	)	$	(479	)	$	(1,526	)

The following table presents the amounts reclassified out of each component of accumulated other comprehensive income (“AOCI”) for the three and six months ended June 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			Six Months
	Ended June			Ended June
	30, 2014			30, 2014

Net Unrealized Gains and Losses	$	2		$	(50	)	(Gain)/loss on sales of investments available for sale
on Investment Securities		3			48		Net OTTI loses
		(2	)		1		Income tax expense
	$	3		$	(1	)	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			Six Months
	Ended June			Ended June
	30, 2013			30, 2013

Net Unrealized Gains and Losses	$	(329	)	$	(387	)	(Gain) on sales of investments available for sale
on Investment Securities		34			34		Net OTTI losses
		100			120		Income tax expense
	$	(195	)	$	(233	)	Net of tax

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

(Dollars in Thousands)

	Before Tax			Tax Effect			Net of Tax

Three months ended June 30, 2014

Net unrealized losses on investment securities:
Net unrealized gains arising during the period	$	898		$	305		$	593
Less: reclassification adjustments for net gains realized in net income		5		$	2			3
Net unrealized losses on investment securities	$	903		$	307		$	596

Net unrealized losses on investment securities:
Amortization of unrecognized prior service costs and net actuarial gains/losses	$	44		$	15		$	29

Other Comprehensive Income (Loss)	$	947		$	322		$	625

Six months ended June 30, 2014

Net unrealized losses on investment securities:
Net unrealized gains arising during the period	$	1,459		$	496		$	963
Less: reclassification adjustments for net gains realized in net income		(2	)	$	(1	)		(1	)
Net unrealized losses on investment securities	$	1,457		$	495		$	962

Net unrealized losses on investment securities:
Amortization of unrecognized prior service costs and net actuarial gains/losses	$	88		$	30		$	58

Other Comprehensive Income (Loss)	$	1,545		$	525		$	1,020

	Before Tax			Tax Effect			Net of Tax

Three months ended June 30, 2013

Net unrealized losses on investment securities:
Net unrealized losses arising during the period	$	(2,544	)	$	(865	)	$	(1,679	)
Less: reclassification adjustments for net gains realized in net income		(295	)	$	(100	)		(195	)
Net unrealized losses on investment securities	$	(2,839	)	$	(965	)	$	(1,874	)

Net unrealized losses on investment securities:
Amortization of unrecognized prior service costs and net actuarial gains/losses	$	42		$	14		$	28

Other Comprehensive Income (Loss)	$	(2,797	)	$	(951	)	$	(1,846	)

Six months ended June 30, 2013

Net unrealized losses on investment securities:
Net unrealized losses arising during the period	$	(2,682	)	$	(912	)	$	(1,770	)
Less: reclassification adjustments for net gains realized in net income		(353	)		(120	)		(233	)
Net unrealized losses on investment securities	$	(3,035	)	$	(1,032	)	$	(2,003	)

Net unrealized losses on investment securities:
Amortization of unrecognized prior service costs and net actuarial gains/losses	$	85		$	29		$	56

Other Comprehensive Income (Loss)	$	(2,950	)	$	(1,003	)	$	(1,947	)

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

June 30, 2014	6.5 years		2.28	%		23.38	%		3.15	%	$	1.10
June 30, 2013	6.5 years		1.35	%		23.04	%		4.15	%	$	0.57

A summary of stock option activity as of June 30, 2014 and 2013, and changes during the six months then ended are presented below:

	Shares			Weighted Average Exercise Price		Weighted Average Remaining Contractual Term (Years)		Aggregate Intrinsic Value
June 30, 2014

Outstanding beginning of period		625,495		$	9.53

Granted		2,500			6.35
Exercised		-			-
Forfeited		-			-
Expired		(70,400	)		15.17

Outstanding end of period		557,595		$	8.80		5.3	$	226,100

Exercisable end of period		294,795		$	11.45		3.5	$	45,192

	Shares			Weighted Average Exercise Price		Weighted Average Remaining Contractual Term (Years)		Aggregate Intrinsic Value
June 30, 2013

Outstanding beginning of period		537,107		$	11.28

Granted		182,500			5.02
Exercised		-			-
Forfeited		(1,275	)		7.92
Expired		(51,467	)		10.98

Outstanding end of period		666,865		$	9.60		5.3	$	117,870

Exercisable end of period		338,890		$	13.26		2.7	$	1,439

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

	June 30, 2014					June 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		2,500			1.10		182,500			0.57
Vested		(36,350	)		0.58		(1,050	)		0.26
Forfeited		-			-		(755	)		0.28

Non-vested end of period		262,800		$	0.46		327,975		$	0.45

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)

Six months ended June 30, 2014	Before Tax		Tax Effect		Net of Tax

Recognized compensation expense	$	20	$	7	$	13

Six months ended June 30, 2013	Before Tax		Tax Effect		Net of Tax

Recognized compensation expense	$	21	$	7	$	14

	June 30, 2014		June 30, 2013

Future compensation expense (1)	$	63	$	106

Weighted Average Remaining Contractual Term (Years)		1.6		1.8

(1) related to non-vested stock options

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 six months ended June 30, 2014 and 2013:

	June 30, 2014
	Shares			Weighted Average Grant Price		Weighted Average Remaining Contractual terms (in years)

Outstanding, January 1, 2014		50,024

Granted		11,444		$	6.46
Forfeited		(944	)	$	5.27

Non-vested end of period		60,524				1.7

	June 30, 2013
	Shares			Weighted Average Grant Price		Weighted Average Remaining Contractual terms (in years)

Outstanding, January 1, 2013		16,059

Granted		31,150		$	4.84
Forfeited		(1,284	)	$	-

Non-vested end of period		45,925				2.4

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

RSU compensation expense
(Unaudited)
(Dollars in Thousands)

Six months ended June 30, 2014	Before Tax		Tax Effect		Net of Tax

RSU recognized compensation expense	$	49	$	17	$	32

Six months ended June 30, 2013	Before Tax		Tax Effect		Net of Tax

RSU recognized compensation expense	$	21	$	7	$	14

	June 30, 2014		June 30, 2013

Future compensation expense (1)	$	193	$	193

(1) related to non-vested RSU's

NOTE 7 – COMMITMENTS AND CONTINGENCIES

The Company’s wholly owned subsidiary, the Bank of the Pacific (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 June 30, 2014 and December 31, 2013 is as follows:

(Dollars in Thousands)
	June 30, 2014		December 31, 2013

Commitments to extend credit	$	99,656	$	106,017
Standby letters of credit	$	1,486	$	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.

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 June 30, 2014 or December 31, 2013.

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

(Dollars in Thousands)	Fair Value Measurements
	At June 30, 2014
Description	Fair Value 06/30/2014		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	$	38,822	$	-	$	38,822	$	-
Collateralized mortgage obligations: non agency		604		-		604		-
Mortgage-backed securities: agency issued		11,919		-		11,919		-
U.S. Government agency securities		8,721		-		8,721		-
State and municipal securities		28,646		-		27,252		1,394
Corporate bonds		-		-		-		-
Total assets measured at fair value	$	88,712	$		$	87,318	$	1,394

	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 June 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 six months ended June 30, 2014 and 2013, respectively. There were no transfers of assets into or out of Level 1, 2 or 3 for the three and six months ended June 30, 2014.

	Three months ended June 30,						Six months ended June 30,
	2014			2013			2014			2013

Balance beginning of period	$	1,401		$	1,614			1,419		$	1,614
Principal paydowns		(21	)		(20	)		(31	)		(29	)
Change in FV (included in other comprehensive income)		14			(103	)		6			(94	)

Balance end of period	$	1,394		$	1,491			1,394		$	1,491

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 discounts are typically significant, 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.

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 six months ended June 30, 2014 and year ended December 31, 2013:

(Dollars in Thousands)	Fair Value Measurements
	As of June 30, 2014
Description	Fair Value 06/30/2014		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	$	252	$	$	$	252
Loans measured for impairment, net of specific reserves		303				303
Total impaired assets measured at fair value	$	555	$	$	$	555

	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 $317,000 was acquired during the six months ended June 30, 2014. Upon foreclosure, these assets did not have write downs charged to the allowance for credit losses during the period.

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

(Dollars in Thousands)

Description

Fair Value
06/30/2014

Valuation
Technique

Significant
Unobservable
Inputs

Range
(Weighted
Average)

Other real estate owned and foreclosed assets

252

Appraised value

Adjustment for market conditions

0-10% (0.5%)

Loans measured for impairment, net of specific reserves

303

Appraised value

Adjustment for market conditions

0-20% (1.1%)

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.

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.

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.

Short-term borrowings

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

Long-term borrowings

The fair values of the Company’s long-term borrowings 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.

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

(Dollars in Thousands)
	As of June 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	$	17,694	$	17,694	$	-	$	-	$	17,694
Interest-bearing certificates of deposit (original maturities greater than 90 days)		2,727		2,727		-		-		2,727
Investment securities available-for-sale		88,712		-		87,318		1,394		88,712
Investment securities held-to-maturity		1,871		-		1,894		-		1,894
Federal Home Loan Bank stock		2,956		-		2,956		-		2,956
Loans held-for-sale		7,632		-		7,632		-		7,632
Loans		538,968		-		-		512,233		512,233

Financial liabilities:
Deposits	$	619,301	$		$	620,909	$	-	$	620,909
Short-term borrowings		-		-		-		-		-
Long-term borrowings		10,000		-		10,172		-		10,172
Junior subordinated debentures		13,403		-		-		7,683		7,683

	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 June 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.

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 June 30, 2014 for the common capital securities issued by the issuer trusts.

As of June 30, 2014, regular accrued interest on junior subordinated debentures totaled $39,000 and is included in accrued interest payable on the balance sheet.

Following are the terms of the junior subordinated debentures as of June 30, 2014.

(Dollars in Thousands)

Issued

Maturity

Trust Name

Issue Date

Amount

Rate

Date

Pacific Financial Corporation Statutory Trust I

December 2005

5,000

LIBOR + 1.45% ⁽¹⁾

March 2036

Pacific Financial Corporation Statutory Trust II

June 2006

8,000

LIBOR + 1.60% ⁽²⁾

July 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 (0.231% at June 16, 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 (0.226% at April 14, 2014) plus 1.60% or 1.83%, adjusted quarterly, through the final maturity date in July 2036.

NOTE 10 – RECENTLY ISSUED ACCOUNTING STANDARDS

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.

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 June 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
Equity		—

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.

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 June 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.

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.

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.

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

•

Earnings per share (EPS) increased 40% to $0.14, compared to $0.10 in first quarter 2014, and grew 8% from $0.13 in second quarter 2013. Year-to-date, EPS increased 20% to $0.24, from $0.20 for the first half of 2013.

•

Net interest income grew $241,000, or 4%, to $6.8 million, compared to $6.6 million in first quarter 2014, and grew $844,000, or 14%, from $6.0 million in second quarter 2013. For the six months of 2014, net interest income increased $1.8 million, or 16%, to $13.4 million, from $11.5 million for the like period in 2013.

•

Net interest margin (NIM) remained stable at 4.28%, compared to 4.27% for the preceding quarter, and improved 19 basis points from 4.09% for second quarter 2013. Year-to-date, net interest margin expanded 22 basis points to 4.27%, compared to 4.05% for the first half of 2013.

•

Gross loans increased 6% to $547.3 million, up from $518.6 million at March 31, 2014, and grew 15% from $474.6 million a year ago.

•

Nonperforming assets declined to $7.4 million, or 1.03% of total assets, down from $9.7 million, or 1.35% of total assets, at March 31, 2014 and $13.8 million, or 2.01% of total assets a year ago.

•

Classified loans decreased to $16.0 million, or 2.91% of gross loans, from $16.8 million, or 3.23% of gross loans, at March 31, 2014, and dropped from $17.0 million, or 3.59% of gross loans at June 30, 2013.

•

Net charge-offs totaled $73,000, compared to $71,000 in first quarter 2014 and $64,000 in net recoveries for second quarter 2013. Year-to-date, net charge-offs were $144,000, compared to net recoveries of $54,000 for the first half of 2013.

•

Capital levels exceeded regulatory requirements for a well-capitalized financial institution, with a total risk-based capital ratio of 13.50% and a leverage ratio of 9.83%, at quarter end.

OPERATING RESULTS

Net Interest Income

Net interest income for the quarter and six month ended June 30, 2014 increased from the quarter and six month ended June, 30, 2013. This increase was primarily due to the growth in earning assets. Changes in the balance sheet mix also contributed to increases in net interest income during these periods. Loan balances increased due to new loans generated predominately within the Company’s primary market area of Western Washington. Investment securities and federal funds sold declined 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. As a result, the net interest margin improved.

Net interest income for the current quarter increased from the quarter ended March 31, 2014 primarily for the same reasons noted above. However, funding costs were unchanged 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. This is primarily because certificates of deposit renewing during the most recent quarters are receiving rates as low as those granted at previous renewals.

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

INCOME STATEMENT OVERVIEW

(Unaudited)

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

	For the Three Months Ended June 30, 2014		For the Three Months Ended March 31, 2014			$ Change			% Change			For the Three Months Ended June 30, 2013			$ Change			% Change

Interest and dividend income	$	7,337	$	7,085		$	252			4	%	$	6,600		$	737			11	%
Interest expense		541		530			11			2	%		648			(107	)		-17	%
Net interest income		6,796		6,555			241			4	%		5,952			844			14	%
Loan loss provision		100		-			100			100	%		(450	)		550			-122	%
Non-interest income		2,176		1,608			568			35	%		3,175			(999	)		-31	%
Non-interest expense		7,066		6,830			236			3	%		7,872			(806	)		-10	%
INCOME BEFORE PROVISION FOR INCOME TAXES		1,806		1,333			473			35	%		1,705			101			6	%
PROVISION FOR INCOME TAXES		403		305			98			32	%		373			30			8	%

NET INCOME	$	1,403	$	1,028		$	375			36	%	$	1,332		$	71			5	%

INCOME PER COMMON SHARE:
BASIC ⁽¹⁾	$	0.14	$	0.10		$	0.04			40	%	$	0.13		$	0.01			8	%
DILUTED ⁽¹⁾	$	0.14	$	0.10		$	0.04			40	%	$	0.13		$	0.01			8	%

Average common shares outstanding - basic ⁽¹⁾		10,189,386		10,182,083			7,303.00			0	%		10,121,853			67,533			1	%
Average common shares outstanding - diluted ⁽¹⁾		10,275,628		10,272,341			3,287.00			0	%		10,182,524			93,104			1	%

		For the Six Months Ended June 30, 2014		For the Six Months Ended June 30, 2013			$ Change			% Change

Interest and dividend income	$	14,422		12,871			1,551			12	%
Interest expense		1,071		1,337			(266	)		-20	%
Net interest income		13,351		11,534			1,817			16	%
Loan loss provision		100		(450	)		550			100	%
Non-interest income		3,784		5,801			(2,017	)		-35	%
Non-interest expense		13,896		15,291			(1,395	)		-9	%
INCOME BEFORE PROVISION FOR INCOME TAXES		3,139		2,494			645			26	%
PROVISION FOR INCOME TAXES		708		461			247			54	%

NET INCOME	$	2,431		2,033			398			20	%

INCOME PER COMMON SHARE:
BASIC ⁽¹⁾	$	0.24		0.20			0.04			20	%
DILUTED ⁽¹⁾	$	0.24		0.20			0.04			20	%

Average common shares outstanding - basic ⁽¹⁾		10,185,755		10,121,853			63,902			1	%
Average common shares outstanding - diluted ⁽¹⁾		10,273,994		10,172,356			101,638			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	June 30, 2014		March 31, 2014		$ Change			% Change			June 30, 2013			$ Change			% Change

Net income	$	1,403	$	1,028	$	375			36	%	$	1,332		$	71			5	%
Provision for loan losses		100		-		100			100	%		(450	)		550			-122	%
Other real estate owned write-downs		54		12		42			350	%		108			(54	)		-50	%
Other real estate owned operating costs		30		61		(31	)		-51	%		125			(95	)		-76	%
Provision for income taxes		403		305		98			32	%		373			30			8	%
Pre-tax, pre-credit cost operating income*	$	1,990	$	1,406	$	584			42	%	$	1,488		$	502			34	%

For The Six Months Ended	June 30, 2014		June 30, 2013			$ Change			% Change

Net income	$	2,431	$	2,033		$	398			20	%
Provision for loan losses		100		(450	)		550			-122	%
Other real estate owned write-downs		66		460			(394	)		-86	%
Other real estate owned operating costs		91		209			(118	)		-56	%
Provision for income taxes		708		461			247			54	%
Pre-tax, pre-credit cost operating income*	$	3,396	$	2,713		$	683			25	%

Reconciliation of Non-GAAP Measure:

Tax Equivalent Income

(Dollars in Thousands)

For the Three Months ended	June 30, 2014			March 31, 2014			$ Change			% Change			June 30, 2013			$ Change			% Change

Net interest income	$	6,796		$	6,555		$	241			4	%	$	5,952		$	844			14	%
Tax equivalent adjustment for municipal loan interest		46			46			-			0	%		60			(14	)		-23	%
Tax equivalent adjustment for municipal bond interest		120			118			2			2	%		135			(15	)		-11	%
Tax equivalent net interest income		6,962			6,719			243			4	%		6,147			815			13	%
Provision for loan losses		100			-			100			100	%		(450	)		550			-122	%
Non-interest income		2,176			1,608			568			35	%		3,175			(999	)		-31	%
Non-interest expense		7,066			6,830			236			3	%		7,872			(806	)		-10	%
Tax equivalent income before income taxes*		1,972			1,497			475			32	%		1,900			72			4	%
Provision for income taxes		403			305			98			32	%		373			30			8	%
Accumulative tax adjustment		(166	)		(164	)		(2	)		1	%		(195	)		29			-15	%
Common stock dividends		-			-			-			0	%		-			-			0	%
Net income	$	1,403		$	1,028		$	375			36	%	$	1,332		$	71			5	%

For the Six Months ended	June 30, 2014			June 30, 2013			$ Change			% Change

Net interest income	$	13,351		$	11,534		$	1,817			16	%
Tax equivalent adjustment for municipal loan interest		92			117			(25	)		-21	%
Tax equivalent adjustment for municipal bond interest		238			272			(34	)		-13	%
Tax equivalent net interest income		13,681			11,923			1,758			15	%
Provision for loan losses		100			(450	)		550			100	%
Non-interest income		3,784			5,801			(2,017	)		-35	%
Non-interest expense		13,896			15,291			(1,395	)		-9	%
Tax equivalent income before income taxes*		3,469			2,883			586			20	%
Provision for income taxes		708			461			247			54	%
Accumulative tax adjustment		(330	)		(389	)		59			-15	%
Common stock dividends		-			-			-			0	%
Net income	$	2,431		$	2,033		$	398			20	%

*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 the second quarter 2014 was up compared to the first quarter 2014, but down significantly from second quarter 2013, driven primarily by changes in gains from sales of loans and securities available for sale, as described in further detail below. Service charges on deposit accounts grew during the current quarter due to an increase in new deposit relationships as a result of the acquisition of three branches from Sterling Savings Bank completed in the second quarter of 2013. Losses on sale of other real estate owned (OREO) were higher in the current period as compared to the most recent quarter and were in contrast to a small gain in second quarter in 2013. This was primarily due to a larger volume of sales in the current quarter as compared to the prior periods. A small OTTI impairment charge was taken in both first quarter 2014 and second quarter 2013 to reflect a reduction in fair value of a private-label CMO investment security.

Gains on sale of residential mortgage loans and related fee income rose in second quarter 2014 compared to first quarter 2014, but was below second quarter 2013. The recent rebound in home purchases throughout many of our markets is fueling new residential mortgage originations, but were not sufficient to offset the high volumes of both purchase and refinancing activity generated in 2013. In addition, net gains on sales of securities available for sale were taken in first quarter 2014 and second quarter 2013 for the purpose of adjusting the mix of securities to mitigate the impact of changes in market rates on the value of the portfolio.

Noninterest income for the six months ended June 30, 2014 was down as compared to the same period in 2013, impacted by the decline in gains on sale of residential mortgage loans and securities available for sale and increase in losses on sale of OREO, as noted above.

Noninterest income

(Unaudited)

(Dollars in Thousands)

For The Three Months Ended

	June 30, 2014			March 31, 2014			$ Change			% Change			June 30, 2013			$ Change			% Change

Service charges on deposit accounts	$	474		$	435		$	39			9.0	%	$	431		$	43			10	%
Net (loss) on sale of other real estate owned		(57	)		(36	)		(21	)		58.3	%		45			(102	)		-227	%
Net gains from sales of loans		968			627			341			54.4	%		1,669			(701	)		-42	%
Net gains on sales of securities available for sale		(2	)		52			(54	)		-103.8	%		329			(331	)		-101	%
Net other-than-temporary impairment (net of $0, $15, and $3,
respectively recognized other comprehensive income before taxes)		(3	)		(45	)		42			100.0	%		(34	)		31			-91	%
Earnings on bank owned life insurance		140			111			29			26.1	%		116			24			21	%
Other operating income
Fee income		442			364			78			21.4	%		504			(62	)		-12	%
Income from other real estate owned		17			11			6			54.5	%		14			3			21	%
Other non-interest income		197			89			108			121.3	%		101			96			95	%
Total non-interest income	$	2,176		$	1,608		$	568			35.3	%	$	3,175		$	(999	)		-31	%

For The Six Months Ended
		June 30, 2014			June 30, 2013			$ Change			% Change

Service charges on deposit accounts	$	909		$	841		$	68			8.1	%
Net (loss) on sale of other real estate owned		(93	)		25			(118	)		-472.0	%
Net gains from sales of loans		1,596			3,178			(1,582	)		-49.8	%
Net gains on sales of securities available for sale		50			387			(337	)		-87.1	%
Net other-than-temporary impairment (net of $15, and $3,
respectively recognized other comprehensive income before taxes)		(48	)		(34	)		(14	)		41.2	%
Earnings on bank owned life insurance		251			237			14			5.9	%
Other operating income
Fee income		806			970			(164	)		-16.9	%
Income from other real estate owned		28			29			(1	)		-3.4	%
Other non-interest income		285			168			117			69.6	%
Total non-interest income	$	3,784		$	5,801		$	(2,017	)		-34.8	%

Noninterest Expense

Noninterest expense for the three months ended June 30, 2014 increased compared to the three months ended March 31, 2014. This was primarily due to increases in commissions expense associated with recent growth in real estate mortgage purchase lending activity and bonus accruals related to other incentive compensation plans. This increase was partially offset by decreases in OREO write-downs and expenses and professional service costs associated with the reduction of non-performing assets.

Noninterest expense for second quarter 2014 declined versus the quarter ended June 30, 2013. This was primarily due to a decrease of $471,000 in personnel costs associated with the reduction in staff initiated in first quarter 2014 commensurate with the decline in residential mortgage loan refinance activity referred to above. Also, in second quarter 2013 the Bank incurred one-time expenses of $395,000 in conversion costs associated with the acquisition of three branches from Sterling Savings Bank in June 2013. Total costs associated with OREO and related third-party loan expenses also decreased due to the decline in OREO balances and stabilization in real estate valuations. This was partially offset by an increase in occupancy and equipment expense primarily associated with the Sterling branch acquisitions and the opening of the Warrenton, OR branch in October 2013. Noninterest expense for the six months ended June 30, 2014 was down as compared to the same period in 2013, primarily related to lower residential real estate mortgage personnel costs, OREO write-downs and expenses and one-time costs associated with the Sterling branch acquisitions, as noted above.

Noninterest expense

(Unaudited)

(Dollars in Thousands)

For The Three Months Ended

	June 30, 2014		March 31, 2014		$ Change			% Change			June 30, 2013		$ Change			% Change

Salaries and employee benefits	$	4,283	$	4,055	$	228			6	%	$	4,499	$	(216	)		-5	%
Occupancy		504		506		(2	)		0	%		452		52			12	%
Equipment		263		252		11			4	%		195		68			35	%
Data processing		462		433		29			7	%		809		(347	)		-43	%
Professional services		201		185		16			9	%		236		(35	)		-15	%
Other real estate owned write-downs		54		12		42			350	%		108		(54	)		-50	%
Other real estate owned operating costs		30		61		(31	)		-51	%		125		(95	)		-76	%
State taxes		107		97		10			10	%		133		(26	)		-20	%
FDIC and state assessments		129		134		(5	)		-4	%		130		(1	)		-1	%
Other non-interest expense:
Director fees		72		56		16			29	%		70		2			3	%
Communication		53		37		16			43	%		42		11			26	%
Advertising		76		78		(2	)		-3	%		68		8			12	%
Professional liability insurance		19		23		(4	)		-17	%		23		(4	)		-17	%
Amortization		98		95		3			3	%		98		0			0	%
Other non-interest expense		715		806		-91			-11	%		884		(169	)		-19	%
Total non-interest expense	$	7,066	$	6,830	$	236			3	%	$	7,872	$	(806	)		-10	%

For The Six Months Ended
		June 30, 2014		June 30, 2013		$ Change			% Change

Salaries and employee benefits	$	8,338	$	8,885	$	(547	)		-6	%
Occupancy		1,010		865		145			17	%
Equipment		515		386		129			33	%
Data processing		895		1,239		(344	)		-28	%
Professional services		386		498		(112	)		-22	%
Other real estate owned write-downs		66		460		(394	)		-86	%
Other real estate owned operating costs		91		209		(118	)		-56	%
State taxes		204		250		(46	)		-18	%
FDIC and state assessments		263		266		(3	)		-1	%
Other non-interest expense:
Director fees		128		115		13			11	%
Communication		90		88		2			2	%
Advertising		154		146		8			5	%
Professional liability insurance		41		46		(5	)		-11	%
Amortization		192		195		(3	)		-2	%
Other non-interest expense		1,523		1,643		(120	)		-7	%
Total non-interest expense	$	13,896	$	15,291	$	(1,395	)		-9	%

Income Taxes

The Company recorded an income tax provision for the three months ended June 30, 2014, March 31, 2014 and June 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 June 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.

SUMMARY BALANCE SHEET OVERVIEW

(Unaudited)

(Dollars in Thousands)

	June 30,			March 31,						%			June 30,						%
	2014			2014			$ Change			Change			2013			$ Change			Change
Assets:
Cash and cash equivalents	$	17,694		$	35,619		$	(17,925	)		-50	%	$	54,243		$	(36,549	)		-67	%
Interest-bearing certificates of deposit		2,727			2,727			0			0	%		2,235			492			22	%
Federal Home Loan Bank stock, at cost		2,956			2,985			(29	)		-1	%		3,069			(113	)		-4	%
Investment securities		90,583			97,239			(6,656	)		-7	%		89,551			1,032			1	%

Loans held-for-sale		7,632			7,997			(365	)		-5	%		10,855			(3,223	)		-30	%

Gross loans, net of deferred fees		547,283			518,552			28,731			6	%		474,580			72,703			15	%
Allowance for loan losses		(8,315	)		(8,288	)		(27	)		0	%		(8,962	)		647			-7	%
Net loans		538,968			510,264			28,704			6	%		465,618			73,350			16	%

Other assets		58,912			60,609			(1,697	)		-3	%		60,763			(1,851	)		-3	%
Total assets	$	719,472		$	717,440		$	2,032			0	%	$	686,334		$	33,138			5	%

Liabilities and shareholders' equity
Total deposits	$	619,301		$	620,456		$	(1,155	)		0	%	$	591,147		$	28,154			5	%
Accrued interest payable		151			166			(15	)		-9	%		185			(34	)		-18	%
Borrowings		23,743			23,403			340			1	%		23,403			340			1	%
Other liabilities		5,417			4,820			597			12	%		4,750			667			14	%
Shareholders' equity		70,860			68,595			2,265			3	%		66,849			4,011			6	%
Total liabilities and shareholders' equity	$	719,472		$	717,440		$	2,032			0	%	$	686,334		$	33,138			5	%

Cash and Cash Equivalents and Investment Securities

(Unaudited)

(Dollars in Thousands)

	June 30, 2014		% of Total			March 31, 2014		% of Total			$ Change			% Change			June 30, 2013		% of Total			$ Change			% Change

Cash and due from banks	$	17,455		15	%	$	15,747		11	%	$	1,708			11	%	$	18,158		12	%	$	(703	)		-4	%
Cash equivalents:
Interest-bearing deposits		239		0	%		19,872		14	%		(19,633	)		-99	%		36,085		24	%		(35,846	)		-99	%
Interest-bearing certificates of deposit		2,727		2	%		2,727		2	%		-			0	%		2,235		1	%		492			22	%
Total cash equivalents and certificate of deposits		20,421		18	%		38,346		28	%		(17,925	)		-47	%		56,478		38	%		(36,057	)		-64	%

Investment securities:
Collateralized mortgage obligations: agency issued		38,822		34	%		37,567		27	%		1,255			3	%		30,085		20	%		8,737			29	%
Collateralized mortgage obligations: non-agency issued		604		1	%		1,974		1	%		(1,370	)		-69	%		2,349		2	%		(1,745	)		-74	%
Mortgage-backed securities: agency issued		12,059		11	%		13,182		10	%		(1,123	)		-9	%		12,038		8	%		21			0	%
U.S. Government and agency securities		8,721		8	%		9,828		7	%		(1,107	)		-11	%		8,874		6	%		(153	)		-2	%
State and municipal securities		30,377		27	%		34,688		25	%		(4,311	)		-12	%		33,635		23	%		(3,258	)		-10	%
Corporate bonds		-		0	%		-		0	%		-			0	%		2,570		2	%		(2,570	)		-100	%
FHLB Stock		2,956		3	%		2,985		2	%		(29	)		-1	%		3,069		2	%		(113	)		-4	%
Total investment securities		93,539		82	%		100,224		72	%		(6,685	)		-7	%		92,620		62	%		919			1	%

Total cash equivalents and investment securities	$	113,960		100	%	$	138,570		100	%	$	(24,610	)		-18	%	$	149,098		100	%	$	(35,138	)		-24	%

Total cash equivalents and investment securities as a % of total assets				16	%				19	%										22	%

Investment securities and interest-bearing certificates of deposit

(Unaudited)

(Dollars in Thousands)

For the Three Months Ended	June 30, 2014			March 31, 2014			$ Change			% Change			June 30, 2013			$ Change			% Change

Balance beginning of period	$	102,951		$	104,016		$	(1,065	)		-1	%	$	82,624		$	20,327			25	%
Principal purchases		3,806			5,741			(1,935	)		-34	%		24,688			(20,882	)		-85	%
Proceeds from sales		(8,979	)		(4,849	)		(4,130	)		85	%		(2,987	)		(5,992	)		201	%
Principal paydowns, maturities, and calls		(2,144	)		(2,259	)		115			-5	%		(6,568	)		4,424			-67	%
Gains on sales of securities		159			62			97			156	%		329			(170	)		-52	%
Losses on sales of securities		(161	)		(10	)		(151	)		1510	%		-			(161	)		100	%
OTTI loss writedown		(3	)		(45	)		42			-93	%		(51	)		48			-94	%
Change in unrealized gains (loss) before tax		903			555			348			63	%		(2,840	)		3,743			-132	%
Amortization and accretion of discounts and premiums		(266	)		(260	)		(6	)		2	%		(340	)		74			-22	%
Total investment portfolio	$	96,266		$	102,951		$	(6,685	)		-6	%	$	94,855		$	1,411			1	%

Liquidity remains strong based on the current level of combined cash equivalents and investment securities. We also have unsecured lines of credit totaling $16.0 million with correspondent banks, all of which is currently available. In addition, we have a secured borrowing facility with the Federal Home Loan Bank of Seattle of $143.4 million, of which $10.3 million is currently outstanding. In an effort to enhance our net interest income and margin, we reduced our cash equivalents and investment securities portfolio to fund loan growth. The expected modified duration (adjusted for calls, consensus pre-payment speeds and rate adjustment dates) of the investment portfolio was 4.5 years at June 30, 2014, 4.2 years at March 31, 2014 and 4.4 years at June 30, 2013.

LOANS

Loan portfolio growth continues to be well diversified, with higher balances in all lending categories. The recent loan growth was generated predominately within our Washington and Oregon markets. The portfolio includes $37.5 million in purchased government-guaranteed commercial and commercial real estate loans. In addition, the portfolio contains $20.7 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)	June 30,			% of			March 31,			% of			$						June 30,			% of			$
(Dollars in Thousands)	2014			Gross Loans			2014			Gross Loans			Change			% Change			2013			Gross Loans			Change			% Change

Commercial and agricultural	$	109,368			20	%	$	101,971			20	%	$	7,397			7	%	$	89,894			19	%	$	19,474			22	%
Real estate:
Construction and development		32,071			6	%		30,765			6	%		1,306			4	%		25,804			6	%		6,267			24	%
Residential 1-4 family		90,549			17	%		89,244			17	%		1,305			1	%		83,896			18	%		6,653			8	%
Multi-family		20,110			4	%		18,982			4	%		1,128			6	%		13,978			3	%		6,132			44	%
Commercial real estate — owner occupied		117,203			22	%		112,771			22	%		4,432			4	%		112,148			24	%		5,055			5	%
Commercial real estate — non owner occupied		124,929			23	%		119,803			23	%		5,126			4	%		109,323			23	%		15,606			14	%
Farmland		23,900			4	%		22,940			4	%		960			4	%		24,717			5	%		(817	)		-3	%
Consumer		30,241			6	%		23,156			5	%		7,085			31	%		15,841			3	%		14,400			91	%
Gross loans		548,371						519,632						28,739			6	%		475,601						72,770			15	%
Less: allowance for loan losses		(8,315	)		-2	%		(8,288	)		-2	%		(27	)		0	%		(8,962	)		-2	%		647			-7	%
Less: deferred fees		(1,088	)		0	%		(1,080	)		0	%		(8	)		1	%		(1,021	)		0	%		(67	)		7	%
Loans, net	$	538,968					$	510,264					$	28,704			6	%	$	465,618					$	73,350			16	%

The table provided below summarizes the Bank’s level of concentrations in commercial real estate as of June 30, 2014, December 31, 2013 and June 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.

Commercial Real Estate ("CRE")
Portfolio Policy Concentrations

	June 30, 2014			December 31, 2013			June 30, 2013			Guideline
Total Regulatory CRE ¹		230	%		231	%		203	%		300	%
Construction & Land Development CRE ²		42	%		44	%		35	%		100	%

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

¹ Consists 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

² Consists 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. Declining values 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 June 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 $298,000 at December 31, 2013 and June 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 June 30, 2014.

DEPOSITS

Total deposits were virtually unchanged at June 30, 2014 versus first quarter of this year and up 5% from the second quarter a year ago. Non-interest bearing, interest bearing demand and money market deposits continued to grow. This growth is due to recent success in acquiring business deposit relationships in conjunction with the growth in lending achieved over the past year and the deposits obtained in the Sterling branch acquisition last year. Time deposits continued to decline as a percentage of total deposits. 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 second quarter 2014 from second quarter in 2013.

Total brokered deposits were $22.9 million at June 30, 2014, which included $2.9 million via reciprocal deposit arrangements. This compares to $24.2 million and $24.6 million at March 31, 2014 and June 30, 2013, respectively. In addition, the Company’s funding structure contains $10.0 million in borrowings from the Federal Home Loan Bank. We view 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)	June 30, 2014		Percent of Total			March 31, 2014		Percent of Total			$ Change			June 30, 2013		Percent of Total			$ Change

Interest-bearing demand and money market	$	268,480		43.4	%	$	263,953		42.5	%	$	4,527		$	259,956		44.0	%	$	8,524
Savings		74,336		12.0	%		78,055		12.6	%		(3,719	)		64,360		10.9	%		9,976
Time deposits		119,531		19.3	%		125,532		20.2	%		(6,001	)		141,246		23.9	%		(21,715	)
Total interest-bearing deposits		462,347		74.7	%		467,540		75.4	%		(5,193	)		465,562		78.8	%		(3,215	)
Non-interest bearing demand		156,954		25.3	%		152,916		24.6	%		4,038			125,585		21.2	%		31,369
Total deposits	$	619,301		100.0	%	$	620,456		100.0	%	$	(1,155	)	$	591,147		100.0	%	$	28,154

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 June 30, 2014, March 31, 2013 and June 30, 2013 as well as the six months ended June 30, 2014 and 2013:

AVERAGE DEPOSITS AND BORROWINGS

(Unaudited)
(Dollars in Thousands)
Averages for the Three Months Ended	June 30, 2014		% of Total			March 31, 2014		% of Total			$ Change			% Change			June 30, 2013		% of Total			$ Change			% Change

Non-interest bearing demand deposits	$	150,776		24	%	$	140,980		22	%	$	9,796			2	%	$	119,499		20	%	$	31,277			4	%

Interest bearing demand		270,702		42	%		261,473		42	%		9,229			0	%		244,907		41	%		25,795			1	%
Savings		74,414		12	%		74,728		12	%		(314	)		0	%		67,552		11	%		6,862			1	%
Time deposits		122,134		19	%		126,841		20	%		(4,707	)		-1	%		135,107		23	%		(12,973	)		-4	%
Total average interest bearing deposits		467,250		73	%		463,042		74	%		4,208			-1	%		447,566		76	%		19,684			-3	%
Total average deposits	$	618,026				$	604,022				$	14,004					$	567,065				$	50,961

Average rate on total average deposits

Federal Home Loan Bank borrowings	$	10,000		2	%	$	10,000		2	%	$	-			0	%	$	10,000		2	%	$	0			0	%
Short term borrowings		6		0	%		-		0	%		6			0	%		-		0	%		6			0	%
Junior subordinated debentures		13,403		2	%		13,403		2	%		-			0	%		13,403		2	%		-			0	%
Total average borrowings	$	23,409		4	%	$	23,403		4	%	$	6					$	23,403		4	%	$	6			0	%

Total average interest-bearing liabilities	$	490,659				$	486,445				$	4,214					$	470,969				$	19,690
Total average deposits and borrowings	$	641,435		100	%	$	627,425		100	%	$	14,010					$	590,468		100	%	$	50,967

Averages for the Six Months Ended		June 30, 2014		% of Total			June 30, 2013		% of Total			$ Change			% Change

Non-interest bearing demand deposits	$	145,905		23	%	$	116,240		20	%	$	29,665			3	%

Interest bearing demand		266,113		42	%		240,452		41	%		25,661			1	%
Savings		74,570		12	%		65,845		11	%		8,725			1	%
Time deposits		124,475		20	%		135,898		23	%		(11,423	)		-3	%
Total average interest bearing deposits		465,158		73	%		442,195		76	%		22,963			-3	%
Total average deposits	$	611,063				$	558,435				$	52,628

Average rate on total average deposits

Federal Home Loan Bank borrowings	$	10,000		2	%	$	10,099		2	%	$	(99	)		0	%
Short term borrowings		3		0	%		-		0	%		3			0	%
Junior subordinated debentures		13,403		2	%		13,403		2	%		-			0	%
Total average borrowings	$	23,406		4	%	$	23,502		4	%	$	(96	)

Total average interest-bearing liabilities	$	488,564				$	465,697				$	22,867
Total average deposits and borrowings	$	634,469		100	%	$	581,937		100	%	$	52,532

Two wholly-owned subsidiary grantor trusts established by the Company had issued and outstanding $13.4 million of trust preferred securities. 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, met the thresholds to be considered “Well-Capitalized” under published regulatory standards for total risk-based capital, Tier 1 risk-based capital and Tier 1 leverage capital at June 30, 2014. Capital ratios decreased slightly as compared to the linked quarter and the second quarter of 2013, primarily due to the successful execution of the Company’s growth strategy and shift in the balance sheet mix to higher risk-weighted loan assets.

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 June 30, 2014, under guidance issued by the Federal Reserve. As provided in the Dodd-Frank Act, the Company expects to continue to rely on these junior subordinated debentures as part of its regulatory capital.

	June 30, 2014			March 31, 2014			Change			June 30, 2013			Change			Regulatory Minimum to be "Adequately Capitalized"			Regulatory Minimum to be "Well Capitalized"
																greater than or equal to			greater than or equal to
Pacific Financial Corporation
Total risk-based capital ratio		13.76	%		14.03	%		(0.27	)		15.24	%		(1.48	)		8	%		n/a
Tier 1 risk-based capital ratio		12.51	%		12.77	%		(0.26	)		13.98	%		(1.47	)		4	%		n/a
Leverage ratio		10.04	%		10.03	%		0.01			10.44	%		(0.40	)		4	%		n/a
Tangible common equity ratio		8.11	%		7.81	%		0.30			7.90	%		0.21			n/a			n/a

Bank of the Pacific
Total risk-based capital ratio		13.73	%		13.99	%		(0.26	)		15.21	%		(1.48	)		8	%		10	%
Tier 1 risk-based capital ratio		12.48	%		12.74	%		(0.26	)		13.96	%		(1.48	)		4	%		6	%
Leverage ratio		10.01	%		9.99	%		0.02			10.42	%		(0.41	)		4	%		5	%

FINANCIAL PERFORMANCE OVERVIEW

(Unaudited)

(Dollars in Thousands, Except per Share Data)

For The Three Months Ended
	June 30, 2014			March 31, 2014			Change			June 30, 2013			Change
Selective quarterly performance ratios
Return on average assets, annualized		0.79	%		0.59	%		0.20			0.81	%		(0.02	)
Return on average equity, annualized		8.04	%		6.12	%		1.92			7.83	%		0.21
Efficiency ratio ⁽¹⁾		78.76	%		83.67	%		(4.91	)		86.25	%		(7.49	)

Share and per share information
Average common shares outstanding - basic		10,189,386			10,182,083			7,303			10,121,853			67,533
Average common shares outstanding - diluted		10,275,628			10,272,341			3,287			10,182,524			93,104
Basic income per common share		0.14			0.10			0.04			0.13			0.01
Diluted income per common share		0.14			0.10			0.04			0.13			0.01
Book value per common share ⁽²⁾		6.95			6.74			0.21			6.60			0.35
Tangible book value per common share ⁽³⁾		5.65			5.45			0.20			5.40			0.25

For The Six Months Ended
		June 30, 2014			June 30, 2013			Change
Selective quarterly performance ratios
Return on average assets, annualized		0.69	%		0.63	%		0.06
Return on average equity, annualized		7.10	%		6.05	%		1.05
Efficiency ratio ⁽¹⁾		81.10	%		88.21	%		(7.11	)

Share and per share information
Average common shares outstanding - basic		10,185,755			10,121,853			63,902
Average common shares outstanding - diluted		10,273,994			10,172,356			101,638
Basic income per common share		0.24			0.20			0.04
Diluted income per common share		0.24			0.20			0.04
Book value per common share ⁽²⁾		6.96			6.60			0.36
Tangible book value per common share ⁽³⁾		5.65			5.40			0.25

⁽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 remained virtually unchanged as compared to first quarter 2014, as improvement in investment securities yields offset slight declines in loan yields. Improvements in yields on investment securities were partially due to the decline in amortization expense associated with the decrease in prepayment speeds of mortgage-backed securities. Loan yield declines resulted from increased competition for high quality borrowing relationships in the marketplace. Net interest margin improved when compared to second quarter 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 current period. A similar enhancement to loan yields occurred in first quarter 2014 due to the collection of $108,000 in non-accrual interest. There was no similar collection of non-accrual interest during the corresponding periods in 2013.

The improvement in yields on investment securities also enhanced net interest margin between the six months ending June 30, 2014 and the same period in 2013. This was partially due to the decline in amortization expense associated with the decrease in prepayment speeds of mortgage-backed securities between the two periods. In addition, we reduced the proportion of lower yielding cash-equivalent investments and increased the proportion of relatively higher-yielding federal government guaranteed and municipal securities.

NET INTEREST MARGIN

(Annualized, tax-equivalent basis)

(Unaudited)

For The Three Months Ended
	June 30, 2014			March 31, 2014			Change			June 30, 2013			Change
Selective quarterly performance ratios
Yield on average gross loans ⁽¹⁾		5.04	%		5.13	%		(0.09	)		5.17	%		(0.13	)
Yield on average investment securities ⁽¹⁾		2.54	%		2.37	%		0.17			1.91	%		0.63
Cost of average interest bearing deposits		0.37	%		0.37	%		-			0.48	%		(0.11	)
Cost of average borrowings		1.90	%		1.96	%		(0.06	)		1.99	%		(0.09	)
Cost of average total deposits and borrowings		0.34	%		0.34	%		-			0.44	%		(0.10	)
Cost of average interest-bearing liabilities		0.44	%		0.44	%		-			0.55	%		(0.11	)

Yield on average interest-earning assets		4.61	%		4.61	%		-			4.53	%		0.08
Cost of average interest-bearing liabilities		0.44	%		0.44	%		-			0.55	%		(0.11	)
Net interest spread		4.17	%		4.17	%		-			3.98	%		0.19

Net interest margin ⁽¹⁾		4.28	%		4.27	%		0.01			4.09	%		0.19

For The Six Months Ended
		June 30, 2014			June 30, 2013			Change
Selective quarterly performance ratios
Yield on average gross loans ⁽¹⁾		5.09	%		5.14	%		(0.05	)
Yield on average investment securities ⁽¹⁾		2.45	%		1.91	%		0.54
Cost of average interest bearing deposits		0.37	%		0.50	%		(0.13	)
Cost of average borrowings		1.93	%		2.04	%		(0.11	)
Cost of average total deposits and borrowings		0.34	%		0.46	%		(0.12	)
Cost of average interest-bearing liabilities		0.44	%		0.58	%		(0.14	)

Yield on average interest-earning assets		4.61	%		4.51	%		0.10
Cost of average interest-bearing liabilities		0.44	%		0.58	%		(0.14	)
Net interest spread		4.17	%		3.93	%		0.24

Net interest margin ⁽¹⁾		4.27	%		4.05	%		0.22

⁽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.

Average Interest Earning Balances:	For the Three Months Ended
	June 30, 2014								March 31, 2014								June 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 000's)
ASSETS:
Interest bearing certificate of deposit	$	2,727		$	10		1.47	%	$	2,727		$	10		1.49	%	$	2,235		$	7		1.21	%
Interest bearing deposits in banks		12,552			9		0.29	%		17,954			12		0.27	%		29,544			17		0.23	%
Investments - taxable		65,964			343		2.09	%		67,695			339		2.03	%		51,990			145		1.12	%
Investments - nontaxable		31,607			352		4.47	%		32,770			347		4.29	%		34,857			397		4.57	%
Gross loans (1)		532,490			6,718		5.06	%		511,200			6,492		5.15	%		474,403			6,149		5.20	%
Loans held for sale		7,685			71		3.71	%		5,436			49		3.66	%		9,170			80		3.50	%
Total interest earning assets		653,025			7,503		4.61	%		637,782			7,249		4.61	%		602,199			6,795		4.53	%
Cash and due from banks		13,135								11,989								11,321
Bank premises and equipment (net)		16,703								16,806								15,499
Other real estate owned		2,088								2,565								3,776
Deferred fees		(1,068	)							(1,137	)							(1,032	)
Allowance for loan losses		(8,271	)							(8,388	)							(9,375	)
Other assets		40,705								41,129								40,666
Total assets	$	716,317							$	700,746							$	663,054

LIABILITIES AND SHAREHOLDERS' EQUITY:

Interest-bearing deposits	$	345,116			140		0.16	%	$	336,201			141		0.17	%	$	312,459			181		0.23	%
Time deposits		122,134			290		0.95	%		126,841			276		0.88	%		135,107			351		1.04	%
FHLB borrowings		10,000			60		2.41	%		10,000			53		2.15	%		10,000			62		2.49	%
Short term borrowings		6			-		0.00	%		-			-		0.00	%		-			-		0.00	%
Junior subordinated debentures		13,403			51		1.53	%		13,403			60		1.82	%		13,403			54		1.62	%
Total interest bearing liabilities		490,659			541		0.44	%		486,445			530		0.44	%		470,969			648		0.55	%
Non-interest-bearing deposits		150,776								140,980								119,499
Other liabilities		4,928								5,196								4,316
Equity		69,954								68,125								68,270
Total liabilities and shareholders' equity	$	716,317							$	700,746							$	663,054

Net interest income (3)				$	6,962							$	6,719							$	6,147
Net interest spread							4.17	%					243		4.17	%					815		3.98	%

Average yield on earning assets (2) (3)							4.61	%							4.61	%							4.53	%
Interest expense to earning assets							0.19	%							0.19	%							0.24	%
Net interest income to earning assets (2) (3)							4.28	%							4.27	%							4.09	%

Reconciliation of Non-GAAP measure:
Tax Equivalent Net Interest Income

Net interest income				$	6,796							$	6,555							$	5,952
Tax equivalent adjustment for municipal loan interest					46								46								60
Tax equivalent adjustment for municipal bond interest					120								118								135
Tax equivalent net interest income				$	6,962							$	6,719							$	6,147

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 $6.4 million at 06/30/14, $7.3 million at 03/31/2014, and $10.4 million for 06/30/2013 are included in the average loan balances.

(2) Loan interest income includes loan fee income of $180,000, $149,000, and $131,000 for the three months ended 06/30/2014, 03/31/2014, and 06/30/2013, 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 $166,000, $164,000, and $195,000 for the three months ended June 30, 2014, March 31, 2014, and June 30, 2013, respectively.

	For the Three Months Ended									For the Three Months Ended
	June 30, 2014 vs. March 31, 2014									June 30, 2014 vs. June 30, 2013
	Increase (Decrease) Due To									Increase (Decrease) Due To
(Dollars in 000's)							Net									Net
	Volume			Rate			Change			Volume			Rate			Change
ASSETS:
Interest bearing certificate of deposit	$	-		$	-		$	-		$	1		$	2		$	3
Interest bearing deposits in banks		(4	)		1			(3	)		(10	)		2			(8	)
Investments - taxable		(9	)		13			4			39			159			198
Investments - nontaxable		(12	)		17			5			(37	)		(8	)		(45	)
Gross loans		273			(47	)		226			753			(184	)		569
Loans held for sale		21			1			22			(13	)		4			(9	)
Total interest earning assets	$	269		$	(15	)	$	254		$	733		$	(25	)	$	708

LIABILITIES AND SHAREHOLDERS' EQUITY:
Interest-bearing deposits	$	4		$	(5	)	$	(1	)	$	19		$	(60	)	$	(41	)
Time deposits		(10	)		24			14			(34	)		(27	)		(61	)
FHLB borrowings		-			7			7			-			(2	)		(2	)
Short-term borrowings		-			-			-			-			-			-
Long-term borrowings		-			(9	)		(9	)		-			(3	)		(3	)
Total interest bearing liabilities		(6	)		17			11			(15	)		(92	)		(107	)
Net increase (decrease) in net interest income	$	275		$	(32	)	$	243		$	748		$	67		$	815

Average Interest Earning Balances:	For the Six Months Ended
	June 30, 2014								June 30, 2013
	Average Balance			Interest Income or Expense		Average Yields or Rates			Average Balance			Interest Income or Expense		Average Yields or Rates
(Dollars in 000's)
ASSETS:
Interest bearing certificate of deposit	$	2,727		$	21		1.55	%	$	2,536		$	14		1.11	%
Interest bearing deposits in banks		15,238			19		0.25	%		32,629			37		0.23	%
Investments - taxable		66,825			682		2.06	%		46,747			250		1.08	%
Investments - nontaxable		32,185			700		4.39	%		34,319			800		4.70	%
Gross loans (1)		521,904			13,210		5.10	%		465,727			11,982		5.19	%
Loans held for sale		6,567			120		3.68	%		11,268			177		3.17	%
Total interest earning assets		645,446			14,752		4.61	%		593,226			13,260		4.51	%
Cash and due from banks		12,565								11,028
Bank premises and equipment (net)		16,755								15,231
Other real estate owned		2,325								4,095
Deferred fees		(1,104	)							(989	)
Allowance for loan losses		(8,330	)							(9,371	)
Other assets		40,917								40,910
Total assets	$	708,574							$	654,130

LIABILITIES AND SHAREHOLDERS' EQUITY:

Interest-bearing deposits	$	340,683			281		0.17	%	$	306,297			381		0.25	%
Time deposits		124,475			566		0.92	%		135,898			718		1.07	%
FHLB borrowings		10,000			120		2.42	%		10,099			124		2.48	%
Short term borrowings		3			-		0.00	%		-			-		0.00	%
Junior subordinated debentures		13,403			104		1.56	%		13,403			114		1.72	%
Total interest bearing liabilities		488,564			1,071		0.44	%		465,697			1,337		0.58	%
Non-interest-bearing deposits		145,905								116,240
Other liabilities		5,060								4,413
Equity		69,045								67,780
Total liabilities and shareholders' equity	$	708,574							$	654,130

Net interest income (3)				$	13,681							$	11,923
Net interest spread							4.17	%					1,758		3.93	%

Average yield on earning assets (2) (3)							4.61	%							4.51	%
Interest expense to earning assets							0.33	%							0.45	%
Net interest income to earning assets (2) (3)							4.27	%							4.05	%

Reconciliation of Non-GAAP measure:
Tax Equivalent Net Interest Income

Net interest income				$	13,351							$	11,534
Tax equivalent adjustment for municipal loan interest					92								117
Tax equivalent adjustment for municipal bond interest					238								272
Tax equivalent net interest income				$	13,681							$	11,923

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 $6.4 million at 06/30/14 and $10.4 million for 06/30/2013 are included in the average loan balances.

(2) Loan interest income includes loan fee income of $330,000 and $226,000 for the six months ended 06/30/2014 and 06/30/2013, 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 $330,000 and $389,000 for the six months ended June 30, 2014 and June 30, 2013, respectively.

	For the Six Months Ended
	June 30, 2014 vs. June 30, 2013
	Increase (Decrease) Due To
(Dollars in 000's)							Net
	Volume			Rate			Change
ASSETS:
Interest bearing certificate of deposit	$	1		$	6		$	7
Interest bearing deposits in banks		(20	)		2			(18	)
Investments - taxable		108			324			432
Investments - nontaxable		(50	)		(50	)		(100	)
Gross loans		1,446			(218	)		1,228
Loans held for sale		(74	)		17			(57	)
Total interest earning assets	$	1,411		$	81		$	1,492

LIABILITIES AND SHAREHOLDERS' EQUITY:
Interest-bearing deposits	$	43		$	(143	)	$	(100	)
Time deposits		(61	)		(91	)		(152	)
FHLB borrowings		(1	)		(3	)		(4	)
Short-term borrowings		-			-			-
Long-term borrowings		-			(10	)		(10	)
Total interest bearing liabilities		(19	)		(247	)		(266	)
Net increase (decrease) in net interest income	$	1,430		$	328		$	1,758

SUMMARY AVERAGE BALANCE SHEETS

(Unaudited)
(Dollars in Thousands)
Averages for the Three Months Ended	June 30,			March 31,									June 30,
	2014			2014			$ Change			% Change			2013			$ Change			% Change
Assets:
Cash and due from banks	$	13,135		$	11,989		$	1,146			10	%	$	11,321		$	1,814			16	%
Interest-bearing deposits in banks		12,552			17,954			(5,402	)		-30	%		29,544			(16,992	)		-58	%
Interest bearing certificate of deposit		2,727			2,727			0			0	%		2,235			492			22	%
Investment securities		97,571			100,465			(2,894	)		-3	%		86,847			10,724			12	%

Loans, net of deferred loan fees		539,106			515,499			23,607			5	%		482,541			56,565			12	%
Allowance for loan losses		(8,271	)		(8,388	)		117			-1	%		(9,375	)		1,104			-12	%
Net loans		530,835			507,111			23,724			5	%		473,166			57,669			12	%

Other assets		59,497			60,500			(1,003	)		-2	%		59,941			(444	)		-1	%
Total assets	$	716,317		$	700,746		$	15,571			2	%	$	663,054		$	53,263			8	%

Liabilities:
Total deposits	$	618,026		$	604,022		$	14,004			2	%	$	567,065		$	50,961			9	%
Borrowings		23,409			23,403			6			0	%		23,403			6			0	%
Other liabilities		4,928			5,196			(268	)		-5	%		4,316			612			14	%
Total liabilities		646,363			632,621			13,742			2	%		594,784			51,579			9	%

Equity:
Common equity		69,954			68,125			1,829			3	%		68,270			1,684			2	%
Total equity		69,954			68,125			1,829			3	%		68,270			1,684			2	%

Total liabilities and shareholders' equity	$	716,317		$	700,746		$	15,571			2	%	$	663,054		$	53,263			8	%

Averages for the Six Months Ended	June 30,			June 30,
	2014			2013			$ Change				% Change
Assets:
Cash and due from banks	$	12,565		$	11,028		$	1,537			14	%
Interest-bearing deposits in banks		15,238			32,629			(17,391	)		-53	%
Interest bearing certificate of deposit		2,727			2,536			191			8	%
Investment securities		99,010			81,066			17,944			22	%

Loans, net of deferred loan fees		527,367			476,006			51,361			11	%
Allowance for loan losses		(8,330	)		(9,371	)		1,041			-11	%
Net loans		519,037			466,635			52,402			11	%

Other assets		59,997			60,236			(239	)		0	%
Total assets	$	708,574		$	654,130		$	54,444			8	%

Liabilities:
Total deposits	$	611,063		$	558,435		$	52,628			9	%
Borrowings		23,406			23,502			(96	)		0	%
Other liabilities		5,060			4,413			647			15	%
Total liabilities		639,529			586,350			53,179			9	%

Equity:
Common equity		69,045			67,780			1,265			2	%
Total equity		69,045			67,780			1,265			2	%

Total liabilities and shareholders' equity	$	708,574		$	654,130		$	54,444			8	%

AVERAGE INTEREST EARNING ASSETS

(Unaudited)
(Dollars in Thousands)			% of					% of			$			%					% of			$			%
Averages for the Three Months Ended	June 30, 2014		Total			March 31, 2014		Total			Change			Change			June 30, 2013		Total			Change			Change

Interest-bearing certificate of deposits	$	2,727		0	%	$	2,727		0	%	$	0			0	%	$	2,235		0	%	$	492			0	%
Interest-bearing deposits in banks		12,552		2	%		17,954		3	%		(5,402	)		-1	%		29,544		5	%		(16,992	)		-3	%
Investments		97,571		15	%		100,465		16	%		(2,894	)		-1	%		86,847		14	%		10,724			1	%
Gross loans		532,490		82	%		511,200		80	%		21,290			2	%		474,403		79	%		58,087			3	%
Loans held for sale		7,685		1	%		5,436		1	%		2,249			0	%		9,170		2	%		(1,485	)		-1	%
Total average interest-earning assets	$	653,025		100	%	$	637,782		100	%	$	15,243					$	602,199		100	%	$	50,826

				% of					% of		$			%
Averages for the Six Months Ended	June 30, 2014			Total		June 30, 2013			Total		Change			Change

Interest-bearing certificate of deposits	$	2,727		0	%	$	2,536		0	%	$	191			0	%
Interest-bearing deposits in banks		15,238		2	%		32,629		6	%		(17,391	)		-4	%
Investments		99,010		15	%		81,066		14	%		17,944			1	%
Gross loans		521,904		81	%		465,727		79	%		56,177			2	%
Loans held for sale		6,567		1	%		11,268		2	%		(4,701	)		-1	%
Total average interest-earning assets	$	645,446		100	%	$	593,226		100	%	$	52,220

ASSET QUALITY

At June 30, 2014, total classified loans declined in dollars and as a percentage of total loans as compared to March 31, 2014, and June 30, 2013. Nonperforming loans consist primarily of commercial real estate loans. Total loans on accruing status 30-89 days past due also continue to remain below 0.50% of gross loans, mirroring the improvement in overall credit quality noted previously. We monitor delinquencies, defined as loans on accruing status 30-89 days past due, as an indicator of future adversely classified loans.

At June 30, 2014, total nonperforming loans were also down compared to March 31, 2014 and June 30, 2013. Nonperforming assets also declined during this period in terms of total outstanding loans and as a percentage of total assets. This was primarily due to the payoff of a $1.8 million non-accrual commercial real estate loan during the current quarter, which was partially offset by the placement on non-accrual of a $1.2 million commercial real estate loan relationship. Reductions in nonperforming assets were also achieved through sales of OREO, as write-downs were minimal during the current period.

Adversely classified loans
(Unaudited)
(Dollars in Thousands)
	June 30, 2014			March 31, 2014			$ Change			% Change			June 30, 2013			$ Change			% Change

Rated substandard or worse, but not impaired	$	6,938		$	6,842		$	96			1	%	$	4,113		$	2,825			69	%
Impaired		9,025			9,952			(927	)		-9	%		12,859			(3,834	)		-30	%
Total adversely classified loans*	$	15,963		$	16,794		$	(831	)		-5	%	$	16,972		$	(1,009	)		-6	%

Gross loans	$	548,371		$	519,632		$	28,739			6	%	$	472,186		$	76,185			16	%
Adversely classified loans to gross loans		2.91	%		3.23	%		-0.32	%					3.59	%		-0.68	%
Allowance for loan losses	$	8,315		$	8,288		$	27			0	%	$	9,348		$	(1,033	)		-11	%
Allowance for loan losses as a percentage of adversely classified loans		52.09	%		49.35	%		2.74	%					55.08	%		-2.99	%
Allowance for loan losses to total impaired loans		92.13	%		83.28	%		8.85	%					72.70	%		19.43	%

* 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)

	June 30, 2014			% of Category			March 31, 2014			% of Category			$ Change			% Change			June 30, 2013			% of Category			$ Change			% Change

Commercial and agricultural	$	23			16.5	%	$	32			4.1	%	$	(9	)		-28	%	$	355			11.8	%	$	(332	)		-94	%
Real estate:
Construction and development		-			0.0	%		-			0.0	%		-			0	%		-			0.0	%		-			0	%
Residential 1-4 family		53			38.1	%		180			23.1	%		(127	)		-71	%		517			17.2	%		(464	)		-90	%
Multi-family		-			0.0	%		-			0.0	%		-			0	%		-			0.0	%		-			0	%
Commercial real estate — owner occupied		-			0.0	%		309			39.6	%		(309	)		-100	%		314			10.4	%		(314	)		-100	%
Commercial real estate — non owner occupied		-			0.0	%		251			32.2	%		(251	)		-100	%		1,745			58.1	%		(1,745	)		-100	%
Farmland		-						-			0.0	%		-			0	%		55			1.8	%		(55	)		-100	%
Total real estate	$	53					$	740					$	(687	)		-93	%	$	2,631					$	(2,578	)
														-
Consumer		63			45.3	%		8			1.0	%		55			688	%		20			0.7	%		43			215	%
Total loans 30-89 days past due, not in nonaccrual status	$	139			100.0	%	$	780			100.0	%	$	(641	)		-82	%	$	3,006			100.0	%	$	(2,867	)		-95	%

Delinquent loans to total loans, not in nonaccrual status		0.03	%					0.15	%											0.66	%

Non-performing assets
(Unaudited)
(Dollars in Thousands)	June 30, 2014			March 31, 2014			$ Change			% Change			June 30, 2013			$ Change			% Change
Loans on nonaccrual status	$	6,388		$	7,296		$	(908	)		-12	%	$	10,368		$	(3,980	)		-38	%
Loans past due greater than 90 days but not on nonaccrual status		-			-			-						-			-
Total non-performing loans		6,388			7,296			(908	)		-12	%		10,368			(3,980	)		-38	%
Other real estate owned and foreclosed assets		991			2,386			(1,395	)		-58	%		3,451			(2,460	)		-71	%
Total nonperforming assets	$	7,379		$	9,682		$	(2,303	)		-24	%	$	13,819		$	(6,440	)		-47	%

Percentage of nonperforming assets to total assets		1.03	%		1.35	%								2.01	%

OREO declined during the second quarter 2014, and year-over year. Additional real estate properties taken into the OREO portfolio during the quarter was modest. OREO properties sold with a larger book value in the quarter compared to prior periods. OREO valuation adjustments continued to be minimal. At June 30, 2014, the OREO portfolio consisted of 10 properties, down in number and balance from both the first quarter 2014 and second 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	June 30, 2014			% of Category			March 31, 2014			% of Category			$ Change			% Change			June 30, 2013			% of Category			$ Change			% Change
Other real estate owned, beginning of period	$	2,386			240.8	%	$	2,771			116.1	%	$	(385	)		-14	%	$	4,148			120.2	%	$	(1,762	)		-42	%
Transfers from outstanding loans		206			20.8	%		111			4.7	%		95			86	%		-			0.0	%		206			100	%
Improvements and other additions		-			0.0	%		-			0.0	%		-			0	%		-			0.0	%		-			0	%
Proceeds from sales		(1,490	)		-150.4	%		(448	)		-18.8	%		(1,042	)		233	%		(634	)		-18.4	%		(856	)		135	%
Net gain (loss) on sales		(57	)		-5.8	%		(36	)		-1.5	%		(21	)		58	%		45			1.3	%		(102	)		-227	%
Impairment charges		(54	)		-5.4	%		(12	)		-0.5	%		(42	)		350	%		(108	)		-3.1	%		54			-50	%
Total other real estate owned	$	991			100.0	%	$	2,386			100.0	%	$	(1,395	)		-58	%	$	3,451			100.0	%	$	(2,460	)		-71	%

For the Six Months Ended	June 30, 2014				% of Category			June 30, 2013			% of Category		$ Change				% Change
Other real estate owned, beginning of period	$	2,771			279.6	%	$	4,678			135.6	%	$	(1,907	)		-41	%
Transfers from outstanding loans		317			32.0	%		209			6.1	%		108			52	%
Improvements and other additions		-			0.0	%		-			0.0	%		-			0	%
Proceeds from sales		(1,938	)		-195.6	%		(1,001	)		-29.0	%		(937	)		94	%
Net gain (loss) on sales		(93	)		-9.4	%		25			0.7	%		(118	)		-472	%
Impairment charges		(66	)		-6.7	%		(460	)		-13.3	%		394			-86	%
Total other real estate owned	$	991			100.0	%	$	3,451			100.0	%	$	(2,460	)		-71	%

Other real estate owned and foreclosed assets by type

(Unaudited)

(Dollars in Thousands)

	June 30, 2014		# of Properties		March 31, 2014		# of Properties		$ Change			% Change			June 30, 2013		# of Properties		$ Change			% Change

Construction, Land Dev & Other Land	$	46		2	$	60		3	$	(14	)		-23	%	$	1,041		8	$	(995	)		-96	%
1-4 Family Residential Properties		317		4		789		7		(472	)		-60	%		570		4		(253	)		-44	%
Nonfarm Nonresidential Properties		628		4		1,537		8		(909	)		-59	%		1,840		11		(1,212	)		-66	%
Total OREO by type	$	991		10	$	2,386		18	$	(1,395	)		-58	%	$	3,451		23	$	(2,460	)		-71	%

ALLOWANCE FOR LOAN LOSSES

The allowance for loan losses continues to decline in relation to total loans in concert with the general trend of reduced levels of classified loans, loan delinquencies and other relevant credit metrics. With the reduction in delinquencies, changes in the loan portfolio composition over the past several years and overall improvement in credit quality, loss factors used in estimates to establish reserve levels have declined commensurately. A provision was made to the allowance for loan losses in second quarter 2014 corresponding to recent growth in the loan portfolio, as compared to no provision in the linked quarter and a reverse provision in second quarter 2013.

For the quarter ended June 30, 2014, total net loan charge-offs were unchanged compared to the quarter ended March 31, 2014, but up versus the quarter ended June 30, 2013. The charge-offs incurred in the second quarter 2014 were primarily centered in one commercial real estate loan, which was written down $371,000 due to an impairment of the collateral securing the loan. This was partially offset by a $337,000 recovery resulting from the payoff of a $1.8 million commercial real estate loan. The ratio of net loan charge-offs to average gross loans (annualized) for the current quarter was unchanged compared to the linked quarter, but up slightly compared to the second quarter one year ago.

The overall risk profile of the loan portfolio continues to improve, as stated above. 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.

Allowance for Loan Losses
(Unaudited)
(Dollars in Thousands)
For the Three Months Ended	June 30, 2014			March 31, 2014			$ Change			% Change			June 30, 2013			$ Change			% Change

Gross loans outstanding at end of period	$	548,371		$	519,632		$	28,739			6	%	$	475,601		$	72,770			15	%
Average loans outstanding, gross	$	532,490		$	511,200		$	21,290			4	%	$	474,403		$	58,087			12	%
Allowance for loan losses, beginning of period	$	8,288		$	8,359		$	(71	)		-1	%	$	9,348		$	(1,060	)		-11	%
Commercial		(9	)		(17	)		8			-47	%		-			(9	)		-100	%
Commercial Real Estate		(389	)		(7	)		(382	)		5457	%		(42	)		(347	)		826	%
Residential Real Estate		(4	)		(40	)		36			-90	%		(61	)		57			-93	%
Consumer		(29	)		(18	)		(11	)		61	%		(49	)		20			-41	%
Total charge-offs		(431	)		(82	)		(349	)		426	%		(152	)		(279	)		184	%
Commercial		1			1			0			0	%		5			(4	)		-80	%
Commercial Real Estate		347			5			342			6840	%		209			138			66	%
Residential Real Estate		9			4			5			125	%		2			7			350	%
Consumer		1			1			-			0	%		-			1			100	%
Total recoveries		358			11			347			3155	%		216			142			66	%
Net charge-offs		(73	)		(71	)		(2	)		3	%		64			(137	)		-214	%
Provision charged to income		100			-			100			100	%		(450	)		550			-122	%
Allowance for loan losses, end of period	$	8,315		$	8,288		$	27			0	%	$	8,962		$	(647	)		-7	%
Ratio of net loans charged-off to average gross loans outstanding, annualized		0.05	%		0.06	%		-0.01	%		-17	%		-0.05	%		0.10	%		-200	%
Ratio of allowance for loan losses to gross loans outstanding		1.52	%		1.59	%		-0.07	%		-4	%		1.88	%		-0.36	%		-19	%

For the Six Months Ended		June 30, 2014			June 30, 2013			$ Change			% Change

Gross loans outstanding at end of period	$	519,632		$	472,186		$	47,446			10	%
Average loans outstanding, gross	$	511,200		$	456,954		$	54,246			12	%
Allowance for loan losses, beginning of period	$	8,359		$	9,358		$	(999	)		-11	%
Commercial		(26	)		-			(26	)		-100	%
Commercial Real Estate		(396	)		(47	)		(349	)		743	%
Residential Real Estate		(44	)		(71	)		27			-38	%
Consumer		(47	)		(60	)		13			-22	%
Total charge-offs		(513	)		(178	)		(335	)		188	%
Commercial		2			15			(13	)		-87	%
Commercial Real Estate		352			214			138			64	%
Residential Real Estate		13			2			11			550	%
Consumer		2			1			1			100	%
Total recoveries		369			232			137			59	%
Net charge-offs		(144	)		54			(198	)		-367	%
Provision charged to income		100			(450	)		550			100	%
Allowance for loan losses, end of period	$	8,315		$	8,962		$	(647	)		-7	%
Ratio of net loans charged-off to average gross loans outstanding, annualized		0.06	%		-0.02	%		0.08	%		0	%
Ratio of allowance for loan losses to gross loans outstanding		1.60	%		1.90	%		-0.30	%		-16	%

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.

Overall, we believe that the allowance for loan losses is adequate to absorb probable losses in the loan portfolio at June 30, 2014, although 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 critical to our financial results. Please refer to Item 1A “Risk Factors” 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 consideration, 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.

	June 30,			December 31,			June 30,
	2014			2013			2013

Primary liquidity		9.7	%		16.3	%		19.7	%
Short term funds availability		23.5	%		29.4	%		28.7	%
Net non-core funding dependency		6.83	%		3.20	%		10.10	%

Gross loans to deposits		88.55	%		80.70	%		80.00	%

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

At June 30, 2014, the Bank had $10.0 million in outstanding borrowings against its $120.6 million in established borrowing capacity with the FHLB. The Bank had the same amount outstanding in borrowings at December 31, 2013 and June 30, 2013. The borrowing capacity at the FHLB was $143.1 million and $128.7 million at December 31, 2013 and June 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 $61.5 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 June 30, 2014, the Bank had commitments to extend credit and standby letters related to extensions of credit of $101.1 million compared to $107.6 million at December 31, 2013 and $91.3 million at June 30, 2013. Such commitments represented 18.7%, 21.3% and 19.6% of total net loans as of June 30, 2014, December 31, 2013 and June 30, 2013, respectively. Please refer to Note 7 – “Commitments and Contingencies” in the accompanying financial statements for further information.

Critical Accounting Policies

Management has identified the calculation of our allowance for credit 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 June 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 President & 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 June 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 April 3, 2014 and August 4, 2014, the Company sold 45,901 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. Of this amount, 27,095 shares were acquired by current officers and directors of the Company. Total proceeds from the exercise of warrants were $298,356.50, 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.]

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

(a) [Not applicable.]

(b) [Not applicable.]

ITEM 4. MINE SAFETY DISCLOSURES

(a) [Not applicable.]

ITEM 5. OTHER INFORMATION

[None.]

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: August 13, 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