**FRONTIER
      FINANCIAL CORPORATION**


**AND
      SUBSIDIARIES**




**REPORT
      OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**








To
      the
      Board of Directors and Shareowners


Frontier
      Financial Corporation





We
      have
      audited the accompanying consolidated balance sheet of Frontier Financial
      Corporation and subsidiaries (Corporation) as of December 31, 2006 and 2005,
      and
      the related consolidated statements of income, shareowners' equity and cash
      flows for the three years in the period ended December 31, 2006. We also have
      audited management's assessment included in the accompanying Management Report
      on Internal Control over Financial Reporting that the Corporation maintained
      effective internal control over financial reporting as of December 31, 2006,
      based on criteria established in Internal Control - Integrated Framework issued
      by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
      The Corporation’s management is responsible for these financial statements, for
      maintaining effective internal control over financial reporting, and for its
      assessment of the effectiveness of internal control over financial reporting.
      Our responsibility is to express an opinion on these financial statements,
      an
      opinion on management's assessment, and an opinion on the effectiveness of
      the
      Corporation’s internal control over financial reporting based on our
      audits.





We
      conducted our audits in accordance with auditing standards of the Public Company
      Accounting Oversight Board (United States). Those standards require that we
      plan
      and perform the audit to obtain reasonable assurance about whether the financial
      statements are free of material misstatement and whether effective internal
      control over financial reporting was maintained in all material respects. An
      audit includes examining, on a test basis, evidence supporting the amounts
      and
      disclosures in the financial statements. An audit also includes assessing the
      accounting principles used and significant estimates made by management, as
      well
      as evaluating the overall financial statement presentation. Our audit of
      internal control over financial reporting included obtaining an understanding
      of
      internal control over financial reporting, evaluating management's assessment,
      testing and evaluating the design and operating effectiveness of internal
      control, and performing such other procedures as we considered necessary in
      the
      circumstances. We believe that our audits provide a reasonable basis for our
      opinions.





The
      Corporation's internal control over financial reporting is a process designed
      to
      provide reasonable assurance regarding the reliability of financial reporting
      and the preparation of financial statements for external purposes in accordance
      with accounting principles generally accepted in the United States of America.
      A
      Corporation’s internal control over financial reporting includes those policies
      and procedures that (1) pertain to the maintenance of records that, in
      reasonable detail, accurately and fairly reflect the transactions and
      dispositions of the assets of the Corporation; (2) provide reasonable assurance
      that transactions are recorded as necessary to permit preparation of financial
      statements in accordance with generally accepted accounting principles, and
      that
      receipts and expenditures of the Corporation are being made only in accordance
      with authorizations of management and Directors of the Corporation; and (3)
      provide reasonable assurance regarding prevention or timely detection of
      unauthorized acquisition, use, or disposition of the Corporation's assets that
      could have a material effect on the financial statements.





Because
      of its inherent limitations, internal control over financial reporting may
      not
      prevent or detect misstatements. Also, projections of any evaluation of
      effectiveness to future periods are subject to the risk that controls may become
      inadequate because of changes in conditions, or that the degree of compliance
      with the policies or procedures may deteriorate.





In
      our
      opinion, the consolidated financial statements referred to above present fairly,
      in all material respects, the consolidated financial position of Frontier
      Financial Corporation and subsidiaries as of December 31, 2006 and 2005, and
      the
      results of their operations and cash flows for each of the three years ended
      December 31, 2006, in conformity with accounting principles generally accepted
      in the United States of America. Also in our opinion, management's assessment
      that Frontier Financial Corporation and subsidiaries maintained effective
      internal control over financial reporting as of December 31, 2006, is fairly
      stated, in all material respects, based on criteria established in Internal
      Control - Integrated Framework issued by the Committee of Sponsoring
      Organizations of the Treadway Commission. Furthermore, in our opinion, Frontier
      Financial Corporation and subsidiaries maintained, in all material respects,
      effective internal control over financial reporting as of December 31, 2006,
      based on criteria established in Internal Control - Integrated Framework issued
      by the Committee of Sponsoring Organizations of the Treadway
      Commission.








Everett,
      Washington


February
      27, 2007




The
      accompanying notes are an integral part of these financial
      statements.  -
            1
            -


**FRONTIER
      FINANCIAL CORPORATION**


**AND
      SUBSIDIARIES**





**CONSOLIDATED
      BALANCE SHEET**


**(In
      Thousands, except for number of shares)**





DECEMBER
                31,ASSETS
            
            2006
            
            2005Cash
                and due from banks
            
            $
            104,222
            
            $
            85,631Federal
                funds sold
            
            
            18,673
            
            
            733Investment
                securitiesAvailable
                for sale, at fair value
            
            
            111,112
            
            
            104,904Held
                to maturity (fair value 2006: $3,623; 2005: $5,919)
            
            
            3,599
            
            
            5,713Total
                investment securities
            
            
            114,711
            
            
            110,617Loans
                for resale
            
            
            7,220
            
            
            5,711Loans
            
            
            2,900,780
            
            
            2,383,513Less
                allowance for loan losses
            
            
            (40,649
            )
            
            (33,805
            )Net
                loans
            
            
            2,867,351
            
            
            2,355,419Premises
                and equipment, net
            
            
            30,026
            
            
            29,769Intangible
                assets
            
            
            41,227
            
            
            6,476Federal
                Home Loan Bank (FHLB) stock
            
            
            15,030
            
            
            14,154Bank
                owned life insurance
            
            
            22,198
            
            
            18,136Other
                assets
            
            
            25,026
            
            
            19,340Total
                assets
            
            $
            3,238,464
            
            $
            2,640,275LIABILITIESDepositsNoninterest
                bearing accounts
            
            $
            406,621
            
            $
            395,852Interest
                bearing accounts
            
            
            2,047,011
            
            
            1,665,528Total
                deposits
            
            
            2,453,632
            
            
            2,061,380Federal
                funds purchased and securities sold under agreements to
                repurchase
            
            
            81,673
            
            
            20,813Federal
                Home Loan Bank advances
            
            
            282,017
            
            
            240,000Junior
                subordinated debentures
            
            
            5,156
            
            
            -Other
                liabilities
            
            
            20,703
            
            
            21,985Total
                liabilities
            
            
            2,843,181
            
            
            2,344,178COMMITMENTS
                AND CONTINGENCIES (Note 16)SHAREOWNERS'
                EQUITYPreferred
                stock, no par value; 10,000,000 shares authorized
            
            
            -
            
            
            -Common
                stock, no par value; 100,000,000 shares authorized; 45,350,316 and
                42,657,225 shares issued and outstanding in 2006 and 2005,
                respectively
            
            
            183,982
            
            
            131,695Retained
                earnings
            
            
            205,126
            
            
            159,978Accumulated
                other comprehensive income, net of tax
            
            
            6,175
            
            
            4,424Total
                shareowners' equity
            
            
            395,283
            
            
            296,097Total
                liabilities and shareowners' equity
            
            $
            3,238,464
            
            $
            2,640,275








The
      accompanying notes are an integral part of these financial
      statements.


-
          2
          -


**FRONTIER
      FINANCIAL CORPORATION**


**AND
      SUBSIDIARIES**





**CONSOLIDATED
      STATEMENT OF INCOME**


**(In
      Thousands, except for number of shares and per share
      amounts**)





YEAR
                ENDED DECEMBER 31,2006
            
            2005
            
            2004INTEREST
                INCOMEInterest
                and fees on loans
            
            $
            244,493
            
            $
            173,753
            
            $
            133,232Interest
                on federal funds sold
            
            
            1,448
            
            
            361
            
            
            170Interest
                on investment securitiesTaxable
            
            
            3,998
            
            
            4,497
            
            
            6,351Exempt
                from federal income tax
            
            
            205
            
            
            275
            
            
            475Total
                interest income
            
            
            250,144
            
            
            178,886
            
            
            140,228INTEREST
                EXPENSEInterest
                on deposits
            
            
            73,526
            
            
            40,714
            
            
            26,418Interest
                on FHLB advances
            
            
            12,195
            
            
            10,434
            
            
            8,365Interest
                on federal funds purchased and securities sold under agreements to
                repurchase
            
            
            1,221
            
            
            588
            
            
            156Total
                interest expense
            
            
            86,942
            
            
            51,736
            
            
            34,939NET
                INTEREST INCOME
            
            
            163,202
            
            
            127,150
            
            
            105,289PROVISION
                FOR LOAN LOSSES
            
            
            (7,500
            )
            
            (4,200
            )
            
            (3,500
            )Net
                interest income after provision for loan losses
            
            
            155,702
            
            
            122,950
            
            
            101,789NONINTEREST
                INCOMEProvision
                for loss on equity investment
            
            
            -
            
            
            (211
            )
            
            -Loss
                on sale of securities
            
            
            (25
            )
            
            -
            
            
            (44
            )Gain
                on sale of secondary market loans
            
            
            1,491
            
            
            1,249
            
            
            1,028Service
                charges
            
            
            4,214
            
            
            4,365
            
            
            4,926Other
            
            
            9,943
            
            
            7,672
            
            
            8,034Total
                noninterest income
            
            
            15,623
            
            
            13,075
            
            
            13,944NONINTEREST
                EXPENSESalaries
            
            
            29,935
            
            
            26,718
            
            
            23,403Employee
                benefits
            
            
            12,050
            
            
            9,825
            
            
            8,509Occupancy
            
            
            9,108
            
            
            7,654
            
            
            7,035State
                business taxes
            
            
            2,213
            
            
            1,798
            
            
            1,751Other
            
            
            13,740
            
            
            12,117
            
            
            10,027Total
                noninterest expense
            
            
            67,046
            
            
            58,112
            
            
            50,725INCOME
                BEFORE PROVISION FOR INCOME TAX
            
            
            104,279
            
            
            77,913
            
            
            65,008PROVISION
                FOR INCOME TAX
            
            
            (35,369
            )
            
            (26,329
            )
            
            (21,963
            )NET
                INCOME
            
            $
            68,910
            
            $
            51,584
            
            $
            43,045Weighted
                average number of sharesoutstanding
                for the period
            
            
            45,009,526
            
            
            42,481,644
            
            
            41,926,625BASIC
                EARNINGS PER SHARE
            
            $
            1.53
            
            $
            1.21
            
            $
            1.03Weighted
                average number of dilutedshares
                outstanding for the period
            
            
            45,484,987
            
            
            42,742,551
            
            
            42,205,634DILUTED
                EARNINGS PER SHARE
            
            $
            1.52
            
            $
            1.21
            
            $
            1.02




The
      accompanying notes are an integral part of these financial
      statements.


-
          3
          -


**FRONTIER
      FINANCIAL CORPORATION**


**AND
      SUBSIDIARIES**





**CONSOLIDATED
      STATEMENT OF SHAREOWNERS’ EQUITY**


**(In
      Thousands, except number of shares)**





**CONSOLIDATED
      STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY**


**AND
      COMPREHENSIVE INCOME**





AccumulatedOtherComprehensiveCommon
                Stock
            
            Comprehensive
            
            Retained
            
            Income/Shares
            
            Amount
            
            Income
            
            Earnings
            
            (Loss)
            
            TotalBalance,
                December 31, 2003
            
            
            18,550,060
            
            $
            118,693
            
            
            
            
            $
            97,221
            
            $
            3,492
            
            $
            219,406Comprehensive
                Income:Net
                income for 2004
            
            
            -
            
            
            -
            
            $
            43,045
            
            
            43,045
            
            
            -
            
            
            43,045Other
                comprehensive income,
              Unrealized
                gain (loss) on available for sale securities, net of tax
                $(51)
            
            
            -
            
            
            -
            
            
            (95
            )
            
            -
            
            
            (95
            )
            
            (95
            )Total
                comprehensive income
            
            
            
            
            
            
            
            $
            42,950Stock
                options exercised
            
            
            104,755
            
            
            2,393
            
            
            
            
            
            -
            
            
            -
            
            
            2,393Stock
                award plan
            
            
            15,995
            
            
            528
            
            
            
            
            
            -
            
            
            -
            
            
            528Issuance
                of common shares
            
            
            74,375
            
            
            3,003
            
            
            
            
            
            
            
            
            
            
            
            3,003Tax
                benefit from stock options
            
            
            -
            
            
            -
            
            
            
            
            
            698
            
            
            -
            
            
            698Cash
                dividends declared (34¢ per share)
            
            
            -
            
            
            -
            
            
            
            
            
            (14,748
            )
            
            -
            
            
            (14,748
            )Balance,
                December 31, 2004
            
            
            18,745,185
            
            
            124,617
            
            
            
            
            
            126,216
            
            
            3,397
            
            
            254,230Comprehensive
                Income:Net
                income for 2005
            
            
            -
            
            
            -
            
            $
            51,584
            
            
            51,584
            
            
            -
            
            
            51,584Other
                comprehensive income,
              Unrealized
                gain on available for sale
              securities,
                net of tax $554
            
            
            -
            
            
            -
            
            
            1,027
            
            
            -
            
            
            1,027
            
            
            1,027Total
                comprehensive income
            
            
            
            
            
            
            
            $
            52,611Stock
                options exercised
            
            
            154,791
            
            
            2,549
            
            
            
            
            
            -
            
            
            -
            
            
            2,549Stock
                award plan
            
            
            22,584
            
            
            601
            
            
            
            
            
            -
            
            
            -
            
            
            601Issuance
                of common shares
            
            
            143,438
            
            
            3,928
            
            
            
            
            
            
            
            
            
            
            
            3,928Tax
                benefit from stock options
            
            
            -
            
            
            -
            
            
            
            
            
            205
            
            
            -
            
            
            205Three
                for two stock split
            
            
            9,372,152
            
            
            -Cash
                dividends declared (40¢ per share)
            
            
            -
            
            
            -
            
            
            
            
            
            (18,027
            )
            
            -
            
            
            (18,027
            )Balance,
                December 31, 2005
            
            
            28,438,150
            
            
            131,695
            
            
            
            
            
            159,978
            
            
            4,424
            
            
            296,097Comprehensive
                Income:Net
                income for 2006
            
            
            -
            
            
            -
            
            $
            68,910
            
            
            68,910
            
            
            -
            
            
            68,910Other
                comprehensive income,
              Unrealized
                gain on available for sale securities, net of tax $943
            
            
            -
            
            
            -
            
            
            1,751
            
            
            -
            
            
            1,751
            
            
            1,751Total
                comprehensive income
            
            
            
            
            
            
            
            $
            70,661Stock
                options exercised
            
            
            275,283
            
            
            4,218
            
            
            
            
            
            -
            
            
            -
            
            
            4,218Stock
                award plan
            
            
            20,542
            
            
            1,156
            
            
            
            
            
            -
            
            
            -
            
            
            1,156Three
                for two stock split
            
            
            15,102,634
            
            
            -
            
            
            
            
            
            
            
            
            
            
            
            -Tax
                benefit from stock options
            
            
            
            
            
            
            
            
            
            
            
            1,205
            
            
            
            
            
            1,205Merger
            
            
            1,513,707
            
            
            46,913
            
            
            
            
            
            
            
            
            
            
            
            46,913Stock
                option expense
            
            
            
            
            
            
            
            
            
            
            
            73
            
            
            
            
            
            73Cash
                dividends declared (50¢ per share)
            
            
            -
            
            
            -
            
            
            
            
            
            (25,040
            )
            
            -
            
            
            (25,040
            )Balance,
                December 31, 2006
            
            
            45,350,316
            
            $
            183,982
            
            
            
            
            $
            205,126
            
            $
            6,175
            
            $
            395,283








The
      accompanying notes are an integral part of these financial
      statements.


-
          4
          -


**FRONTIER
      FINANCIAL CORPORATION**


**AND
      SUBSIDIARIES**





**CONSOLIDATED
      STATEMENT OF CASH FLOWS**


**(In
      Thousands)**





YEAR
                ENDED DECEMBER 31,2006
            
            2005
            
            2004CASH
                FLOWS FROM OPERATING ACTIVITIESNet
                income
            
            $
            68,910
            
            $
            51,584
            
            $
            43,045Adjustments
                to reconcile net income to net cash provided by operating
                activitiesDepreciation
                and amortization
            
            
            4,010
            
            
            2,704
            
            
            2,501Provision
                for loan losses
            
            
            7,500
            
            
            4,200
            
            
            3,500Gain
                on sale of other real estate owned
            
            
            -
            
            
            (25
            )
            
            (512
            )Gain
                (loss) on sale of premises and equipment
            
            
            (2,445
            )
            
            31
            
            
            (9
            )Gain
                (loss) on sale of securities
            
            
            25
            
            
            -
            
            
            44Gain
                on sale of secondary market loans
            
            
            (1,491
            )
            
            (1,249
            )
            
            (1,028
            )Provision
                for loss on equity investment
            
            
            -
            
            
            211
            
            
            -Deferred
                taxes
            
            
            (1,721
            )
            
            (1,633
            )
            
            (199
            )Stock
                award plan compensation
            
            
            1,156
            
            
            601
            
            
            528Stock
                option expense
            
            
            73
            
            
            -
            
            
            -Excess
                tax benefits associated with equity-based compensation
            
            
            (1,205
            )
            
            (205
            )
            
            (698
            )Dividend
                income from Federal Home Loan Bank
            
            
            -
            
            
            (58
            )
            
            (397
            )Increase
                in cash surrender value of BOLI
            
            
            (888
            )
            
            (736
            )
            
            (574
            )Changes
                in operating assets and liabilitiesIncome
                taxes payable
            
            
            (1,950
            )
            
            1,964
            
            
            (726
            )Interest
                receivable
            
            
            (3,780
            )
            
            (3,005
            )
            
            359Interest
                payable
            
            
            4,513
            
            
            3,033
            
            
            290Proceeds
                from sales of mortgage loans
            
            
            111,720
            
            
            91,293
            
            
            65,847Origination
                of mortgage loans held for sale
            
            
            (111,736
            )
            
            (93,191
            )
            
            (67,707
            )Other
                operating activities
            
            
            (2,127
            )
            
            1,984
            
            
            2,900Net
                cash provided by operating activities
            
            
            70,564
            
            
            57,503
            
            
            47,164CASH
                FLOWS FROM INVESTING ACTIVITIESNet
                change in federal funds sold
            
            
            (17,940
            )
            
            5,213
            
            
            (5,938
            )Proceeds
                from maturities of available for sale securities
            
            
            20,515
            
            
            90,294
            
            
            78,368Proceeds
                from maturities of held to maturity securities
            
            
            2,114
            
            
            1,176
            
            
            4,646Proceeds
                from sales of available for sale securities
            
            
            -
            
            
            1,852
            
            
            1,086Purchase
                of investment securities available for sale
            
            
            (17,324
            )
            
            (58,923
            )
            
            (47,127
            )Acquisition
                of bank
            
            
            7,121
            
            
            -
            
            
            -Net
                cash flows from loan activities
            
            
            (517,267
            )
            
            (409,274
            )
            
            (204,804
            )Purchases
                of premises and equipment
            
            
            (3,927
            )
            
            (3,193
            )
            
            (3,052
            )Proceeds
                from the sale of other real estate owned
            
            
            -
            
            
            25
            
            
            5,721Proceeds
                from the sale of premises and equipment
            
            
            3,443
            
            
            147
            
            
            91Other
                investing activities
            
            
            (3,069
            )
            
            (633
            )
            
            (1,065
            )Net
                cash used by investing activities
            
            
            (526,334
            )
            
            (373,316
            )
            
            (172,074
            )CASH
                FLOWS FROM FINANCING ACTIVITIESNet
                change in core deposit accounts
            
            
            182,986
            
            
            (13,360
            )
            
            77,995Net
                change in certificates of deposit
            
            
            209,266
            
            
            278,898
            
            
            50,830Stock
                options exercised
            
            
            4,218
            
            
            2,549
            
            
            2,393Cash
                dividends paid
            
            
            (22,358
            )
            
            (17,021
            )
            
            (14,337
            )Net
                change in federal funds purchased and securities sold under agreements
                to
                repurchase
            
            
            60,860
            
            
            10,608
            
            
            (190
            )Advances
                from the Federal Home Loan Bank
            
            
            111,756
            
            
            110,000
            
            
            55,000Repayments
                to the Federal Home Loan Bank
            
            
            (69,739
            )
            
            (45,088
            )
            
            (50,016
            )Excess
                tax benefits associated with equity-based compensation
            
            
            1,205
            
            
            205
            
            
            698Other
                financing activities
            
            
            (3,833
            )
            
            3,802
            
            
            (1,164
            )Net
                cash provided by financing activities
            
            
            474,361
            
            
            330,593
            
            
            121,209INCREASE
                (DECREASE) IN CASH AND DUE FROM BANKS
            
            
            18,591
            
            
            14,780
            
            
            (3,701
            )CASH
                AND DUE FROM BANKS AT BEGINNING OF YEAR
            
            
            85,631
            
            
            70,851
            
            
            74,552CASH
                AND DUE FROM BANKS AT END OF YEAR
            
            $
            104,222
            
            $
            85,631
            
            $
            70,851SUPPLEMENTAL
                DISCLOSURE OF CASH FLOW INFORMATIONCash
                paid during the year for interest
            
            $
            82,157
            
            $
            48,703
            
            $
            34,649Cash
                paid during the year for income taxes
            
            $
            36,595
            
            $
            26,000
            
            $
            22,505SUPPLEMENTAL
              INFORMATION ABOUT NONCASH INVESTING AND FINANCING
              ACTIVITIESOther
                real estate acquired in settlement of loans in 2004 was $1.0
                million.Purchase
                of investment through issuance of common shares in 2005
                and in 2004 were $3.9 million and $3.0 million,
                respectively.




The
      accompanying notes are an integral part of these financial
      statements.


-
          5
          -


**FRONTIER
      FINANCIAL CORPORATION**


**AND
      SUBSIDIARIES**





**NOTES
      TO FINANCIAL STATEMENTS**








***NOTE
      ONE - Basis of Presentation, Nature of Operations and Summary of Significant
      Accounting Policies***





***Basis
      of Presentation*** - The
      consolidated financial statements include the accounts of Frontier Financial
      Corporation (the Corporation or FFC), a financial holding company, and its
      wholly owned subsidiaries, Frontier Bank (the Bank), and FFP, Incorporated
      (FFP). FFP owns certain real property, which is leased to the Bank for use
      in
      its operations. Significant inter-company account balances and transactions
      have
      been eliminated in consolidation. Assets held by the Bank in an agency or
      fiduciary capacity, are not included in the accompanying financial
      statements.





***Variable
      Interest Entities*** - The
      Trusts were formed in December 2004 for the exclusive purpose of issuing trust
      preferred securities and using the $5.2 million in proceeds from the issuance
      to
      fund future asset growth in the Bank (Note 10). The Trusts are considered a
      variable interest entity as defined in FASB Interpretation No. 46R, *Consolidation
      of Variable Interest Entities (revised December 2003* ),
      which
      are: (1) the entity has equity that is insufficient to permit the entity to
      finance its activities without additional subordinated financial support from
      other parties, or (2) the entity has equity investors that cannot make
      significant decisions about the entity’s operations or that do not absorb the
      expected losses or receive the expected returns of the entity.





The
      Corporation has a significant variable interest in the Trusts, however it is
      not
      consolidated because the Corporation is not the beneficiary.





***Nature
      of Operations*** - The
      Corporation is primarily engaged in providing a full range of banking and
      mortgage services to individual and corporate customers through the Bank. The
      Bank also provides other services such as trust services and insurance and
      financial service brokerage activities. The Corporation is subject to
      competition from other financial institutions and to regulation by certain
      federal and state agencies and undergoes periodic examinations by those
      regulatory authorities.





***Stock
      Split*** - On
      August 16, 2006 the Corporation announced a three-for-two stock split paid
      on
      September 26, 2006 to shareowners of record on September 12, 2006. Accordingly,
      all shares and per share amounts have been adjusted to reflect the
      split.





***Summary
      of Significant Accounting Policies***




**Investment
      Securities** -
      Certain
      debt securities that management has the positive intent and ability to hold
      to
      maturity are classified as held to maturity (HTM) and recorded at amortized
      cost. Trading securities are recorded at fair value with changes in fair value
      included in earnings. Securities not classified as held to maturity or trading,
      including equity securities with readily determinable fair values, are
      classified as available for sale (AFS) and recorded at fair value, with
      unrealized gains and losses excluded from earnings and reported in other
      comprehensive income.





Purchase
      premiums and discounts are recognized in interest income using the interest
      method over the terms of the securities. Declines in the fair value of held
      to
      maturity and available for sale securities below their cost that are deemed
      to
      be other than temporary are reflected in earnings as realized losses. In
      determining whether other than temporary impairment exists, management considers
      many factors, including: (1) the length of time and the extent to which the
      fair
      value has been less than cost; (2) the financial condition and near-term
      prospects of the issuer; and (3) the intent and ability of the Corporation
      to
      retain its investment in the issuer for a period of time sufficient to allow
      for
      any anticipated recovery in fair value. Gains and losses on the sale of
      securities are recorded on the trade date and determined using the specific
      identification method.


-
          6
          -





*NOTE
      ONE - Basis of Presentation, Nature of Operations and Summary of Significant
      Accounting Policies (continued**)*





(b) Federal
      Home Loan Bank (FHLB) Stock - The
      Bank’s investment in Federal Home Loan Bank stock is carried at par value ($100
      per share), which reasonably approximates its fair value. As a member of the
      FHLB system, the Bank is required to maintain a minimum level of investment
      in
      FHLB stock based on specific percentages of its outstanding FHLB advances.
      The
      FHLB announced in December 2004, that it would not repurchase any stock until
      further notice. On April 5, 2005, the FHLB of Seattle submitted a proposed
      business and capital plan to its regulator, the Federal Housing Finance Board
      (“Finance Board”). In May 2005, the Finance Board accepted the Seattle Bank’s
      three-year plan. To meet the Finance Board’s conditions under the three-year
      plan, the Seattle Bank’s board adopted a resolution that suspends dividends on
      all classes of stock going forward. In December 2006, the FHLB of Seattle
      declared a $0.10 per share cash dividend and in January 2007 announced that
      its
      regulator, the Finance Board, has terminated its written plan. The termination
      of the written plan does not affect the resolution adopted by the Seattle Bank’s
      Board of Directors to continue its restrictions on Class B stock repurchases
      and
      limit dividends to 50 percent of year-to-date GAAP net income, except with
      the
      prior written approval of the Finance Board’s Director of the Office of
      Supervision. The dividend income shown on the statement of cash flows represents
      dividends declared in 2004, but not paid until 2005.





(c) **Loans and Related Income** - Loans
      that management has the intent and ability to hold for the foreseeable future,
      or until maturity or payoff are reported at their outstanding principal,
      adjusted for unearned discounts, net of unamortized nonrefundable fees and
      related direct loan origination costs. Interest income is accrued as earned.





Net
      deferred fees and costs are generally amortized into interest income over the
      life of the loan as an adjustment to the loan yield using the interest method.
      Expenses deferred (principally personnel expense) and recognized in the yield
      adjustment result in a reduction in noninterest expense.





Nonrefundable
      fees related to lending activities other than direct loan origination or
      purchase are recognized as credit related fees and included in noninterest
      income during the period the related service is provided. These include standby
      letter of credit and loan commitment fees.





Loans
      are
      placed on nonaccrual status when, in the opinion of management, the collection
      of additional interest is doubtful or when the loan becomes 90 or more days
      past
      due. When a loan is placed on nonaccrual status, all interest previously
      accrued, but not collected, is reversed and charged against interest income.
      Income on nonaccrual loans is then recognized only to the extent cash is
      received and where the future collection of principal is probable. Accruals
      are
      resumed only when the loan is brought current, and when, in the opinion of
      management, the borrower has demonstrated the ability to resume payments of
      principal and interest. Interest income on restructured loans is recognized
      pursuant to the terms of the new loan agreement. Interest income on other
      impaired loans is monitored and based upon the terms of the underlying loan
      agreement. However, the recorded net investment in impaired loans, including
      accrued interest, is limited to the present value of the expected cash flows
      of
      the impaired loan or the observable fair market value of the loan or the fair
      market value of the loan's collateral.





(d) **Allowance for Loan Losses** - The
      allowance for loan losses is established as losses are estimated to have
      occurred through a provision for loan losses charged to earnings. Loan losses
      are charged against the allowance when management believes the uncollectibility
      of a loan balance is confirmed. Subsequent recoveries, if any, are credited
      to
      the allowance.




The
      allowance for loan losses is evaluated on a regular basis by management and
      is
      based upon management’s periodic review of the collectibility of the loans in
      light of historical experience, the nature and volume of the loan portfolio,
      adverse situations that may affect the borrower’s ability to repay, estimated
      value of any underlying collateral and prevailing economic conditions. This
      evaluation is inherently subjective as it requires estimates that are
      susceptible to significant revision as more information becomes
      available.


-
          7
          -





*NOTE**ONE
      -
      Basis of Presentation, Nature of Operations and Summary of Significant
      Accounting Policies (continued)*





The
      allowance consists of specific, general and unallocated components. The specific
      component relates to loans that are classified as impaired, an allowance is
      established when the discounted cash flows (or collateral value or observable
      market price) of the impaired loan is lower than the carrying value of that
      loan. The general component covers nonclassified loans and is based on
      historical loss experience adjusted for qualitative factors. An unallocated
      component is maintained to cover uncertainties that could affect management’s
      estimate of probable losses. The unallocated component of the allowance reflects
      the margin of imprecision inherent in the underlying assumptions used in the
      methodologies for estimated specific and general losses in the
      portfolio.





A
      loan is
      considered impaired when, based on current information and events, it is
      probable that the Corporation will be unable to collect the scheduled payments
      of principal or interest when due according to the contractual terms of the
      loan
      agreement. Factors considered by management in determining impairment include
      payment status, collateral value, and the probability of collecting scheduled
      principal and interest payments when due. Loans that experience insignificant
      payment delays and payment shortfalls generally are not classified as impaired.
      Management determines the significance of payment delays and payment shortfalls
      on a case-by-case basis, taking into consideration all of the circumstances
      surrounding the loan and the borrower, including the length of the delay, the
      reasons for the delay, the borrower’s prior payment record, and the amount of
      the shortfall in relation to the principal and interest owed. Impairment is
      measured on a loan-by-loan basis for commercial and construction loans by either
      the present value of the expected future cash flows discounted at the loan’s
      effective interest rate, the loan’s obtainable market price, or the fair value
      of the collateral if the loan is collateral dependent.





(e) **Loans Held For Sale** -
      Mortgage loans originated and designated as held for sale are carried at the
      lower of cost or estimated fair value, as determined by quoted market prices,
      in
      aggregate. Net unrealized losses are recognized in a valuation allowance by
      charges to income. Gains or losses on the sale of such loans are based on the
      specific identification method.





(f) **Premises
      and Equipment** -
      Premises, leasehold improvements and equipment are shown at cost and depreciated
      using the straight-line method. Depreciation expense is computed over the
      following estimated useful lives:





Premises
            7
                to 40 yearsFurniture,
                fixtures and equipment
            3
                to 7 years





(g) **Other Real Estate Owned** - Other
      real estate owned consists principally of properties acquired through
      foreclosure and is stated at the lower of cost or estimated market value. Losses
      arising from the acquisition of property, in full or partial satisfaction of
      loans, are charged to the allowance for loan losses.





Subsequent
      to the transfer to foreclosed assets held for sale, these assets continue to
      be
      recorded at the lower of cost or fair value (less estimated costs to sell),
      based on periodic evaluations. Generally, legal and professional fees associated
      with foreclosures are expensed as incurred. Costs incurred to improve property
      prior to sale are capitalized, however, in no event are recorded costs allowed
      to exceed fair value. Subsequent gains, losses, or expenses recognized on the
      sale of these properties are included in noninterest income or expense.





(h) **Income Tax** - The
      Corporation reports income and expenses using the accrual method of accounting
      and files a consolidated tax return. Deferred taxes are determined using the
      asset-liability method and are reflected at currently enacted income tax rates
      applicable to the period in which the deferred tax assets or liabilities are
      expected to be realized or settled. As changes in tax laws or rates are enacted,
      deferred tax assets and liabilities are adjusted through the provision for
      income taxes. Deferred taxes result from temporary differences in recognition
      of
      certain income and expense amounts between the Bank's financial statements
      and
      its tax returns.


-
          8
          -





*NOTE**ONE
      -
      Basis of Presentation, Nature of Operations and Summary of Significant
      Accounting Policies (continued)*





(i) **Retirement Plan** - The
      Corporation has a profit sharing and salary deferral plan that covers eligible
      employees. The Corporation's contributions to the plan were $4.3 million in
      2006, $3.2 million in 2005, and $2.5 million in 2004. Contributions to the
      profit sharing plan are discretionary with a minimum of 6% of employee
      compensation. Employer contributions are funded during the period in which
      it is
      committed by the Board of Directors.





(j) **Advertising
      Costs** - The
      Corporation expenses advertising costs as they are incurred and such costs
      are
      not considered to be material.





(k) **Financial
      Instruments** - In the
      ordinary course of business, the Bank has entered into off-balance sheet
      financial instruments consisting of commitments to extend credit, commitments
      under credit card arrangements, commercial letters of credit, and standby
      letters of credit. Such financial instruments are recorded in the financial
      statements when they are funded or related fees are incurred or received.





(l) **Equity-Based
      Compensation** -
      At December 31, 2006, the Corporation has a stock-based employee compensation
      plan, which is described more fully in Note 13. Prior to January 1, 2006,
      the Corporation accounted for stock plans in accordance with the recognition
      and
      measurement provisions of Accounting Principles Board Opinion (APB) No. 25, *Accounting
      for Stock Issued to Employees* ,
      and
      related interpretations, as permitted by FASB Statement No. 123, *Accounting
      for Stock-Based Compensation* .
      No
      stock-based compensation expense was recognized in the Consolidated Statement
      of
      Income for the years ended December 31, 2005 or 2004, as all options granted
      under those plans had an exercise price equal to the market value of the
      underlying common stock on the date of grant. Effective January 1, 2006,
      the Corporation adopted the fair value recognition provisions of
      SFAS No. 123R, *Share-Based
      Payment* (Revised
      2004) using the modified-prospective-transition method. Under that transition
      method, compensation cost recognized in 2006 includes: (a) compensation cost
      for
      all share-based payments granted prior to, but not yet vested as of January
      1,
      2006, based on the grant-date fair value estimated in accordance with the
      original provisions of Statement 123, and (b) compensation cost for all
      share-based payments granted subsequent to January 1, 2006, based on the
      grant-date fair value estimated in accordance with the provisions of Statement
      123R. Results for prior periods have not been restated.





As
      a
      result of adopting Statement 123R on January 1, 2006, the Corporation’s income
      before income taxes and net income for the year ended December 31, 2006 are
      $73
      thousand and $47 thousand lower, respectively, than if it had continued to
      account for share-based compensation under Opinion 25. Basic and diluted
      earnings per share for the year ended December 31, 2006 would have been $1.53
      and $1.52, respectively, if the Corporation had not adopted Statement 123R,
      compared to the reported basic and diluted earning per share of $1.53 and $1.52,
      respectively.





Prior
      to
      adoption of Statement 123R, the Corporation presented all tax benefits of
      deductions resulting from the exercise of stock options as operating cash flows
      in the Consolidated Statement of Cash Flows. Statement 123R requires the cash
      flows resulting from the tax benefits resulting from tax deductions in excess
      of
      the compensation cost recognized for those options (excess tax benefits) to
      be
      classified as financing cash flows. The $1.2 million excess tax benefit
      classified as a financing cash inflow would have been classified as an operating
      cash inflow if the company had not adopted Statement 123R.





The
      following table illustrates the effect on net income and earnings per share
      if
      the company had applied the fair value recognition provisions of Statement
      123
      to options granted under the Corporation’s stock option plans in all periods
      presented. For purposes of this pro forma disclosure, the value of options
      is
      estimated using a Black-Sholes option-pricing formula and amortized to expense
      over the options’ vesting periods.


-
          9
          -





*NOTE**ONE
      -
      Basis of Presentation, Nature of Operations and Summary of Significant
      Accounting Policies (continued)*





In
                Thousands, except for per share amounts
            
            Years
                Ended December 31,2005
            
            2004Net
                income as reported
            
            $
            51,584
            
            $
            43,045Add:
                Stock-based Employee compensation expense included in reported net
                income,
                net of related tax effects
            
            
            -
            
            
            -Deduct:
                Total stock-based employee compensation expense determined under fair
                value based method for all awards, net of related tax
                effects
            
            
            (1,098
            )
            
            (1,091
            )Pro
                forma net income
            
            $
            50,486
            
            $
            41,954Earnings
                per shareBasic
                  - as reported
            
            $
            1.21
            
            $
            1.03Basic
                  -Pro forma
            
            $
            1.18
            
            $
            1.00Diluted
                  -As reported
            
            $
            1.21
            
            $
            1.02Diluted
                  -Pro forma
            
            $
            1.18
            
            $
            0.99








(m) **Earnings
      Per Share** - Basic
      earnings per share amounts are computed based on the weighted average number
      of
      shares outstanding during the period after giving retroactive effect to stock
      dividends and stock splits. Diluted earnings per share are computed by
      determining the number of additional shares that are deemed outstanding due
      to
      stock options under the treasury stock method.





(n) **Cash
      Equivalents** - For
      purposes of reporting cash flows, cash and cash equivalents include cash on
      hand, and amounts due from banks. Cash and cash equivalents have an original
      maturity of three months or less.





(o) **Use
      of Estimates** - The
      preparation of financial statements in conformity with accounting principles
      generally accepted in the United States of America requires management to make
      estimates and assumptions that affect the amounts reported in the financial
      statements and accompanying notes. Actual results could differ from those
      estimates.





Material
      estimates that are particularly susceptible to significant change, relate to
      the
      determination of the allowance for loan losses, deferred income taxes, valuation
      of stock options, and the valuation of real estate acquired in connection with
      foreclosures or in satisfaction of loans. In connection with the determination
      of the allowance for loan losses and the valuation of foreclosed assets held
      for
      sale, management obtains independent appraisals for significant
      properties.





(p) **Tranfer
      of Financial Assets** -
      Transfers of financial assets are accounted for as sales, when control over
      the
      assets has been surrendered. Control over transferred assets is deemed to be
      surrendered when: (1) the assets have been isolated from the Corporation; (2)
      the transferee obtains the right (free of conditions that constrain it from
      taking advantage of that right) to pledge or exchange the transferred assets;
      and (3) the Corporation does not maintain effective control over the transferred
      assets through an agreement to repurchase them before their
      maturity.




(q) **Comprehensive
      Income** -
      Accounting principles generally require that recognized revenue, expenses,
      gains
      and losses be included in net income. Certain changes in assets and liabilities,
      such as unrealized gains and losses on available-for-sale securities, are
      reported as separate component of the equity section of the balance sheet,
      and
      such items, along with net income, are components of comprehensive
      income.


-
          10
          -


*NOTE**ONE
      -
      Basis of Presentation, Nature of Operations and Summary of Significant
      Accounting Policies (continued)*




The
                components of comprehensive income and related tax effects are as
                follows:In
                Thousands
            
            Years
                Ended December 31,2006
            
            2005
            
            2004Unrealized
                holding gains on available-for-sale securities
            
            $
            9,500
            
            $
            6,807
            
            $
            5,226Tax
                effect
            
            
            (3,325
            )
            
            (2,383
            )
            
            (1,829
            )$
            6,175
            
            $
            4,424
            
            $
            3,397





The
                components of accumulated other comprehensive income, included in
                shareowners' equity, are as follows:In
                Thousands
            
            December
                31,2006
            
            2005Net
                unrealized gain (loss) on securities available-for-sale
            
            $
            2,694
            
            $
            1,581Tax
                effect
            
            
            (943
            )
            
            (554
            )$
            1,751
            
            $
            1,027




(r) **Business Combinations** -
      Statement of Financial Accounting Standards (SFAS) No. 141, *Business
      Combinations* ,
      (SFAS
      141), requires that all business combinations initiated after June 30, 2001
      be
      accounted for using the purchase method. The purchase method of accounting
      requires that the cost of an acquired entity be allocated to the assets acquired
      and liabilities assumed based on their estimated fair values at the date of
      acquisition. The difference between the fair values and the purchase price
      is
      recorded to Goodwill. Also, under SFAS 141, identified intangible assets
      acquired in a purchase business combination must be separately valued and
      recognized on the balance sheet if they meet certain requirements. See Note
      2 of
      the consolidated financial statements for further discussion.




(s) **Reclassifications** -
      Certain amounts in prior years' financial statements have been reclassified
      to
      conform to the 2006 presentation. These classifications have not had an effect
      on previously reported income.





***NOTE
      TWO - Acquisition***





On
      February 1, 2006, the Corporation acquired 100 percent of the outstanding shares
      of NorthStar Financial Corporation (NorthStar). NorthStar’s results of
      operations were included in the Corporation’s results beginning in 2006.
      NorthStar had two full service offices in the Seattle communities of Ballard
      and
      Fremont. The purchase of NorthStar provided Frontier the opportunity to fill
      in
      branches within its market area. The aggregate purchase price was $46.9
      million.





The
      acquisition was accounted for as a purchase in accordance with SFAS 141.
      Accordingly the purchase price was allocated to the assets acquired and the
      liabilities assumed based on their estimated fair values at the acquisition
      date
      as summarized in the following table:


-
          11
          -


***NOTE
      TWO - Acquisition (continued)***





In
                ThousandsTotal
                value of the Corporation's common stock exchanged
            
            $
            44,656Value
                of stock options assumed
            
            
            2,257Total
                Purchase Price
            
            
            
            
            
            46,913Allocation
                of purchase priceNorthStar's
                shareowner equity
            
            
            
            
            
            11,931Estimated
                adjustments to reflect assets acquired and liabilities assumed at
                fair
                value:Loan
            
            
            
            
            
            278Core
                deposit intangible
            
            
            
            
            
            681Federal
                Home Loan Bank advances
            
            
            
            
            
            159Junior
                subordinated debentures
            
            
            
            
            
            52Estimated
                fair value of net assets acquired
            
            
            
            
            
            13,101Goodwill
                resulting from acquisition
            
            
            
            
            $
            33,812





The
      acquired core deposit intangible assets has a useful life of approximately
      5
      years. The $33.8 million of goodwill acquired was assigned to the NorthStar
      business segment and none of it is deductible for tax purposes.





The
                fair value of assets and liabilities of NorthStar at the date of
                acquisition are presented below:Cash
            
            $
            3,481Securities
                available-for-sale
            
            
            8,176Federal
                funds sold and interest bearing deposits at banks
            
            
            8,003Loans,
                net of allowance for loan losses of $2,501
            
            
            150,099Premises
                and equipment, net
            
            
            178BOLI
            
            
            3,174Other
                assets
            
            
            2,521Investment
                in Trust I and Trust II
            
            
            156Goodwill
            
            
            33,812Total
                assets
            
            
            209,600Deposits
            
            
            (145,172
            )Federal
                Home Loan Bank advances
            
            
            (11,152
            )Junior
                subordinated debentures
            
            
            (5,104
            )Other
                liabilities
            
            
            (1,259
            )Net
                assets acquired
            
            $
            46,913





The
      following unaudited pro forma condensed consolidated financial information
      presents the results of operations of the Corporation had the acquisition taken
      place at January 1, 2005:





In
                Thousands, except per share amounts
            
            For
                the years ended December 31,2006
            
            2005Net
                interest income
            
            $
            163,806
            
            $
            134,868Provision
                for loan losses
            
            
            7,515
            
            
            (4,990
            )Noninterest
                income
            
            
            15,644
            
            
            14,181Noninterest
                expense
            
            
            67,238
            
            
            63,025Income
                before income tax
            
            
            101,697
            
            
            81,034Net
                income
            
            
            69,190
            
            
            53,646Per
                common share information:Basis
                earnings per share
            
            $
            1.54
            
            $
            1.20Diluted
                earnings per share
            
            $
            1.52
            
            $
            1.19Average
                common shares issued and outstanding
            
            
            45,009,526
            
            
            44,664,107Average
                diluted common shares issued and outstanding
            
            
            45,484,987
            
            
            45,030,953




-
          12
          -





***NOTE
      THREE - Acquisition (continued)***





The
      pro
      forma results presented in the previous table include amortization of purchase
      premiums of approximately $241 thousand for the years ended December 31, 2006
      and 2005. Excluded from the pro forma results are acquisition related expenses
      of approximately $2.5 million paid for by NorthStar prior to the acquisition
      date.





***NOTE
      THREE - Investments***





Investments
      in federal funds sold are made with major banks, which are approved by the
      Board
      of Directors. The Bank has an investment policy that generally permits holding
      securities rated only in one of the four highest rating categories by a
      nationally recognized credit rating organization.





The
      aggregate amortized cost and fair values of investment securities at December
      31
      are as follows:




In
                Thousands2006
            
            Amortized
              Cost
            
            Gross
              Unrealized
              Gains
            
            Less
                than
              12
                months
              Gross
              Unrealized
              Losses
            
            12
                months
              or
                more
              Gross
              Unrealized
              Losses
            
            Fair
              ValueAvailable
                for saleU.S.
                Treasury bonds
            
            $
            4,204
            
            $
            48
            
            
            ($4
            )
            
            -
            
            $
            4,248U.S.
                Agency bonds
            
            
            50,004
            
            
            76
            
            
            (23
            )
            
            ($850
            )
            
            49,207Municipal
                securities
            
            
            1,680
            
            
            -
            
            
            (16
            )
            
            (1
            )
            
            1,663Corporate
                bonds
            
            
            16,672
            
            
            54
            
            
            (7
            )
            
            (232
            )
            
            16,487Equities
            
            
            29,052
            
            
            10,804
            
            
            (91
            )
            
            (258
            )
            
            39,507101,612
            
            
            10,982
            
            
            (141
            )
            
            (1,341
            )
            
            111,112Held
                to maturityMunicipal
                securities
            
            
            2,073
            
            
            35
            
            
            -
            
            
            -
            
            
            2,108Corporate
                bonds
            
            
            1,526
            
            
            -
            
            
            (11
            )
            
            -
            
            
            1,5153,599
            
            
            35
            
            
            (11
            )
            
            -
            
            
            3,623Total
                Securities
            
            $
            105,211
            
            $
            11,017
            
            
            ($152
            )
            
            ($1,341
            )
            $
            114,735





2005
            
            Amortized
              Cost
            
            Gross
              Unrealized
              Gains
            
            Less
                than
              12
                months
              Gross
              Unrealized
              Losses
            
            12
                months
              or
                more
              Gross
              Unrealized
              Losses
            
            Fair
              ValueAvailable
                for saleU.S.
                Treasury bonds
            
            $
            7,232
            
            $
            57
            
            
            ($1
            )
            
            -
            
            $
            7,288U.S.
                Agency bonds
            
            
            49,621
            
            
            109
            
            
            (26
            )
            
            ($1,179
            )
            
            48,525Municipal
                securities
            
            
            45
            
            
            -
            
            
            -
            
            
            -
            
            
            45Corporate
                bonds
            
            
            17,799
            
            
            336
            
            
            (147
            )
            
            (135
            )
            
            17,853Equities
            
            
            23,400
            
            
            8,366
            
            
            (198
            )
            
            (375
            )
            
            31,19398,097
            
            
            8,868
            
            
            (372
            )
            
            (1,689
            )
            
            104,904Held
                to maturityMunicipal
                securities
            
            
            4,186
            
            
            84
            
            
            -
            
            
            (5
            )
            
            4,265Corporate
                bonds
            
            
            1,527
            
            
            127
            
            
            -
            
            
            -
            
            
            1,6545,713
            
            
            211
            
            
            -
            
            
            (5
            )
            
            5,919Total
                Securities
            
            $
            103,810
            
            $
            9,079
            
            
            ($372
            )
            
            ($1,694
            )
            $
            110,823




-
          13
          -


***NOTE
      THREE - Investments (continued)***




Certain
      investment securities shown above currently have fair values less than amortized
      cost and therefore contain unrealized losses. The Corporation has evaluated
      these securities and has determined that the decline in value  is
      temporary, and is not related to any company or industry specific event. There
      are 22 investment securities with unrealized losses at December 31, 2006. The
      Corporation anticipates full recovery of amortized cost with respect to these
      securities at maturity or sooner in the event of a more favorable market
      interest rate environment.





Contractual
      maturities of investment securities as of December 31, 2006 are shown below.
      Expected maturities will differ from contractual maturities because issuers
      may
      have the right to call or prepay obligations with or without prepayment
      penalties.





In
                Thousands
            
            Available
                for Sale
            
            Held
                to MaturityAmortized
              Cost
            
            Fair
              Value
            
            Amortized
              Cost
            
            Fair
              ValueMaturityLess
                than one year
            
            $
            44,823
            
            $
            55,197
            
            $
            715
            
            $
            720One
                to five years
            
            
            53,991
            
            
            53,023
            
            
            1,358
            
            
            1,388Five
                to ten years
            
            
            251
            
            
            299
            
            
            -
            
            
            -Over
                ten years
            
            
            2,547
            
            
            2,593
            
            
            1,526
            
            
            1,515$
            101,612
            
            $
            111,112
            
            $
            3,599
            
            $
            3,623





Investments
      in state and political subdivisions represent purchases of municipal bonds,
      with
      localities principally in western Washington. Investments in corporate bonds
      are
      made in companies located and doing business throughout the United States.
      Approximately 67% and 70% of the investments in corporate bonds at December
      31,
      2006 and 2005, respectively, consisted of investments in companies doing
      business in the financial services sector. Approximately 33% and 30% of the
      investments in corporate bonds at December 31, 2006 and 2005, respectively,
      consisted of investments in companies doing business in the industrial
      sector.





As
      of
      December 31, 2006 and 2005, the Corporation held FHLB bonds that had a book
      value of $35.0
      million and $34.0 m illion
      and a market value of $34.4 million and $33.2 million,
      respectively.





Proceeds
      from sales of available for sale securities were $1.9 million in 2005 and $1.1
      million in 2004. Gross realized losses on sales of securities were $25 thousand
      in 2006 and $44 thousand in 2004. Investment securities, with an amortized
      cost
      of $32.2 million and $32.3 million with fair values of $31.0 and $31.6 million
      in 2006 and 2005, respectively, were pledged to secure public deposits and
      securities sold under agreements to repurchase as required by law.





***NOTE
      FOUR - Loans***





The
      Bank
      originates commercial, real estate mortgage, construction and land development
      and installment loans primarily in Clallam, Island, Jefferson, King, Kitsap,
      Pierce, Skagit, Snohomish, and Whatcom Counties. Although the Bank has a
      diversified loan portfolio, local economic conditions may affect borrowers'
      ability to meet the stated repayment terms. Collateral for each loan is based
      on
      a credit evaluation of the customer, and such collateral may, depending on
      the
      loan, include accounts receivable, inventory, equipment, real estate or other
      collateral. Loans are originated at both fixed, adjustable, and variable
      interest rates.




Major
      classifications of loans at December 31 are as follows:


-
          14
          -


***NOTE
      FOUR - Loans (continued)***




In
                Thousands
            
            2006
            
            2005Commercial
                and agriculture
            
            $
            381,800
            
            $
            321,980Real
                estate commercial
            
            
            901,098
            
            
            860,826Real
                estate construction and land development
            
            
            1,334,051
            
            
            978,120Real
                estate mortgage
            
            
            236,344
            
            
            191,137Installment
            
            
            63,116
            
            
            46,8252,916,409
            
            
            2,398,888Less
                deferred loan fees
            
            
            (15,629
            )
            
            (15,375
            )$
            2,900,780
            
            $
            2,383,513




Contractual
      maturities of loans, net of deferred fees, as of December 31, 2006 are shown
      below. Expected maturities will differ from contractual maturities because
      borrowers may have the right to prepay loans with or without prepayment
      penalties.




In
                Thousands
            
            Within
              1
                Year
            
            1-5
              Years
            
            After
              5
                Years
            
            TotalCommercial
                and agriculture
            
            $
            219,942
            
            $
            136,070
            
            $
            24,928
            
            $
            380,940Real
                estate commercial
            
            
            94,416
            
            
            473,063
            
            
            330,238
            
            
            897,717Real
                estate construction and land development
            
            
            1,230,744
            
            
            82,221
            
            
            10,941
            
            
            1,323,906Real
                estate mortgage
            
            
            94,285
            
            
            90,969
            
            
            49,914
            
            
            235,168Installment
            
            
            11,638
            
            
            15,853
            
            
            35,558
            
            
            63,049$
            1,651,025
            
            $
            798,176
            
            $
            451,579
            
            $
            2,900,780Loans
                maturing after one year with:
            
            
            
            
            
            1-5
              Years
            
            
            After
              5
                YearsFixed
                rates
            
            
            
            
            $
            638,560
            
            $
            56,385Variable
                rates
            
            
            
            
            
            159,616
            
            
            395,194$
            798,176
            
            $
            451,579




**LOAN
      LOSS RESERVE**





Changes
      in the allowance for loan losses for the year ended December 31 are summarized
      below:




In
                Thousands
            
            2006
            
            2005
            
            2004Balance
                at beginning of year
            
            $
            37,075
            
            $
            32,728
            
            $
            29,556Provision
                charged to operating expense
            
            
            7,500
            
            
            4,200
            
            
            3,500Merger
            
            
            2,501
            
            
            -
            
            
            -Loans
                charged-off
            
            
            (3,294
            )
            
            (706
            )
            
            (1,412
            )Less
                recoveries
            
            
            413
            
            
            853
            
            
            1,084Net
                recoveries (charge-offs)
            
            
            (2,881
            )
            
            147
            
            
            (328
            )Balance
                before portion identified for undisbursed loans
            
            
            44,195
            
            
            37,075
            
            
            32,728Portion
                of reserve identified for undisbursed loansand
                reclassified as a liability
            
            
            (3,546
            )
            
            (3,270
            )
            
            (2,307
            )Balance
                at end of period
            
            $
            40,649
            
            $
            33,805
            
            $
            30,421




-
          15
          -


***NOTE
      FOUR - Loans (continued)***




The
      Bank
      had loans amounting to $8.7 at December 31, 2006, $4.9 million at December
      31,
      2005, and $14.1 million at December 31, 2004 that were specifically classified
      as impaired with an average balance during the year of $8.7 million, $5.0
      million, and $14.1 million, respectively. The allowance for loan losses related
      to these loans was approximately  $914
      thousand i n
      2006, $247
      thousand in
      2005,
      and $3.6 million in 2004. Interest collected on these loans in cash and included
      in income amounted to $344 thousand in 2006, $327 thousand in 2005, and $350
      thousand in 2004. If interest on these loans had been accrued the additional
      amount of such income would have approximated $761 thousand in 2006, $67
      thousand in 2005, and $925 thousand in 2004. At December 31, 2006 there were
      no
      commitments to lend additional funds to borrowers whose loans were classified
      as
      impaired.




**NONPERFORMING
      ASSETS**




The
      Bank’s nonperforming assets (NPA’s) (includes loans in nonaccrual and other real
      estate owned) totaled 0.27% and 0.19% of total assets at December 31, 2006
      and
      2005, respectively.





**OTHER
      REAL ESTATE OWNED**




From
      time-to-time management has written-off various parcels of other real estate
      owned due to unresolved issues relating to permitting, zoning and wetlands.
      Management is attempting to work through the above-mentioned issues to be able
      to effectively market these properties. Contingent gains could be realized,
      should the above issues be favorably resolved.





*NOTE
      FIVE - Premises and Equipment*




Premises
      and equipment at December 31 are comprised of the following:




In
                Thousands
            
            2006
            
            2005Premises
            
            $
            28,153
            
            $
            27,440Furniture,
                fixtures and equipment
            
            
            19,896
            
            
            18,280Land
            
            
            9,830
            
            
            9,601Construction
                in progress
            
            
            1,702
            
            
            57859,581
            
            
            55,899Less
                accumulated depreciation and amortization
            
            
            (29,555
            )
            
            (26,130
            )$
            30,026
            
            $
            29,769




Depreciation
      expense on premises and equipment totaled $2.9 million in 2006, $2.7 million
      in
      2005, and $2.5 million in 2004.





***NOTE
      SIX - Interest Bearing Deposits***





The
      major
      classifications of interest bearing deposits at December 31 are as
      follows:





In
                Thousands
            
            2006
            
            2005Money
                market, sweep and NOW accounts
            
            $
            683,948
            
            $
            322,283Savings
            
            
            305,669
            
            
            495,108Time
                deposits, $100,000 and over
            
            
            545,173
            
            
            471,726Other
                time deposits
            
            
            512,221
            
            
            376,411$
            2,047,011
            
            $
            1,665,528




-
          16
          -


***NOTE
      SIX - Interest Bearing Deposits (continued)***





At
      December 31, 2006, the scheduled maturities of time deposits are as
      follows:





In
                  Thousands2007
              
              $
              906,4062008
              
              
              67,8352009
              
              
              37,0882010
              
              
              27,2722011
              
              
              17,489Thereafter
              
              
              1,304$
              1,057,394


***NOTE
        SEVEN - Credit Arrangements***


The
      Bank
      is a member of the Federal Home Loan Bank (FHLB) of Seattle. As a member, the
      Bank has a committed line of credit up to 19% of total assets, or $597.8
      million. At December 31, 2006 committed lines of credit agreements
      totaling approximately $85.0 million were available to the Bank from unaffiliated banks
      and there were no outstanding balances as of December 31, 2006. Such lines
      generally provide for interest at the lending bank's federal funds rate or
      other
      money market rates.





***NOTE
      EIGHT - Federal Home Loan Bank (FHLB) Advances***





Contractual
      maturities of FHLB advances as of December 31, 2006 and 2005, are shown below.
      Expected maturities will differ from contractual maturities because FHLB has
      the
      right to call without penalties:





2006
            
            2005In
                Thousands
            
            Amount
            
            Interest
              Rates
            
            Amount
            
            Interest
              RatesWithin
                one year
            
            $
            41,368
            
            
            2.76%-6.04%
            
            $
            15,000
            
            
            3.05%-4.84%Two
                through three years
            
            
            82,791
            
            
            3.46%-5.58%
            
            
            82,500
            
            
            3.55%-6.04%Four
                through nine years
            
            
            97,858
            
            
            3.53%-6.77%
            
            
            122,500
            
            
            3.53%-6.77%Ten
                through fifteen years
            
            
            60,000
            
            
            4.03%-4.66%
            
            
            20,000
            
            
            3.87%$
            282,017
            
            
            
            
            $
            240,000




Advances
      from FHLB are collateralized by qualifying first mortgage loans, qualifying
      commercial real estate, and government agency securities as required by the
      agreement with FHLB.





The
      maximum and average outstanding balances and average interest rates on advances
      from FHLB were as follows for the year ended December 31:





In
                Thousands
            
            2006
            
            2005Maximum
                outstanding at any month-end
            
            $
            282,017
            
            $
            240,075Average
                outstanding
            
            
            258,604
            
            
            221,392Weighted
                average interest rates:Annual
            
            
            4.72
            %
            
            4.71
            %End
                of year
            
            
            4.69
            %
            
            4.70
            %




-
          17
          -


***NOTE
      NINE - Securities Sold Under Agreements to Repurchase***




The
      Bank
      has sold certain securities of the U.S. Government and its agencies and other
      approved investments under agreements to repurchase on a short-term basis.
      The
      securities underlying the agreements were held by a safekeeping agent.
      Securities sold under agreements to repurchase are reflected at the amount
      of
      cash received in connection with the transaction. The Corporation may be
      required to provide additional collateral based on the fair value of the
      underlying securities.





Securities
      sold under agreement to repurchase were $11.1 million in 2006 and $7.8 million
      in 2005. The average daily balance of outstanding agreements during the period
      was $8.5 million in 2006 and $6.9 million in 2005, with maximum outstanding
      agreements at any month-end of $10.0 million and $8.9 million,
      respectively.





***NOTE
      TEN - Junior Subordinated Debentures***





On
      February 1, 2006, the Corporation acquired 100 percent of the outstanding shares
      of NorthStar Financial Corporation (Note 2). As part of the transaction, the
      Corporation acquired two statutory business trusts which had been formed in
      December of 2004. NorthStar Financial Corporation Statutory Trust I (Trust
      I)
      and NorthStar Financial Corporation Statutory Trust II (Trust II), the Trusts,
      were formed for the exclusive purposes of issuing and selling capital securities
      and utilizing the proceeds to acquire junior subordinated debt.





The
      Trusts raised $5.2 million in cash through the issuance of $5.0 million of
      Trust
      Preferred Securities (“trust preferred securities”) and $156 thousand of common
      stock. The trust preferred securities are owned by third parties and the common
      stock is owned by the Corporation. The proceeds from the sale of the trust
      preferred securities and the common stock was invested by the Trusts in $5.2
      million of junior subordinated debentures issued by NorthStar Financial
      Corporation and assumed by the Corporation in the acquisition. In the December
      31, 2006, balance sheet of the Corporation, the $5.2 million of junior
      subordinated debentures is reflected as a liability and the $156 thousand of
      common stock of the Trusts is included in other assets. There were $5.0 million
      in trust preferred securities outstanding at December 31, 2006.





The
      Trusts accrue interest and make cash distributions on the trust preferred
      securities periodically at rates specified in the trust preferred securities.
      The interest rate on Trust I trust preferred securities is fixed at 6%. The
      interest rate on Trust II trust preferred securities is the Three-Month Libor
      rate plus 2%, and is adjusted quarterly. As of December 31, 2006, the interest
      rate on Trust II trust preferred securities was 7.37%. The Corporation pays
      interest on the junior subordinated debentures to the Trusts equal to the rate
      at which the Trusts accrue and pay interest on their trust preferred securities.
      Interest expense incurred on the junior subordinated debt of $311 thousand
      was
      recorded on the Corporation’s Consolidated Statement of Income in
      2006.





The
      junior subordinated debentures mature in February 2033. The Trust’s trust
      preferred securities are subject to mandatory redemption, in whole or in part,
      upon repayment of the debentures. In the event of certain changes or amendments
      to regulatory requirements or federal tax rules, the Trust’s trust preferred
      securities are redeemable by the Corporation in whole before February 23, 2010,
      at 100% of the liquidation amount. Upon approval of the Federal Reserve, the
      Corporation may redeem the Trust’s trust preferred securities in whole or in
      part on or after February 23, 2010, at 100% of the liquidation amount. The
      Trust’s trust preferred securities are fully and unconditionally guaranteed by
      the Corporation. As of December 31, 2006, $5.0 million of the Trust’s preferred
      securities qualify as Tier I capital under the guidelines of the Federal
      Reserve.


-
          18
          -


***NOTE
      ELEVEN - Income Tax***





The
      components of the provision for income tax are as follows:





In
                Thousands
            
            2006
            
            2005
            
            2004Current
            
            $
            37,090
            
            $
            27,962
            
            $
            22,162Deferred
            
            
            (1,721
            )
            
            (1,633
            )
            
            (199
            )$
            35,369
            
            $
            26,329
            
            $
            21,963





The
      following table shows the nature and components of the Corporation's net
      deferred tax assets, established at an estimated tax rate of 35% at December
      31:





In
                Thousands
            
            2006
            
            2005Deferred
                tax assetsAllowance
                for possible loan losses,in excess of tax reserves
            
            $
            15,341
            
            $
            12,976Other
                deferred tax assets
            
            
            1,684
            
            
            739Total
                deferred tax assets
            
            
            17,025
            
            
            13,715Deferred
                tax liabilitiesFHLB
                stock dividends
            
            
            (2,522
            )
            
            (2,468
            )Deferred
                loan fees
            
            
            (2,276
            )
            
            (1,494
            )Unrealized
                gain on available-for-sale securities
            
            
            (3,325
            )
            
            (2,382
            )Other
                deferred tax liabilities
            
            
            (1,601
            )
            
            (848
            )Total
                deferred tax liabilities
            
            
            (9,724
            )
            
            (7,192
            )Net
                deferred tax assets
            
            $
            7,301
            
            $
            6,523




The
      Corporation believes, based upon available information, that all deferred assets
      will be realized in the normal course of operations. Accordingly, these assets
      have not been reduced by a valuation allowance.




A
      reconciliation of the effective income tax rate with the federal statutory
      tax
      rate is as follows:





2006
            
            2005
            
            2004In
                  Thousands
            
            Amount
            
            Rate
            
            Amount
            
            Rate
            
            Amount
            
            RateIncome
                tax provision at statutory rate
            
            $
            36,498
            
            
            35%
            
            $
            27,270
            
            
            35%
            
            $
            22,753
            
            
            35%Effect
                of nontaxable interest income
            
            
            (1,129)
            
            
            (1%)
            
            
            (740)
            
            
            (1%)
            
            
            (576)
            
            
            (1%)Other
            
            
            -
            
            
            -
            
            
            (201)
            
            
            -
            
            
            (214)
            
            
            -$
            35,369
            
            
            34%
            
            $
            26,329
            
            
            34%
            
            $
            21,963
            
            
            34%




-
          19
          -


***NOTE
      TWELVE - Shareowners’ Equity and Regulatory
      Matters***





In
      addition to 100 million shares of common stock authorized, the Corporation
      is
      authorized to issue up to 10 million shares of preferred stock with no par
      value. The Board of Directors has the authority to determine the rights and
      privileges to be granted to holders of preferred stock. There are no preferred
      shares issued and outstanding.





In
      December 2006, the Board of Directors declared a $0.15 1⁄2 per share cash dividend
      to shareowners of record as of January 9, 2007, and payable on January 24,
      2007.




On
      August
      16, 2006 the Board announced the adoption of a stock repurchase program
      authorizing the Corporation to repurchase up to 5% of its outstanding stock
      in
      the open market. The plan expires in August of 2008. There were 2,263,323 shares
      available to repurchase under the current plan at December 31, 2006. Subsequent
      to year end, the Corporation repurchased 218,940 shares at an average cost
      per
      share of $26.85 through February 21, 2007.





During
      2005 and 2004 the Corporation made a purchase of Skagit State Bank stock through
      the issuance of common shares with a market value of $3.9 million and $3.0
      million, and cash of $3.2 million and $2.5 million, respectively. See Note
      16
      for additional discussion. No purchases were made in 2006.





The
      Corporation and Bank are subject to various regulatory capital requirements
      administered by the federal and state banking agencies. Failure to meet minimum
      capital requirements can initiate certain mandatory and possible additional
      discretionary actions by regulators that, if undertaken, could have a direct
      material effect on the Corporation's financial statements. Under capital
      adequacy guidelines in the regulatory framework for prompt corrective action,
      the Bank must meet specific capital adequacy guidelines that involve
      quantitative measures of each entity's assets, liabilities, and certain
      off-balance sheet items as calculated under regulatory accounting practices.
      Capital amounts and classifications are also subject to qualitative judgments
      by
      the regulators about components, risk weightings, and other
      factors.





Quantitative
      measures established by regulation to ensure capital adequacy require
      maintenance of minimum amounts and ratios (set forth in the following table).
      Tier I capital includes common stock, surplus, retained earnings and undivided
      profits less goodwill. Total capital includes Tier I capital and a portion
      of
      the loan loss reserve. Tier I capital to average risk weighted assets is
      referred to as the Tier I ratio. Management believes, as of December 31, 2006
      and 2005, that the Corporation and Bank meet the capital adequacy requirements
      to which they are subject.





As
      of the
      most recent notification from the Bank's primary regulator, the Bank was
      categorized as well capitalized under the regulatory framework for prompt
      corrective action. To be categorized as well capitalized, the Bank must maintain
      minimum total risk-based, Tier I risk-based, and Tier I leverage ratios as
      set
      forth in the table. There are no conditions or events since that notification
      that management believes have changed this category.


-
          20
          -


***NOTE
      TWELVE - Shareowners’ Equity and Regulatory Matters
      (continued)***





In
                Thousands
            
            Actual
            
            To
                Be Well
              Capitalized
                Under
              Prompt
                Corrective
              Action
                Provisions
            
            For
                Capital
              Adequacy
                Purposes2006
            
            Amount
            
            Ratio
            
            Amount
            
            Ratio
            
            Amount
            
            RatioTotal
                Capital (to risk weighted assets)Consolidated
            
            $
            390,752
            
            
            12.85
            %
            
            N/A
            
            
            N/A
            
            $
            243,324
            
            
            8.00
            %Frontier
                Bank
            
            
            360,051
            
            
            11.92
            %
            
            302,158
            
            
            10.00
            %
            
            241,726
            
            
            8.00
            %Tier
                I Capital (to risk weighted assets)Consolidated
            
            
            352,656
            
            
            11.59
            %
            
            N/A
            
            
            N/A
            
            
            121,662
            
            
            4.00
            %Frontier
                Bank
            
            
            322,202
            
            
            10.66
            %
            
            181,295
            
            
            6.00
            %
            
            120,863
            
            
            4.00
            %Tier
                I Capital (to average assets)Consolidated
            
            
            352,656
            
            
            11.32
            %
            
            N/A
            
            
            N/A
            
            
            124,638
            
            
            4.00
            %Frontier
                Bank
            
            
            322,202
            
            
            10.47
            %
            
            153,894
            
            
            5.00
            %
            
            123,115
            
            
            4.00
            %2005Total
                Capital (to risk weighted assets)Consolidated
            
            $
            316,902
            
            
            12.37
            %
            
            N/A
            
            
            N/A
            
            $
            204,891
            
            
            8.00
            %Frontier
                Bank
            
            
            289,801
            
            
            11.39
            %
            
            254,470
            
            
            10.00
            %
            
            203,576
            
            
            8.00
            %Tier
                I Capital (to risk weighted assets)Consolidated
            
            
            284,825
            
            
            11.12
            %
            
            N/A
            
            
            N/A
            
            
            102,445
            
            
            4.00
            %Frontier
                Bank
            
            
            257,947
            
            
            10.14
            %
            
            152,682
            
            
            6.00
            %
            
            101,788
            
            
            4.00
            %Tier
                I Capital (to average assets)Consolidated
            
            
            284,825
            
            
            10.99
            %
            
            N/A
            
            
            N/A
            
            
            103,654
            
            
            4.00
            %Frontier
                Bank
            
            
            257,947
            
            
            10.07
            %
            
            128,081
            
            
            5.00
            %
            
            102,465
            
            
            4.00
            %





Under
      federal regulations, the Bank is limited, unless previously approved, as to
      the
      amount it may loan the holding company and other affiliates to 10% of its
      capital stock ( approximately
      $6.8 million at December 31, 2006 and $5.6 million at December 31,
      2005).





Federal
      Reserve Board regulations require maintenance of certain minimum reserve
      balances on deposit with the Federal Reserve Bank. The average amount of such
      balances was $27.4 million in 2006 and $22.3 million in 2005.





***NOTE
      THIRTEEN - Benefit Plans***





On
      December 31, 2006, The Corporation had two share-based compensation plans,
      which
      are described below. The compensation cost that has been charged against income
      for those plans was $73 thousand in 2006. There were no compensations costs
      charged against income in 2005 or 2004 for those plans. The total income tax
      benefit recognized in the income statement for share-based compensation
      arrangements was $26 thousand in 2006. There was no income tax benefit
      recognized in the income statement for share-based compensation arrangements
      in
      2005 or 2004.


-
          21
          -


***NOTE
      THIRTEEN - Benefit Plans (continued)***





On
      February 17, 1999, the Corporation adopted the 1999 Employee Stock Award Plan
      to
      recognize, motivate, and reward eligible employees for longstanding performance
      with the Corporation and its subsidiaries. Employees eligible to receive stock
      awards under this plan must have been employees of the Corporation for at least
      20 years, or some other tenure as determined from time to time by the Board
      of
      Directors. The maximum number of shares that may be issued is 45,000 and is
      adjusted to reflect future common share dividends, splits, recapitalization
      or
      reorganization. During the year
      2006, there were 813 shares with a fair value of $17 thousand awarded and vested
      to employees. In 2005, and 2004, there were 1,502 and 1,778 shares with fair
      values of $25 thousand and $24 thousand, respectively, awarded and vested under
      this plan. Through December 31, 2006, there have been 7,222 shares issued under
      this plan. The stock awards vest immediately when granted. The plan is effective
      for ten years from adoption. There are currently 37,778 shares remaining under
      this plan.





In
      2006,
      the Shareowners of the Corporation approved a Stock Incentive Plan (the Plan)
      to
      promote the best interest of the Corporation, its subsidiaries and its
      shareowners, by providing an incentive to those key employees who contribute
      to
      the operating success of the Corporation. The plan allows for incentive stock
      options, stock grants and stock appreciation rights to be awarded. The maximum
      number of shares that may be issued under the Plan is 5,250,000 common shares
      of
      the Corporation. Shares issued and outstanding are adjusted to reflect common
      stock dividends, splits, recapitalization, or reorganization. The Board of
      Directors make available sufficient shares for each award granted. Options
      are
      granted at fair market value, generally vest over three years, and expire ten
      years from the date of grant. Dividends are paid on stock grants and are not
      paid on incentive stock options. Certain options provide for accelerated vesting
      if there is a change in control.





The
      fair
      value of each option award is estimated on the date of grant using the
      Black-Scholes option valuation model that uses the assumptions noted in the
      following table. Expected volatilities are based on historical volatility of
      the
      Corporation’s stock. The Corporation uses historical data to estimate option
      exercise and employee termination within the valuation model; separate groups
      of
      employees that have similar historical exercise behavior are considered
      separately for valuation purposes. The expected term of options granted is
      derived from the output of the option valuation model and represents the period
      of time that options granted are expected to be outstanding; the range given
      below results from certain groups of employees exhibiting different behavior.
      The risk-free rate for periods within the contractual life of the option is
      based on the U.S. Treasury yield curve in effect at the time of
      grant.





The
      following table presents the assumptions used in the fair value
      calculation:


Years
                  Ended December 31,2006
              
              2005
              
              2004Risk-free
                  interest rate
              
              
              4.60
              %
              
              5.25
              %
              
              3.25
              %Expected
                  dividends
              
              
              1.68
              %
              
              2.20
              %
              
              2.20
              %Volatility
              
              
              35.61
              %
              
              23.34
              %
              
              35.51
              %Expected
                  term (in years)
              
              
              3.2
              
              
              3.4
              
              
              3.1





A
      summary
      of option activity under the Plan as of December 31, 2006, and changes during
      the year then ended is as follows:


-
          22
          -


***NOTE
      THIRTEEN - Benefit Plans (continued)***





WeightedShares
                of Common Stock
            
            Average
                ofExercisable
            
            Weighted
            
            AggregatePrice
            
            Average
            
            IntrinsicAvailable
                for
            
            Under
            
            of
                Shares
            
            Contractual
            
            ValueAward
            
            Plans
            
            Under
                Plans
            
            Term
            
            (Thousands)Outstanding,
                December 31, 2005
            
            
            3,776
            
            
            952,123
            
            $
            24.75New
                plan
            
            
            3,500,000Merger
            
            
            148,401
            
            
            148,401
            
            
            10.93Three-for-two
                stock split
            
            
            1,583,637
            
            
            415,910Granted
            
            
            (122,163
            )
            
            122,163
            
            
            29.83Exercised
            
            
            
            
            
            (275,283
            )
            
            11.21Forfeited/Expired
            
            
            14,186
            
            
            (14,186
            )
            
            20.65Outstanding,
                December 31, 2006
            
            
            5,127,837
            
            
            1,349,128
            
            $
            17.78
            
            
            7.6
            
            $
            15,533Exercisable
                at December 31, 2006
            
            
            
            
            
            1,226,965
            
            $
            16.57
            
            
            7.4
            
            $
            15,533




The
      numbers of shares under award for the plans represent 3.0% of the total shares
      outstanding as of December 31, 2006. The following table summarizes information
      concerning currently outstanding and exercisable awards:




Awards
                Outstanding
            
            Awards
                ExercisableRange
                of
              Exercise
              Prices
            
            Number
              Outstanding
            
            Weighted
              Average
              Remaining
              Contractual
              Life
            
            Weighted
              Exercise
              Average
              Price
            
            Number
              Exercisable
            
            Weighted
              Average
                Exercise
              Price$
                1-10
            
            57,924
            
            3.72
            
            $7.65
            
            57,924
            
            $7.6510-15
            
            479,446
            
            6.08
            
            12.88
            
            479,446
            
            12.8815-20
            
            298,560
            
            7.95
            
            17.78
            
            298,560
            
            17.7820-30
            
            513,198
            
            9.20
            
            23.50
            
            391,035
            
            21.50





The
      weighted-average grant-date fair value of options granted during the years
      2006,
      2005, and 2004 was $8.06, $3.86, and $4.13, respectively. The total intrinsic
      value of options exercised during the years ended December 31, 2006, 2005,
      and
      2004 was $4.8 million, $1.7 million, and $1.6 million,
      respectively.





A
      summary
      of the status of the Corporation’s nonvested shares as of December 31, 2006, and
      changes during the year ended December 31, 2006, is presented in
      below:





Shares
            
            Weighted
              Average
              Grant-Date
              Fair
                ValueNonvested
                at January 1, 2006
            
            
            -
            
            
            -Granted
            
            
            131,464
            
            $
            29.76Vested
            
            
            (813
            )
            
            20.91Forfeited
            
            
            (525
            )
            
            29.83Outstanding,
                December 31, 2006
            
            
            130,126
            
            $
            29.83




-
          23
          -





***NOTE
      THIRTEEN - Benefit Plans (continued)***





As
      of
      December 31, 2006, there was $4.9 million of total unrecognized compensation
      cost related to nonvested share-based compensation arrangements granted under
      the Plan. That cost is expected to be recognized over a weighted-average period
      of 3.2 years. The fair value of shares vested during the year was $17 thousand.





Cash
      received from option exercise under all share-based payment arrangements for
      the
      years ended December 31, 2006, 2005, and 2004 was $4.2 million, $2.5 million,
      and $2.4 million, respectively. The actual tax benefit realized for the tax
      deductions from option exercise of the share-based payment arrangements totaled
      $1.2 million, $205 thousand, and $698 thousand, respectively, for the years
      ended December 31, 2006, 2005, and 2004.




***NOTE
      FOURTEEN - Earnings per Share***




The
      numerators and denominators of basic and fully diluted earnings per share are
      as
      follows:





In
                Thousands, except for number of shares and per share
                amounts2006
            
            2005
            
            2004Net
                income (numerator)
            
            $
            68,910
            
            $
            51,584
            
            $
            43,045Shares
                used in the calculation(denominator)Weighted
                average shares outstanding
            
            
            45,009,526
            
            
            42,481,644
            
            
            41,926,625Effect
                of dilutive stock options
            
            
            475,461
            
            
            260,907
            
            
            279,009Diluted
                shares
            
            
            45,484,987
            
            
            42,742,551
            
            
            42,205,634Basic
                Earnings per share
            
            $
            1.53
            
            $
            1.21
            
            $
            1.03Diluted
                Earnings per share
            
            $
            1.52
            
            $
            1.21
            
            $
            1.02




***NOTE
      FIFTEEN - Related Party Transactions***




Loans
      to
      directors, executive officers and their affiliates are subject to regulatory
      limitations. Such loans had aggregate balances and activity during 2006, 2005
      and 2004 as follows and were within regulatory limitations:




In
                Thousands
            
            2006
            
            2005
            
            2004Balance
                at beginning of year
            
            $
            72,700
            
            $
            55,762
            
            $
            49,496New
                loans or advances
            
            
            23,342
            
            
            35,322
            
            
            22,804Repayments
            
            
            (10,765
            )
            
            (18,384
            )
            
            (16,538
            )Balance
                at end of year
            
            $
            85,277
            
            $
            72,700
            
            $
            55,762




Total
      deposits beneficially owned by related parties were $6.4 million, $4.8 million,
      and $4.5 million at December 31, 2006, 2005, and 2004,
      respectively.


-
          24
          -




***NOTE
      SIXTEEN - Commitments and Contingent Liabilities***





The
      Bank
      leases various branch offices under agreements, which expire between 2007 and
      2021.
      The agreements contain various renewal options and generally require the Bank
      to
      maintain the properties.





The
      total
      future minimum lease commitments through 2011 and thereafter are as
      follows:





In
                ThousandsYear
                ending December 31,
            
            
            2007
            
            $
            1,8242008
            
            
            1,7562009
            
            
            1,4882010
            
            
            1,0502011
            
            
            894Thereafter
            
            
            2,421$
            9,433





Rental
      expense charged to operations was $1.6
      million in 2006, $1.6 million in 2005, and $1.3 million in 2004.





The
      Bank
      is a party to financial instruments with off-balance sheet risk in the normal
      course of business to meet financing needs of its customers. These financial
      instruments include commitments to extend credit, standby letters of credit
      and
      financial guarantees. Those instruments involve, to varying degrees, elements
      of
      credit and interest-rate risk in excess of the amount recognized in the balance
      sheet. The contract amount of those instruments reflect the extent of the Bank's
      involvement in particular classes of financial instruments.





The
      Bank's exposure to credit loss in the event of nonperformance by the other
      party
      to the instrument for commitments to extend credit, standby letters of credit,
      and financial guarantees written is represented by the contractual amount of
      those instruments. The Bank uses the same credit policies in making commitments
      and conditional obligations as it does for on-balance-sheet
      instruments.





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. Commitments generally
      have fixed expiration dates or other termination clauses and may require payment
      of a fee. Since many of the commitments are expected to expire without being
      drawn upon, the total commitment amounts do not necessarily represent future
      cash requirements. The Bank's experience has been that approximately 49 percent
      of loan commitments are drawn upon by customers. While approximately 100 percent
      of commercial letters of credit are utilized, a significant portion of such
      utilization is on an immediate payment basis. The Bank evaluates each customer's
      creditworthiness on a case-by-case basis. The amount of collateral obtained,
      if
      it is deemed necessary by the Bank upon extension of credit, is based on
      management's credit evaluation of the borrower. Collateral held varies but
      may
      include accounts receivable, inventory, property, plant, and equipment, and
      income-producing commercial properties.





Standby
      letters of credit and financial guarantees written are conditional commitments
      issued by the Bank to guarantee the performance of a customer to a third party.
      Those guarantees are primarily issued to support public and private borrowing
      arrangements, bond financing, and similar transactions. The Bank underwrites
      its
      standby letters of credit using its policies and procedures applicable to loans
      in general. Standby letters of credit are made on an unsecured and secured
      basis. The Bank has not been required to perform on any financial guarantees
      during the past two years. The Bank has not incurred any significant losses
      on
      its commitments in 2006, 2005, or 2004.





A
      summary
      of the notional amount of the Bank’s financial instruments with off-balance
      sheet risk at December 31, 2006 follows:


-
          25
          -


***NOTE
      SIXTEEN - Commitments and Contingent Liabilities
      (continued)***





In
                Thousands
            
            AmountCommitments
                to extend credit
            
            $
            902,701Credit
                card arrangements
            
            
            37,051Standby
                letters of credit
            
            
            27,035




The
      Corporation is a defendant in certain claims and legal actions arising in the
      ordinary course of business. In the opinion of management, after consultation
      with legal counsel, the ultimate disposition of these matters is not expected
      to
      have a material adverse effect on the Corporation’s financial condition or
      results of operations.





In
      December 2004, the Corporation entered into an agreement to purchase a total
      of
      80,000 shares Skagit State Bank (SSB) stock, headquartered in Burlington,
      Washington. An initial purchase of 35,000 shares representing 4.95% of SSB
      total
      outstanding shares was made in December 2004, through an issuance of common
      shares with a market value of $3.0 million and cash of $2.5 million. A second
      purchase of 22,500 shares was made in February 2005 through the issuance of
      common shares with a market value of $1.8 million and cash of $1.6 million
      for a
      cumulative ownership percentage of 8.13%. In July 2005, a third installment
      of
      22,500 shares was made through the issuance of common shares with a market
      value
      of $2.1 million and cash of $1.6 million for a cumulative ownership of 11.3%.
      In
      January 2006, the Corporation purchased 5,022 shares, from a separate party,
      for
      $653 thousand, bringing total ownership to 12.62%.





***NOTE
      SEVENTEEN - Fair Value of Financial Instruments***





The
      following disclosure of the estimated fair value of financial instruments is
      made in accordance with the requirements of SFAS No. 107, *Disclosures
      About Fair Value of Financial Instruments* .
      The
      estimated fair value amounts have been determined by the Corporation using
      available market information and appropriate valuation methodologies. However,
      considerable judgment is necessary to interpret market data in the development
      of the estimates of fair value. The use of different market assumptions and/or
      estimation methodologies may have a material effect on the estimated fair value
      amounts. The following methods and assumptions were used to estimate the fair
      value of each class of financial instruments for which it is practicable to
      estimate that value.





(a) **Cash
      equivalents and federal funds sold** - For
      these short-term instruments, the carrying amount is a reasonable estimate
      of
      fair value.





(b) **Investment
      securities** - For
      investment securities fair values are based on quoted market prices or dealer
      quotes, if available. If a quoted market price is not available, fair value
      is
      estimated using quoted market prices for similar securities.





(c) **Loans**
      - The
      fair
      value of loans generally is estimated by discounting the future cash flows
      using
      the current rates at which similar loans would be made to borrowers with similar
      credit ratings and for the same remaining maturities. For certain homogeneous
      categories of loans, such as Small Business Administration guaranteed loans,
      fair value is estimated using the quoted market prices for securities backed
      by
      similar loans, adjusted for differences in loan characteristics.





(d) **Deposits
      and federal funds purchased** - The
      fair value of demand deposits, savings accounts, certain money market deposits,
      and federal funds purchased, is the amount payable on demand at the reporting
      date. The fair value of fixed-maturity certificates of deposit is estimated
      by
      discounting the future cash flows using the rates currently offered for deposits
      of similar remaining maturities.





(e) **FHLB
      advances and securities sold under agreements to repurchase** -
      Fair
      value is determined by discounting future cash flows using rates currently
      available to the Bank for debt with similar terms and remaining maturities.


-
          26
          -





***NOTE
      SEVENTEEN - Fair Value of Financial Instruments
      (continued)***





(f) **Off-Balance
      sheet financial instruments** -
      Commitments to extend credit and letters of credit represent the principal
      categories of off-balance sheet financial instruments (see Note 16). The fair
      value of these commitments is not material.





The
      estimated fair values at December 31 are as follows:




In
                Thousands
            
            2006
            
            2005Assets
            
            Carrying
              Value
            
            Fair
              Value
            
            Carrying
              Value
            
            Fair
                ValueCash
                and due from banks
            
            $
            104,222
            
            $
            104,222
            
            $
            85,631
            
            $
            85,631Federal
                funds sold
            
            
            18,673
            
            
            18,673
            
            
            733
            
            
            733Investment
                securitiesAvailable
                for sale
            
            
            111,112
            
            
            111,112
            
            
            104,904
            
            
            104,904Held
                to maturity
            
            
            3,599
            
            
            3,623
            
            
            5,713
            
            
            5,919Net
                loans
            
            
            2,867,351
            
            
            2,883,518
            
            
            2,355,419
            
            
            2,355,206LiabilitiesNoninterest
                bearing deposits
            
            
            406,621
            
            
            406,621
            
            
            395,852
            
            
            395,852Interest
                bearing deposits
            
            
            2,047,011
            
            
            2,047,748
            
            
            1,665,528
            
            
            1,666,295Federal
                funds purchased and securities sold under agreements to
                repurchase
            
            
            81,673
            
            
            81,673
            
            
            20,813
            
            
            20,813Subordinated
                debt
            
            
            5,156
            
            
            5,123
            
            
            -
            
            
            -FHLB
                Advances
            
            
            282,017
            
            
            277,450
            
            
            240,000
            
            
            238,521





***NOTE
      EIGHTEEN - Parent Company (Only) Financial
      Information***




Condensed
      balance sheets for Frontier Financial Corporation (only) at December 31 are
      as
      follows:




In
                Thousands
            
            2006
            
            2005ASSETSCash
            
            $
            1,357
            
            $
            306Investment
                in subsidiaries:Bank
            
            
            321,626
            
            
            259,621Nonbank
            
            
            9,314
            
            
            9,343Investment
                securitiesAvailable
                for sale, at fair value
            
            
            35,213
            
            
            27,470Other
                assets
            
            
            40,247
            
            
            4,350$
            407,757
            
            $
            301,090LIABILITIESOther
                liabilities
            
            $
            12,474
            
            $
            4,993SHAREOWNERS'
                EQUITYCommon
                stock
            
            
            183,982
            
            
            131,695Retained
                earnings
            
            
            205,126
            
            
            159,978Accumulated
                other comprehensive income, net of tax
            
            
            6,175
            
            
            4,424Total
                Shareowners' equity
            
            
            395,283
            
            
            296,097$
            407,757
            
            $
            301,090




-
          27
          -




***NOTE
      EIGHTEEN - Parent Company (Only) Financial Information
      (continued)***





Condensed
      statements of income for the years ended December 31 are as
      follows:




In
                Thousands
            
            2006
            
            2005
            
            2004IncomeDividends
                from Bank
            
            $
            23,846
            
            $
            16,416
            
            $
            12,322Dividend
                from FFP
            
            
            1,100
            
            
            900
            
            
            1,200Other
                dividends
            
            
            526
            
            
            367
            
            
            214Other
                income
            
            
            32
            
            
            95
            
            
            14Interest
            
            
            186
            
            
            167
            
            
            187Total
                income
            
            
            25,690
            
            
            17,945
            
            
            13,937ExpensesPersonnel
            
            
            677
            
            
            910
            
            
            688Depreciation
                and amortization
            
            
            267
            
            
            35
            
            
            25Other
            
            
            1,934
            
            
            1,362
            
            
            804Total
                expenses
            
            
            2,878
            
            
            2,307
            
            
            1,517Income
                before equity in undistributed income of subsidiaries and benefit
                equivalent to income tax
            
            
            22,812
            
            
            15,638
            
            
            12,420Benefit
                equivalent to income tax
            
            
            800
            
            
            622
            
            
            438Income
                before equity in undistributed income of subsidiaries
            
            
            23,612
            
            
            16,260
            
            
            12,858Equity
                in undistributed income of subsidiaries
            
            
            45,298
            
            
            35,324
            
            
            30,187Net
                income
            
            $
            68,910
            
            $
            51,584
            
            $
            43,045




Condensed
      statements of cash flows for the years ended December 31:




In
                Thousands
            
            2006
            
            2005
            
            2004Cash
                flows from operating activitiesNet
                income
            
            $
            68,910
            
            $
            51,584
            
            $
            43,045Adjustments
                to reconcile net income to net cash provided by operating
                activitiesEquity
                in undistributed income of subsidiaries
            
            
            (45,298
            )
            
            (35,324
            )
            
            (30,187
            )Depreciation
                and amortization
            
            
            267
            
            
            35
            
            
            25Excess
                tax benefits associated with equity-based compensation
            
            
            (1,205
            )
            
            (205
            )
            
            (698
            )Other
                operating activities
            
            
            486
            
            
            714
            
            
            543Net
                cash flows from operating activities
            
            
            23,160
            
            
            16,804
            
            
            12,728Cash
                flows from investing activitiesPurchase
                of available for sale securities
            
            
            (5,496
            )
            
            (3,196
            )
            
            (2,485
            )Other
                investment activities
            
            
            (390
            )
            
            79
            
            
            452Net
                cash flows from investing activities
            
            
            (5,886
            )
            
            (3,117
            )
            
            (2,033
            )Cash
                flows from financing activitiesStock
                options exercised
            
            
            4,218
            
            
            2,549
            
            
            2,393Cash
                dividends paid to shareowners
            
            
            (22,358
            )
            
            (17,021
            )
            
            (14,337
            )Excess
                tax benefits associated with equity-based compensation
            
            
            1,205
            
            
            205
            
            
            698Other
                financing activities
            
            
            712
            
            
            (13
            )
            
            -Net
                cash flows from financing activities
            
            
            (16,223
            )
            
            (14,280
            )
            
            (11,246
            )Increase
                (decrease) in cash
            
            
            1,051
            
            
            (593
            )
            
            (551
            )Cash
                at beginning of year
            
            
            306
            
            
            899
            
            
            1,450Cash
                at end of year
            
            $
            1,357
            
            $
            306
            
            $
            899




-
          28
          -




***NOTE
      NINETEEN - Recent Accounting Pronouncements***





In
      July
      2006, the FASB issued Interpretation (FIN) No. 48, *Accounting
      for Uncertainty in Income Taxes* - an
      Interpretation of SFAS No. 109, *Accounting
      for Income Taxes* .
      FIN 48
      defines the threshold for recognizing the benefits of tax return positions
      in
      the financial statements as "more-likely-than-not" to be sustained by a taxing
      authority. The term "more-likely-than-not" means a likelihood of more than
      50
      percent. FIN 48 is effective as of Jan. 1, 2007, with early application
      permitted. Any impact from the adoption of FIN 48 will be recorded directly
      to
      the beginning balance of retained earnings and reported as a change in
      accounting principle. Management does not expect that the provision of FIN
      48
      will materially impact the Corporation’s results of operations or financial
      condition.





In
      September 2006, the Financial Accounting Standards Board released Statement
      No.
      157, *Fair
      Value Measurements* which
      defines fair value, establishes a framework for measuring fair value in GAAP,
      and enhances disclosures about fair value measurements. This Statement applies
      when other accounting pronouncements require fair value measurements; it does
      not require new fair value measurements. This Statement is effective for
      financial statements issued for fiscal years beginning after November 15, 2007,
      and interim periods within those years. Management is currently evaluating
      the
      effect of the impact of this interpretation on the Corporation.





In
      September 2006, the Financial Accounting Standards Board issued SFAS No. 158, *Employers’
      Accounting for Defined Benefit Pension and Other Postretirement
      Plans* ,
      an
      amendment of FASB Statements No. 87, 88, 106 and 132-R.”
SFAS No. 158 requires an entity to recognize in its statement of
      financial condition the funded status of its defined benefit pension and
      postretirement plans, measured as the difference between the fair value of
      the
      plan assets and the benefit obligation. SFAS No. 158 also requires an
      entity to recognize changes in the funded status of a defined benefit pension
      and postretirement plan within accumulated other comprehensive income, net
      of
      tax, to the extent such changes are not recognized in earnings as components
      of
      periodic net benefit cost. SFAS No. 158 is effective as of the end of
      the first fiscal year ending after December 15, 2006. The Corporation will
      adopt SFAS No. 158 as of the end of 2007. The Corporation does not
      expect that the adoption of SFAS No. 158 will have a material effect
      on its financial condition, results of operations or cash flows.





Prior
      to
      January 1, 2006, the Corporation accounted for shared-based compensation to
      employees under the intrinsic value method in Accounting Principal Board (APB)
      Option No. 25, *Accounting
      for Stock Issued to Employees* .
      At
      January 1, 2006, the Corporation began recognizing compensation expense for
      stock options with the adoption of SFAS No. 123 (Revised), *Share-Based
      Payment* ,
      as
      described in Note 13.


-
          29
          -


***NOTE
      TWENTY- Unaudited Quarterly Financial Data - Condensed Consolidated Statement
      of
      Income***




2006
                Quarter EndedIn
                Thousands
            
            (Unaudited)December
                31
            
            September
                30
            
            June
                30
            
            March
                31Interest
                income
            
            $
            67,377
            
            $
            66,201
            
            $
            61,346
            
            $
            55,220Interest
                expense
            
            
            24,327
            
            
            23,533
            
            
            21,166
            
            
            17,916Net
                interest income
            
            
            43,050
            
            
            42,668
            
            
            40,180
            
            
            37,304Provision
                for loan losses
            
            
            (2,300
            )
            
            (1,700
            )
            
            (1,000
            )
            
            (2,500
            )Net
                interest income after provision for loan losses
            
            
            40,750
            
            
            40,968
            
            
            39,180
            
            
            34,804Non
                interest income
            
            
            3,403
            
            
            3,466
            
            
            3,438
            
            
            5,316Non
                interest expense
            
            
            17,601
            
            
            16,408
            
            
            16,269
            
            
            16,768Income
                before income tax
            
            
            26,552
            
            
            28,026
            
            
            26,349
            
            
            23,352Provision
                for income tax
            
            
            (9,001
            )
            
            (9,500
            )
            
            (8,944
            )
            
            (7,924
            )Net
                income
            
            $
            17,551
            
            $
            18,526
            
            $
            17,405
            
            $
            15,428Basic
                earnings per share
            
            $
            0.39
            
            $
            0.41
            
            $
            0.39
            
            $
            0.35Diluted
                earnings per share
            
            $
            0.38
            
            $
            0.40
            
            $
            0.38
            
            $
            0.35Weighted
                average basic shares outstanding
            
            
            45,328,840
            
            
            45,276,225
            
            
            45,202,309
            
            
            44,215,528Weighted
                average diluted shares outstanding
            
            
            45,866,921
            
            
            45,743,603
            
            
            45,573,583
            
            
            44,685,555





2005
                Quarter EndedIn
                Thousands
            
            (Unaudited)Interest
                income
            
            $
            50,569
            
            $
            46,763
            
            $
            43,204
            
            $
            38,350Interest
                expense
            
            
            15,082
            
            
            13,633
            
            
            12,497
            
            
            10,524Net
                interest income
            
            
            35,487
            
            
            33,130
            
            
            30,707
            
            
            27,826Provision
                for loan losses
            
            
            (900
            )
            
            (1,400
            )
            
            (1,050
            )
            
            (850
            )Net
                interest income after provision for loan losses
            
            
            34,587
            
            
            31,730
            
            
            29,657
            
            
            26,976Non
                interest income
            
            
            3,042
            
            
            3,417
            
            
            3,474
            
            
            3,142Non
                interest expense
            
            
            16,020
            
            
            14,571
            
            
            13,848
            
            
            13,673Income
                before income tax
            
            
            21,609
            
            
            20,576
            
            
            19,283
            
            
            16,445Provision
                for income tax
            
            
            (7,308
            )
            
            (6,998
            )
            
            (6,485
            )
            
            (5,538
            )Net
                income
            
            $
            14,301
            
            $
            13,578
            
            $
            12,798
            
            $
            10,907Basic
                earnings per share
            
            $
            0.34
            
            $
            0.32
            
            $
            0.30
            
            $
            0.26Diluted
                earnings per share
            
            $
            0.33
            
            $
            0.32
            
            $
            0.30
            
            $
            0.26Weighted
                average basic shares outstanding
            
            
            42,639,612
            
            
            42,558,987
            
            
            42,415,247
            
            
            42,308,258Weighted
                average diluted shares outstanding
            
            
            42,960,444
            
            
            42,832,271
            
            
            42,625,095
            
            
            42,545,471




-
          30
          -


**FRONTIER
      FINANCIAL CORPORATION**


**AND
      SUBSIDIARIES**





***MANAGEMENT’S
      DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION***


***AND
      RESULTS OF OPERATION***







The
      information contained in this section should be read in conjunction with the
      Consolidated Financial Statements and accompanying Notes to the Consolidated
      Financial Statements.




Frontier
      Financial Corporation (“the Corporation”) a Washington corporation, is a
      financial holding company owning all of the equity of its wholly owned
      subsidiaries, Frontier Bank (the "Bank") and FFP, Inc., a bank premises holding
      company.




**FINANCIAL
      HIGHLIGHTS**




Frontier
      Financial Corporation’s performance in 2006 reflects another year of record
      earnings, continued asset growth, and good credit quality.




Net
      income was up 33.6%, totaling $68.9 million, or $1.52 per diluted share, which
      compares to $51.6 million, $1.21 per diluted share, in 2005 and $43.0 million,
      or $1.02 per diluted share in 2004. Net income in 2006 was influenced by a
      favorable increase in net interest income which improved 28.4% to $163.2 million
      in 2006 from $127.2 million in 2005. This was similar to the improvement in
      2005
      when our net interest income increased 20.8% from $105.3 million.




Contributing
      to our record earnings for 2006 was the growth in total assets, which increased
      $598.2 million, or 22.7% and increased $393.6 million, or 17.5% in 2005. By
      comparison, the increase in assets in 2004 was $168.0 million, or 8.1%. In
      all
      three years the growth in our assets occurred principally in the loan portfolio.
      Portfolio loans (loans receivable) in 2006 increased to $2.90 billion, or 21.7%
      and in 2005 increased to $2.39 billion, a growth of 20.8% from the 2004 balance
      of $1.98 billion.




Nonperforming
      assets were .27% of total assets at December 31, 2006, up from .19% at December
      31, 2005 which was less than the .63% at year-end 2004. Nonaccruing loans
      increased to $8.7 million at year-end, up from $4.9 million at December 31,
      2005. In the year ended 2004 the amount was $14.1 million and was up from $6.7
      million at year-end 2003. For the years ended December 31, 2006, 2005 and 2004,
      net loan charge offs amounted to $2.9 million, a net recovery of $.1 million
      and
      a net charge-off of $.3 million, respectively. This represents a loss of 11
      basis points for 2006, a recovery of 1 basis point for 2005 and a loss of 2
      basis points for 2004 of average loans outstanding. The total allowance for
      loan
      losses stood at $40.6 million, or 1.40% of total loans outstanding in 2006
      compared to $33.8 million, or 1.41% of total loans outstanding in 2005, and
      $30.4 million or 1.54% of total loans at year-end 2004.




During
      the year 2006 cash dividends of $22.4 million were paid to shareowners and
      the
      Corporation did not purchase any common stock in the open market under the
      stock
      repurchase program. There were no shares repurchased in 2006, 2005 and 2004.
      Subsequent to year-end, the Corporation repurchased 218,940 shares at an average
      cost per share of $26.85 through February 21, 2007.




**RESULTS
      OF OPERATIONS**




**Net
      Interest Income**




Net
      interest income is the Corporation’s principal source of revenue and is
      comprised of interest income on earning assets, less interest expense on
      interest bearing liabilities. The net interest margin is net interest income
      expressed as a percent of average earning assets and represents the difference
      between the yield on earning assets and the composite interest rate paid on
      all
      sources of funds.




Net
      interest income is adjusted to a taxable equivalent basis to present income
      earned on taxable and tax-exempt assets on a comparable basis. Reference to
      net
      interest income and net interest margin (NIM), in this discussion, represents
      taxable equivalent (TE) amounts using a tax rate of 35%, and applies only to
      loans and investments as no other assets or liabilities are affected by the
      adjustment.


-
          31
          -




The
      level
      of growth in our earning assets and the repricing characteristics of our assets
      and liabilities influenced net interest income, which increased 28.4% from
      the
      prior year. The latter, repricing of assets and liabilities, is in turn
      influenced by the direction of interest rates. In 2006, we benefited from FRB’s
      four rate increases totaling 100 basis points during the first six months of
      the
      year. These increases caused the yield on assets to increase, while the cost
      on
      interest bearing liabilities lagged. The tables on pages 47 and 48 include
      a
      breakdown of the change in earning assets and liabilities, referred to as
      "volume," and the repricing of assets and liabilities labeled "rate."




Average
      earning assets rose $532.3 million, or 22.8%, in 2006, following increases
      of
      13.1% and 8.4% in 2005 and 2004, respectively. The growth over the past year
      in
      earning assets has come from the increase in the loan portfolio. Average loans
      rose $530.9 million, or 24.1% this past year, $312.8 million, or 16.6%, in
      2005
      and $196.5 million or 11.6% in 2004. Average investments decreased $15.7
      million, or 12.8% for the year and decreased $40.7 million, or 24.9% in 2005
      and
      increased $2.8 million, or 1.8% in 2004. The increase in earning assets
      contributed $46.4 million to net interest income in 2006. In 2005 and 2004
      the
      growth in assets increased net interest income by $21.3 million and $14.4
      million, respectively. The increase in income from the change in interest rates
      on average earning assets totaled $25.0 million for the year and an increase
      of
      $17.4 million and a reduction of $9.6 million for 2005 and 2004, respectively.




Average
      interest bearing liabilities rose $434.7 million during the year, following
      increases of $193.4 million and $92.5 million in 2005 and 2004, respectively.
      The growth over the past year has been from interest bearing deposits, which
      increased $393.9 million. The increase in interest bearing liabilities
      contributed $13.5 million to interest expense in 2006. The effect of changing
      interest rates increased interest expense $21.7 million in 2006. In 2005,
      increased balances of interest bearing liabilities increased interest expense
      by
      $6.1 million, while increasing rates increased interest expense by $10.7
      million. In 2004, increased volume of interest bearing liabilities increased
      interest expense by $2.9 million and declining rates decreased interest expense
      by $5.8 million.




The
      tax
      equivalent net interest margin increased in 2006 to 5.73% from 5.48% the
      previous year, and 5.14% in 2004. The increase in the net interest margin in
      2006 is attributable to the four rate increases in our base rate during the
      first six months of the year and liabilities not repricing as quickly. During
      2005 there were eight rate increases in our base rate which had the same effect
      as in 2006. The decrease in the net interest margin in 2004 is attributable
      to
      the interest income ratio decreasing faster than interest expense ratio. The
      interest expense ratio (interest expense/average deposits and borrowings)
      increased from 2.83% in 2005 to 3.84% in 2006, an increase of 101 basis points
      over the prior year end. During the same period the interest income ratio
      (interest income/average earning assets) increased 106 basis points. Several
      factors contributed to the movement in the ratios, including the effect of
      interest rates and the repricing characteristics of loans and
      deposits.





During
      2006 the Federal Reserve Bank (FRB) increased short-term rates four times,
      50
      basis points in the first quarter and 50 basis points in the second quarter.
      The
      FRB increased short-term interest rates eight times in 2005, 25 basis points
      each time, for a total of two 25 basis point rate increases in each quarter
      of
      2005. These increases increased our net interest margin to 5.73%, up 25 basis
      points from 2005. Although rates were increased in 2004, the 25 basis point
      increases were not substantial enough to bring many loans off of their floors,
      and not until the fourth quarter did we see a meaningful movement of the net
      interest margin, which was 5.32%.





Interest
      bearing liabilities are mainly comprised of deposits, which make up 87.5% of
      all
      interest-bearing liabilities at December 31, 2006. In contrast to
      adjustable-rate loans, deposit rates are not directly governed by indexes.
      We
      set our deposit rates as often as weekly depending on the general rates in
      effect for competing financial institutions. When interest rates drop quickly,
      there is a tendency for deposit rates to decline more slowly than loan rates,
      because of local competitive factors.


-
          32
          -





Following
      is a table showing the tax equivalent net interest margin at each quarter
      end:





Tax
                Equivalent
            
            Tax
                EquivalentNet
                Interest
            
            Effect
                on
            
            Net
                InterestQuarter
                Ended
            
            Margin
            
            Margin
            
            MarginDecember
                31, 2005
            
            
            5.75
            %
            
            0.05
            %
            
            5.80
            %March
                31, 2006
            
            
            5.57
            %
            
            0.04
            %
            
            5.61
            %June
                30, 2006
            
            
            5.62
            %
            
            0.04
            %
            
            5.66
            %September
                30, 2006
            
            
            5.79
            %
            
            0.03
            %
            
            5.82
            %December
                31, 2006
            
            
            5.78
            %
            
            0.03
            %
            
            5.81
            %






A
      review
      of the past 12 months shows that the tax equivalent net interest margin began
      year 2006 at 5.80% (quarter ended December 31, 2005). The margin then declined
      to 5.61% for the first quarter and then increased to 5.66% in the second
      quarter. The increase continued in the third quarter to 5.82% and decreased
      slightly to 5.81% in the fourth quarter. The Corporation increased its key
      lending index 25 basis points in January, March, May, and June. The movement
      in
      the net interest margin was attributed to these rate increases. During 2005,
      the
      Corporation increased its index eight times. In 2004, the Corporation increased
      its key lending index 25 basis points in August, September, November and
      December.




We
      attempt to measure the effect of changing interest rates with our interest
      rate
      simulation model. The simulation model suggests that rising rates would continue
      to be to our advantage. At December 31, 2006, if rates were to raise 200 basis
      points ratably over the next 3 months and then maintain that level for the
      next
      nine months, our net interest income would improve by 8.2%, or $14.2 million.
      If
      rates were to fall 100 basis points, our net interest income would decrease
      3.5%, or $6.0 million. The model indicates that we are currently positively
      gapped, meaning that more assets will reprice within a one-year period than
      liabilities. See a further discussion of this subject, under the headings
“Market Risk Sensitivity Instruments” and “Asset/Liability Management”, on pages
      36 and 37.




**OTHER
      OPERATING INCOME**




**Service
      Charges**




Deposit
      fee income has decreased $151 thousand to $4.2 million, or 3.5% less than the
      prior year-end. In 2005, deposit fee income decreased $561 thousand to $4.4
      million and increased from $4.9 million in 2004. Virtually all of this income
      is
      attributable to checking accounts. While our growth in checking account balances
      has moderated this year, with an increase from $395.9 million last year to
      $406.6 million this year, or 2.7%, the continued increase in the use of debit
      cards results in reduced service fees.




**Other
      Income**




Other
      income is comprised of a variety of sources, and increased in 2006 by $2.3
      million, or 29.6%, to $9.9 million. The 2006 increase was primarily due to
      the
      sale of a property which had been held for several years for branch expansion,
      but was no longer needed. As a result of this sale we recognized a nonrecurring
      pre-tax gain on the sale of $2.1 million. Other income in 2005 of $7.7 million
      was comparable to that reported for the year 2004, which was $8.0 million.
      The
      $8.0 million of other income in 2004 included a gain on the sale of other real
      estate owned for $610 thousand, an increase in insurance and financial service
      fees of $648 thousand, and an increase in trust department fees of $273 thousand
      over the prior year.




-
          33
          -




**Gain
      (Loss) On the Sale of Investments**




In
      2006,
      we had a small loss of $25 thousand on the sale of a security. In 2005, the
      $211
      thousand loss on sale of securities was due to a write down of an equity
      investment in a financial services company. For 2004, we had a small loss on
      the
      sale of a security of $44 thousand due to credit concerns.




**OTHER
      OPERATING EXPENSES**




**Salaries
      and Employee Benefits**





Salaries
      and benefits expense rose $5.4 million or 14.9% for 2006 to $42.0 million.
      These
      costs similarly rose $4.6 million or 14.5% in 2005 and $3.1 million or 10.8%
      in
      2004. Salaries and employee benefits costs in these years were affected by
      increases in staff, merit raises and a rise in commissions and bonuses.




The
      staffing level, referred to as full-time equivalent (FTE), totaled 721 at
      year-end 2006, an increase of 8.7%, over the prior year. That figure compares
      to
      663 at December 2005, and 643 at December 31, 2004.




One
      of
      the issues that complicates the reporting of compensation expense is the
      deferral of loan origination costs. In accordance with the current accounting
      standards, loan origination costs are deferred and amortized over the life
      of
      the loan. The loan costs, which are determined for each loan type, are then
      deducted from personnel expense, with the net figures reported in the financial
      statements. Compensation is thus comprised of the expected items such as
      salaries, benefits and commissions, but also the effect of deferred loan
      origination costs, which can vary substantially from year-to-year.





**Occupancy
      Expense**





Occupancy
      expense increased $1.5 million or 19.0% to $9.1 million for 2006 primarily
      as a
      result of increases of $147 thousand in depreciation expense, $428 thousand
      in
      office rentals, $265 thousand in software expense, and $432 thousand in
      maintenance agreements. Occupancy expense of $7.7 million in 2005 was up 8.8%
      from $7.0 million in 2004 mainly due to increased depreciation expense of $203
      thousand related to new or relocated offices and infrastructure improvements
      of
      $416 thousand.





**Other
      Expenses**





Other
      expense increased $1.5 million in 2006, or 13.4% due to increased marketing
      expense of $413 thousand, director fees of $317 thousand, communication networks
      of $256 thousand, amortization expense of intangible assets related to the
      NorthStar merger of $232 thousand, and equity compensation expense of $73
      thousand. Other expense increased $2.1 million in 2005, or 20.8% and increased
      $678 thousand, or 7.7% in 2004. For 2005, the largest increase in this category
      was consulting fees, which increased $518 thousand over the previous year as
      a
      part of our information technology upgrade. Some of the other areas of increases
      were legal fees of $120 thousand, data security expenses of $130 thousand,
      audits and examinations of $310 thousand, deposit account fees paid of $150
      thousand and Nasdaq fees of $49 thousand. Other expense increased $678 thousand
      in 2004, or 7.7%.





**Allowance
      for Loan Losses**





Management’s
      determination of the level of the provision for loan losses is based on various
      judgments and assumptions, including general economic conditions, loan portfolio
      composition, prior loan loss experience, the evaluation of credit risk related
      to specific credits and market segments, and monitoring results from the
      Corporation’s ongoing internal credit review staff. Management believes our
      methodology for assessing credit risk is adequate and reflected in the resulting
      allowance calculation. The allowance methodology takes into account that the
      loan loss reserve will change at different points in time based on economic
      conditions, credit performance, loan mix and collateral values.





The
      allowance for loan losses increased to $40.6 million as of December 31, 2006.
      At
      year-end 2005, the allowance balance was $33.8 million, which was an increase
      of
      $3.4 million over year-end 2004 balance of $30.4 million. The allowance for
      loan
      loss reserve was 1.40% of totals loans as of year-end December 31, 2006. For
      year-end December 31, 2005 our reserve ratio was 1.41% and was 1.54% for
      year-end 2004.


-
          34
          -


The
      Bank
      considers the allowance for loan losses adequate to cover losses inherent in
      the
      portfolio at December 31, 2006.




**REVIEW
      OF FINANCIAL CONDITION**




**Investment
      Securities**




Investment
      securities increased $4.1 million, or 3.7% to $114.7 million as of December
      31,
      2006. Approximately 20% of the securities matured or were called during the
      year; however short-term securities were purchased for collateral purposes
      thereby showing a slight increase in the investment portfolio. During 2005
      and
      2004, investment securities decreased $42.8 million or 27.9% and $34.5 million
      or 18.3%, respectively. Almost all of this run off was due to maturities and
      calls prior to maturity. During 2005 and 2004, management used these cash flows
      for funding growth in the loan portfolio.




**Loans**




Loans
      increased 21.7% in 2006, from $2.39 billion at December 31, 2005, to $2.91
      billion at year-end 2006. Approximately $165.0 million of this increase was
      from
      the merger with NorthStar. Loans grew 20.8% in 2005 or $411.2 million. In 2004,
      loans grew to $1.98 billion from $1.77 billion in 2003, an increase of 11.9%.
      Please see pages 44 and 45 of this report and Form 10-K for the year-ended
      December 31, 2006 for a further discussion of loans.




**Deposits**




Deposits
      increased $392.3 million, or 19.0%, in 2006, and $265.5 million, or 14.8% in
      2004 and $128.8 million, or 7.7% in 2004. The movement between types of deposit
      accounts was characterized by a changing interest rate environment.




Interest
      bearing deposits at December 31,





In
                Thousands2006
            
            2005
            
            2004NOW
                and money market accounts
            
            $
            683,948
            
            $
            322,283
            
            $
            270,894Savings
                accounts
            
            
            305,669
            
            
            495,108
            
            
            642,434Time
                deposits
            
            
            1,057,394
            
            
            848,137
            
            
            569,239Total
            
            $
            2,047,011
            
            $
            1,665,528
            
            $
            1,482,567




As
      reflected on the above chart, the shift from decreasing savings balances into
      short-term NOW, money market accounts and time deposits continued in 2006.
      The
      trend prior to 2004, had been declining time deposits and increasing savings
      balances, due to the aversion of customers to lock into low rate CD’s. However,
      with interest rates on the rise in late 2004, 2005 and 2006, that trend has
      reversed. Total interest bearing deposits increased $381.5 million, or 22.9%
      in
      2006, $183.0 million, or 12.3% in 2005 and $87.0 million, or 6.2% in 2004.
      NOW
      and money market accounts increased all three years. Starting in the second
      half
      of 2004, CD’s became more attractive to investors and continued throughout 2005
      and 2006. Balances increased to $1.1 billion in 2006, $209.3 million over 2005
      of $848.1 million and $278.9 million over 2004. Prior to 2004, the type of
      savings accounts having the largest increase over the last 3 years was our
      premium savings account, which increased from $415.4 million in 2002 to $577.8
      million in 2004. This account was created as an alternative to certificates
      of
      deposit and pays a higher annual percentage yield than other core deposits.
      However, these accounts ran off substantially in 2005 to a portfolio balance
      of
      $450.2 million and in 2006 to a balance of $258.5 million. As an alternative
      to
      this account, investors moved money into our premier treasury account, which
      is
      a tiered account, tied to the discount rate for 13-week U.S. Treasury Bill
      and
      offering a higher short-term yielding account. The balance of premier treasury
      accounts at December 31, 2006 and 2005 was $369.5 million and $40.4 million,
      respectively.


-
          35
          -


**MARKET
      RISK SENSITIVE INSTRUMENTS**




Market
      risk is the risk of loss from adverse changes in market prices and rates. A
      significant market risk arises from interest rate risk inherent in our lending,
      deposit, borrowing, and mortgage-banking activities. To that end, we actively
      monitor and manage interest rate risk exposure.




A
      number
      of measures are utilized to monitor and manage interest rate risk, including
      income simulation and "gap" analysis (further discussed under the subheading
      "Asset and Liability Management" on page 37). An income simulation model is
      primarily used to assess the impact on earnings changes that interest rates
      may
      produce. Key assumptions in the model include, cash flows and maturities of
      financial instruments, changes in market conditions, loan volumes and pricing,
      deposit sensitivity, consumer preferences, and management's capital leverage
      plans. These assumptions are inherently uncertain; therefore, the model cannot
      precisely estimate net interest income or precisely predict the impact of higher
      or lower interest rates on net interest income. Actual results may significantly
      differ from simulated results due to timing, magnitude and frequency of interest
      rate changes, and changes in market conditions and specific strategies, among
      other factors. The model also uses a multiplier effect which is discussed
      later.




We
      use a
      simulation model to estimate the impact of changing interest rates on the
      Corporation’s earnings and capital. The model calculates the change in net
      interest income under various rate shocks. As of December 31, 2006, the model
      predicted that net income would increase about $9.0 million if rates increased
      2%, and decrease about $3.8 million if rates fell 1%.




Based
      on
      the results of simulations at the end of the last three years, the estimated
      impact of a steady change in interest rates over the next 12 months is shown
      in
      the table below (assumes a 34% tax rate):




In
                Thousands2007
                Estimated Change
            
            2006
                Estimated Change
            
            2005
                Estimated ChangeRate
                shock
            
            
            -1.0
            %
            
            2.0%
            
            
            -1.0
            %
            
            2.0%
            
            
            -1.0
            %
            
            2.0%Net
                interest income
            
            
            ($6,034
            )
            $
            14,162
            
            
            ($5,213
            )
            $
            19,922
            
            
            ($309
            )
            $
            8,969Net
                income
            
            
            (3,817
            )
            
            9,004
            
            
            (3,409
            )
            
            12,768
            
            
            (71
            )
            
            5,597





During
      2006, we had a 100 basis point upward movement in rates. At year-end 2005,
      the
      model predicted that our net interest income would increase $9.2 million and
      our
      net income would increase $5.9 million, if rates increased by 1%. Actually,
      our
      net interest income increased $36.1 million and our net income increased $17.3
      million, approximately 4 and 3 times the model estimate. Net loan growth was
      approximately 4 times the growth anticipated at the time of the projections
      and
      gross loan production for the year was approximately $3.8 billion, considerably
      more than estimated.





The
      interest rate scenarios reflected above represent the results of possible
      near-term interest rate movements. Approximately 57% of the loan portfolio
      is
      tied to rate indexes that are one year or less in duration. These indexes
      include our Base rate, Federal Home Loan Bank of Seattle (FHLB) Advance Rate,
      Wall Street Journal prime, London Interbank Offering Rate (LIBOR), and Constant
      Maturity Treasury (CMT).




The
      percentages shown represent changes over a 12-month period in net interest
      income and net income under two rate scenarios. The cash flows have been
      adjusted to account for prepayments and other factors.




Our
      primary objective in managing interest rate risk is to minimize the adverse
      impact of changes in interest rates on our net interest income and capital,
      while structuring the asset and liability components to obtain the maximum
      net
      interest margin. We rely primarily on our asset and liability structure to
      control interest rate risk.


-
          36
          -




**ASSET
      AND LIABILITY MANAGEMENT**




Asset
      and
      liability management is the responsibility of the Asset/Liability Committee,
      which acts within policy directives established by the Board of Directors.
      This
      Committee meets regularly to monitor the composition of the balance sheet,
      to
assess projected earnings trends, and to formulate strategies consistent with
      the objectives for liquidity, interest rate risk, and capital adequacy. The
      objective of asset/liability management is to maximize long-term shareholder
      returns by optimizing net interest income within the constraints of credit
      quality, interest rate risk policies, levels of capital leverage, and adequate
      liquidity.




Assets
      and liabilities are managed by matching maturities and repricing in a systematic
      manner. In addition to a simulation model, an interest rate "gap" analysis
      is
      used to measure the effect interest rate changes have on net interest income.
      The gap is the difference between the amount of interest-earning assets maturing
      or repricing within a specific time period and the amount of interest bearing
      liabilities maturing or repricing in that same time period. A gap is considered
      positive when the amount of interest-rate-sensitive assets exceeds the amount
      of
      interest-rate-sensitive liabilities. A gap is considered negative in the reverse
      situation. However, the exact impact of the gap on future income is uncertain
      both in timing and amount because interest rates for our assets and liabilities
      can change rapidly as a result of market conditions and customer behavior
      patterns.




In
      the
      following table the expected maturities for financial liabilities with no stated
      maturity, reflect assumptions using the run-off rates for noninterest bearing
      deposits of 6% per year; for NOW, sweep and money market accounts 8% per year;
      and for savings accounts 10% per year. The weighted average interest rates
      for
      financial instruments presented are for year-end 2006. Please refer to page
      26
      of this report for details regarding estimated fair value.


-
          37
          -




***MARKET
      RISK***




In
                Thousands, at December 31, 2006Expected
                Maturity Date
            
            
            
            
            
            Fair2007
            
            2008
            
            2009
            
            2010
            
            2011
            
            Thereafter
            
            Total
            
            Value**Financial
                Assets**Cash
                and due from banksNoninterest
                bearing
            
            $
            104,222
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            $
            104,222
            
            $
            104,222Fed
                Funds SoldVariable
                Rate
            
            
            18,673
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            18,673
            
            
            18,673Weighted
                average interest rate
            
            
            5.39
            %
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            5.39
            %Securities
                available for saleFixed
                Rate
            
            
            44,823
            
            
            32,878
            
            
            18,615
            
            
            2,163
            
            
            335
            
            
            2,798
            
            
            101,612
            
            
            111,112Weighted
                average interest rate(1)
            
            
            3.45
            %
            
            3.59
            %
            
            3.90
            %
            
            3.12
            %
            
            5.68
            %
            
            10.20
            %
            
            3.76
            %Securities
                held to maturityFixed
                Rate
            
            
            715
            
            
            680
            
            
            200
            
            
            244
            
            
            234
            
            
            1,526
            
            
            3,599
            
            
            3,623Weighted
                average interest rate(1)
            
            
            8.02
            %
            
            8.17
            %
            
            7.95
            %
            
            8.25
            %
            
            8.90
            %
            
            9.66
            %
            
            8.81
            %Loans
                Receivable, netFixed
                Rate
            
            
            179,901
            
            
            222,536
            
            
            153,250
            
            
            126,730
            
            
            134,308
            
            
            59,584
            
            
            876,309
            
            
            877,250Weighted
                average interest rate(2)
            
            
            7.23
            %
            
            6.65
            %
            
            6.92
            %
            
            7.15
            %
            
            7.83
            %
            
            6.69
            %
            
            7.07
            %Variable
                Rate
            
            
            1,471,124
            
            
            88,874
            
            
            35,357
            
            
            14,034
            
            
            23,087
            
            
            391,995
            
            
            2,024,471
            
            
            2,046,917Weighted
                average interest rate(2)
            
            
            9.51
            %
            
            8.97
            %
            
            9.10
            %
            
            8.42
            %
            
            8.10
            %
            
            7.01
            %
            
            8.98
            %**Financial
                Liabilities**Noninterest
                bearing deposits
            
            
            24,397
            
            
            22,933
            
            
            21,557
            
            
            20,264
            
            
            19,048
            
            
            298,422
            
            
            406,621
            
            
            406,621NOW,
                Sweep and Money Market accounts
            
            
            54,716
            
            
            50,339
            
            
            46,311
            
            
            42,607
            
            
            39,198
            
            
            450,777
            
            
            683,948
            
            
            683,948Weighted
                average interest rate
            
            
            3.52
            %
            
            3.52
            %
            
            3.52
            %
            
            3.52
            %
            
            3.52
            %
            
            3.52
            %
            
            3.52
            %Savings
                accounts
            
            
            30,567
            
            
            27,510
            
            
            24,759
            
            
            22,283
            
            
            20,055
            
            
            180,495
            
            
            305,669
            
            
            305,669Weighted
                average interest rate
            
            
            2.38
            %
            
            2.38
            %
            
            2.38
            %
            
            2.38
            %
            
            2.38
            %
            
            2.38
            %
            
            2.38
            %Time
                CertificatesFixed
                Rate
            
            
            906,406
            
            
            67,835
            
            
            37,088
            
            
            27,272
            
            
            17,489
            
            
            1,304
            
            
            1,057,394
            
            
            1,058,131Weighted
                average interest rate
            
            
            4.91
            %
            
            4.35
            %
            
            4.15
            %
            
            4.32
            %
            
            5.00
            %
            
            5.02
            %
            
            4.83
            %Federal
                funds purchased & securitiessold
                under agreements to repurchaseVariable
                rate
            
            
            81,673
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            81,673
            
            
            81,673Weighted
                average interest rate
            
            
            5.24
            %
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            5.24
            %Subordinate
                debt
            
            
            -
            
            
            -
            
            
            -
            
            
            5,156
            
            
            -
            
            
            -
            
            
            5,156
            
            
            5,123Weighted
                average interest rate
            
            
            
            
            
            
            
            
            
            
            
            6.42
            %
            
            
            
            
            
            
            
            6.42
            %FHLB
                advancesFixed
                Rate
            
            
            41,368
            
            
            42,906
            
            
            39,885
            
            
            72,087
            
            
            20,000
            
            
            65,771
            
            
            282,017
            
            
            277,450Weighted
                average interest rate
            
            
            4.50
            %
            
            4.39
            %
            
            4.14
            %
            
            5.66
            %
            
            4.89
            %
            
            4.24
            %
            
            4.70
            %





(1)
      Represents tax equivalent yield


(2)
      Represents weighted note rates exclusive of loan fees





Please
      note that in the above chart, financial assets and liabilities are listed at
      their expected maturity date. Our variable rate financial assets will reprice
      much sooner than their expected maturity date and liabilities may or may not
      run
      off at the expected rate as indicated above. We like to analyze our assets
      and
      liabilities as shown in the chart below, which indicates when the assets and
      liabilities can be repriced.


-
          38
          -




**REPRICING
      OPPORTUNITIES FOR ASSETS AND LIABILITIES**





In
                Thousands, at December 31, 20062007
            
            2008
            
            2009
            
            2010
            
            2011
            
            Thereafter
            
            TotalASSETSLoans(1)
                (2)
            
            $
            1,908,940
            
            $
            360,447
            
            $
            237,018
            
            $
            185,627
            
            $
            162,474
            
            $
            46,274
            
            $
            2,900,780Yield
            
            
            9.14
            %
            
            6.62
            %
            
            6.96
            %
            
            7.12
            %
            
            7.73
            %
            
            6.67
            %
            
            8.39
            %Investments(2) (3)
            
            
            45,538
            
            
            33,558
            
            
            18,815
            
            
            2,407
            
            
            569
            
            
            4,324
            
            
            105,211Yield
            
            
            3.52
            %
            
            3.68
            %
            
            3.94
            %
            
            3.64
            %
            
            7.00
            %
            
            10.01
            %
            
            3.93
            %Fed
                funds sold
            
            
            18,673
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            18,673Yield
            
            
            5.39
            %
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            5.39
            %Total
                earning assets
            
            
            1,973,151
            
            
            394,005
            
            
            255,833
            
            
            188,034
            
            
            163,043
            
            
            50,598
            
            
            3,024,664Yield
            
            
            9.06
            %
            
            6.95
            %
            
            7.01
            %
            
            7.21
            %
            
            7.87
            %
            
            6.99
            %
            
            8.22
            %LIABILITIESNOW,
                money market, and sweep accounts
            
            
            526,845
            
            
            62,261
            
            
            50,376
            
            
            38,621
            
            
            5,845
            
            
            -
            
            
            683,948Cost
            
            
            3.52
            %
            
            3.52
            %
            
            3.52
            %
            
            3.52
            %
            
            3.52
            %
            
            
            
            
            3.52
            %Savings
            
            
            56,064
            
            
            42,847
            
            
            25,848
            
            
            25,848
            
            
            25,848
            
            
            129,214
            
            
            305,669Cost
            
            
            2.38
            %
            
            2.38
            %
            
            2.38
            %
            
            2.38
            %
            
            2.38
            %
            
            2.38
            %
            
            2.38
            %Time
                deposits
            
            
            906,406
            
            
            67,835
            
            
            37,088
            
            
            27,272
            
            
            17,489
            
            
            1,304
            
            
            1,057,394Cost
            
            
            4.91
            %
            
            4.35
            %
            
            4.15
            %
            
            4.32
            %
            
            5.00
            %
            
            5.02
            %
            
            4.83
            %Fed
                funds purchased nd repurchase agreements
            
            
            81,673
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            81,673Cost
            
            
            5.24
            %
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            5.24
            %Subordinated
                debt
            
            
            -
            
            
            -
            
            
            -
            
            
            5,156
            
            
            -
            
            
            -
            
            
            5,156Cost
            
            
            
            
            
            
            
            
            
            
            
            6.42
            %
            
            
            
            
            
            
            
            6.42
            %FHLB
                borrowings
            
            
            41,368
            
            
            42,906
            
            
            39,885
            
            
            72,087
            
            
            20,000
            
            
            65,771
            
            
            282,017Cost
            
            
            4.50
            %
            
            4.39
            %
            
            4.14
            %
            
            5.66
            %
            
            4.89
            %
            
            4.24
            %
            
            4.70
            %Total
                interest bearing liabilities
            
            
            1,612,356
            
            
            215,849
            
            
            153,197
            
            
            168,984
            
            
            69,182
            
            
            196,289
            
            
            2,415,857Cost
            
            
            4.38
            %
            
            3.73
            %
            
            3.64
            %
            
            4.14
            %
            
            3.86
            %
            
            3.02
            %
            
            4.15
            %GAP
            
            $
            360,795
            
            $
            178,156
            
            $
            102,636
            
            $
            19,050
            
            $
            93,861
            
            
            ($145,691
            )
            $
            608,807




(1)
        Loan
        fees and costs are included in balance but not in the yield
 (2)
        Taxable equivalent
 (3)
        Amortized cost
  It
        is
        generally assumed that during a period of rising interest rates, the net
        earnings of an institution with a negative gap may be adversely affected
        due to
        its interest bearing liabilities repricing to a greater extent than its
        interest-earning assets. Conversely, during a period of falling interest
        rates,
        net earnings may increase. That assumption, however, is based on the premise
        that assets/liabilities within a one-year time frame will generally move
        in the
        same direction at approximately the same rate. However, historical data reflects
        that the relationship between one-year asset/liabilities may not be as strongly
        correlated as assumed. Loans with one-year repricing characteristics are
        tied to
        a number of indexes to include our base rate, the Wall Street Journal prime,
        the
        one-year constant maturity treasury, LIBOR, and FHLB rates. Those indexes
        are
        subject to the movement of the one-year market rates. On the other hand,
        NOW and
        CD’S, which constitute the bulk of the one-year repricing liabilities, are
        subject to the local financial institutions' market. Pricing for NOW and
        CD’s is
        dependent on customer preferences and the subjective pricing influence of
        local
        banks, credit unions, etc. Thus, while a good portion of our loans are tied
        to
        national and international money markets, deposits are subject to the conditions
        of the Puget Sound area. Additionally, when interest rates change, different
        rates change by different amounts. The use of “multipliers” is used that
        represent the change of each asset/liability rate compared to the change
        in the
        federal funds rate. For example, the prime rate has a factor of 1 indicating
        it
        changes the same amount as any federal funds rate change. Core deposit sectors
        may have a factor of .25, indicating those rates move only 25% as much. Applying
        the multipliers to the balance sheet, at December 31, 2006, the Bank had
        a
        positive gap of $360.8 million, compared to a positive gap of $577.0 million
        at
        December 31, 2005.


-
          39
          -


**ASSET
      QUALITY**





The
      Bank’s nonperforming assets (NPA’s) include the balances of loans placed in
      nonaccrual status and Other Real Estate Owned. The following chart summarizes
      the composition of our nonperforming assets, including restructured
      debt.





In
                Thousands
            
            Years
                ending December 31,2006
            
            2005
            
            2004Total
                nonaccruing loans
            
            $
            8,653
            
            $
            4,949
            
            $
            14,107Other
                real estate owned
            
            
            -
            
            
            -
            
            
            -Total
                nonperforming assets
            
            $
            8,653
            
            $
            4,949
            
            $
            14,107Restructured
                loans
            
            
            -
            
            
            -
            
            
            -NPA's
                to total loans
            
            
            0.30
            %
            
            0.21
            %
            
            0.71
            %NPA's
                to total assets
            
            
            0.27
            %
            
            0.19
            %
            
            0.63
            %NPA's
                to total capital
            
            
            2.19
            %
            
            1.67
            %
            
            5.55
            %NPA's
                & restructured loans to total assets
            
            
            0.27
            %
            
            0.19
            %
            
            0.63
            %





**NONACCRUAL
      LOANS**





It
      is the
      Bank's practice to discontinue accruing interest on virtually all loans that
      are
      delinquent in excess of 90 days regardless of risk of loss, collateral, etc.
      Some problem loans, which are less than 90 days delinquent, are also placed
      into
      nonaccrual status if the success of collecting full principal and interest
      in a
      timely manner is in doubt. Some loans will remain in nonaccrual even after
      improved performance until a consistent timely repayment pattern is exhibited
      and/or timely performance is considered reliable.





The
      Bank
      ended the year 2006 with eight nonaccruing loans with a combined balance of
      $8.7
      million. This compares to three nonaccruing loans with a combined year-end
      balance of $4.9 million in 2005 and six nonaccruing loans with a combined
      balance of $14.1 million at the end of 2004. One loan, totaling $7.1 million,
      makes up 82.5% of our 2006 year-end balance.





**OTHER
      REAL ESTATE OWNED**




Other
      real estate owned (OREO) is carried at the lesser of book value or market value.
      The costs related to completion, repair, maintenance, or other costs of such
      properties, are generally expensed with any gains or inadvertent shortfalls
      from
      the ultimate sale of OREO being shown as other income or other
      expense.




The
      Bank
      had no OREO totals to report at year-end December 31, 2006, 2005 and
      2004.




Certain
      other loans, currently in nonaccrual, are in the process of foreclosure and
      there is a likelihood these foreclosures will be completed and the loans will
      then become OREO. This is viewed as an ordinary part of the collection process
      and efforts are constantly underway to reduce and minimize such nonperforming
      assets.


-
          40
          -


**LIQUIDITY**




Liquidity
      refers to the ability to generate sufficient cash to meet the funding needs
      of
      current loan demand, deposit withdrawals, principal and interest payments with
      respect to outstanding borrowings, and payment of operating expenses. The need
      for liquidity is affected by loan demand, net changes in deposit levels, and
      the
      scheduled maturities of borrowings. Liquidity is derived from assets by receipt
      of interest and principal payments and prepayments, by the ability to sell
      assets at market prices, earnings, and by utilizing unpledged assets as
      collateral for borrowings. Liquidity is also derived from a variety of funding
      sources, including advances from the FHLB, and other short and long term
      borrowings.




The
      principal use of funds is to invest in loans and securities. Security purchases
      amounted to $17.3 million in 2006, down 71% from $58.9 million in purchases
      in
      2005. Security purchases totaled $47.1 million in 2004. The reduction in
      security purchases was to allow lower yielding securities to run off. Net cash
      flows funding loan activities totaled $517.3 million, $409.3 million, and $204.8
      million during 2006, 2005, and 2004, respectively. Our continued use of cash
      to
      fund loan activities reflects the continuing growth of our
      business.




The
      increased use of cash for the origination of mortgage loans held for sale
      totaled $111.7 million, $93.2 million, and $67.7 million during 2006, 2005,
      and
      2004, respectively. This corresponds to the increase in cash provided by the
      proceeds from the sales of mortgage loans with amounted to $111.7 million in
      2006, $91.3 million in 2005, and $65.8 million in 2004, reflecting the increased
      volume of business in this area.




In
      2006,
      almost all of the funding for our $598.2 increase in assets came from three
      sources; $183.0 million came from increased core deposits, $209.3 million came
      from increased certificates of deposits (cd’s) and $42.0 million came from net
      FHLB advances. In 2005, the major funding activities were cd’s which provided
      $278.9 million, net FHLB advances which provided $64.9 million and maturities
      or
      calls of securities which provided $90.3 million in cash flows. In 2004, the
      major funding activities were core deposit increases of $78.0 million, increased
      cd’s of $50.8 million and maturities or calls of securities in the amount of
      $84.1 million.




Our
      line
      of credit with the FHLB has been established at 19% of qualifying loans, which
      at December 31, 2006 equaled $597.8 million. Net advances totaled $42.0 million,
      $64.9 million and $5.0 million for 2006, 2005 and 2004, respectively. Borrowings
      totaled $282.0 million, $240.0 million, $175.1 million, at December 31, 2006,
      2005, and 2004, respectively. These borrowings represented 8.7% of year-end
      assets in 2006, 9.1% in 2005, and 7.8% in 2004.




Unused
      lines of credit available to us include $247.8 million available at FHLB and
      $85.0 million available from correspondent banks. We also have the option of
      funding asset growth or funding withdrawals with brokered deposits. At year-end
      2006, broker deposits were $44.9 million, representing 1/8% of total
      deposits.




The
      table
      on the next page is a probable indication of when we might expect assets to
      mature, but we cannot be certain that we will receive or pay out these cash
      flows as loans may be renewed and depositors may not want to roll over their
      deposits at the current rate we are willing to pay.


-
          41
          -


**MATURITY
      SCHEDULE FOR EARNING ASSETS**





In
                ThousandsDecember
                31, 2006
            
            0-1
              Year
            
            1-5
              Years
            
            After
              5
                Years
            
            Total
            
            Total
                Fair
              Value
            
            Percent
              of
                Total
              Fair
              ValueInvestments(1)
            
            $
            45,538
            
            $
            55,349
            
            $
            4,324
            
            $
            105,211
            
            $
            114,735
            
            
            3.8
            %Loans
            
            
            1,651,025
            
            
            798,176
            
            
            451,579
            
            
            2,900,780
            
            
            2,883,518
            
            
            95.6
            %Federal
                funds sold
            
            
            18,673
            
            
            -
            
            
            -
            
            
            18,673
            
            
            18,673
            
            
            0.6
            %Total
            
            $
            1,715,236
            
            $
            853,525
            
            $
            455,903
            
            $
            3,024,664
            
            $
            3,016,926
            
            
            100.0
            %





In
                ThousandsDecember
                31, 2005
            
            0-1
              Year
            
            1-5
              Years
            
            After
                5
              Years
            
            Total
              Carrying
              Cost
            
            Total
              Fair
              Value
            
            Percent
                of
              Total
              Fair
              ValueInvestments(1)
            
            $
            35,599
            
            $
            63,635
            
            $
            4,576
            
            $
            103,810
            
            $
            110,823
            
            
            4.5
            %Loans
            
            
            1,101,193
            
            
            925,635
            
            
            362,396
            
            
            2,389,224
            
            
            2,355,206
            
            
            95.5
            %Federal
                funds sold
            
            
            733
            
            
            -
            
            
            -
            
            
            733
            
            
            733
            
            
            0.0
            %Total
            
            $
            1,137,525
            
            $
            989,270
            
            $
            366,972
            
            $
            2,493,767
            
            $
            2,466,762
            
            
            100.0
            %


(1)
      Amortized cost




For
      additional information regarding liquidity, see the Statement of Cash Flows
      in
      the Consolidated Financial Statements.




**CAPITAL**




We
      are
      subject to various regulatory capital requirements administered by the federal
      banking agencies. Failure to meet minimum capital requirements can initiate
      certain mandatory and possibly additional discretionary actions by regulators
      that, if undertaken, could have a material effect on our financial statements.
      Under capital adequacy guidelines and the regulatory framework for prompt
      corrective action, we must meet specific capital guidelines that involve
      quantitative measures of assets, liabilities, and certain off-balance-sheet
      items as calculated under regulatory accounting practices. The capital amounts
      and classifications are also subject to qualitative judgments by the regulators
      about components, risk weightings, and other factors. The minimum ratios and
      the
      actual capital ratios are set forth in the table below.




CAPITAL
                RATIOS
            
            Frontier
              Financial
              Corporation
            
            Frontier
              Bank
            
            Well
              Capitalized
              MinimumTotal
                capital to risk-weighted assets
            
            
            12.85
            %
            
            11.92
            %
            
            10.00
            %Tier
                1 capital to risk-weighted assets
            
            
            11.59
            %
            
            10.66
            %
            
            6.00
            %Tier
                1 leverage capital to average assets
            
            
            11.32
            %
            
            10.47
            %
            
            5.00
            %





The
      holding company is registered with the Federal Reserve Bank as a financial
      holding company. The Federal Reserve Bank requires financial holding companies
      to meet the well-capitalized status of the regulatory capital requirements.


-
          42
          -


The
      capital of the Corporation at year-end 2006 was $395.3 million, up from $296.1
      million a year ago, or an increase of 33.5%. Frontier began paying cash
      dividends to shareowners in 1999 and approved a stock repurchase plan in 2000.
      During 2006, cash dividends of $22.4 million were paid to shareowners. The
      Corporation did not repurchase any common stock in the open market in 2006.
      Subsequent to year end, the Corporation repurchased 218,940 shares at an average
      cost per share of $26.85 through February 21, 2007.




**CONTRACTUAL
      OBLIGATIONS AND COMMITMENTS**




The
      following table sets forth the Corporation’s long-term contractual obligations
      at December 31, 2006:




In
                Thousands
            
            Payments
                due per periodLess
                Than
              One
                Year
            
            1-3
                Years
            
            3-5
                Years
            
            Thereafter
            
            TotalTime
                deposits
            
            $
            906,406
            
            $
            104,923
            
            $
            44,761
            
            $
            1,304
            
            $
            1,057,394FHLB
                borrowings
            
            
            41,369
            
            
            82,791
            
            
            92,087
            
            
            65,770
            
            
            282,017Junior
              subordinated debt
            
            
            -
            
            
            -
            
            
            -
            
            
            5,156
            
            
            5,156Operating
                leases
            
            
            1,824
            
            
            3,244
            
            
            1,944
            
            
            2,421
            
            
            9,433Total
            
            $
            949,599
            
            $
            190,958
            
            $
            138,792
            
            $
            74,651
            
            $
            1,354,000




See
      additional discussion under Notes 6, 8 and 16 of the Consolidated Financial
      Statements.




**OFF-BALANCE
      SHEET ARRANGEMENTS**




See
      Note
      16 of the Consolidated Financial Statements for discussion.




**MARKET
      FOR FRONTIER FINANCIAL CORPORATION’S COMMON STOCK AND RELATED SHAREOWNERS’
MATTERS**




Frontier
      Financial Corporation’s common stock began trading on the National Association
      of Securities Dealers’ Automated Quotation System (Nasdaq) on April 16, 1998.
      Nasdaq reported the 2006 daily average trade volume was 118,275 shares and
      a
      total trade volume of 29,686,942. During 2006, the market price of our common
      stock ranged from $20.38 to $31.33. The average price for the year was
      $24.607.




At
      December 31, 2006, the total number of shareowners of record of Frontier
      Financial Corporation’s common stock was 3,556 and there were 45,350,316 shares
      outstanding, which included 24,866,577 shares registered in street
      name.




Prior
      to
      1999 the Corporation had always paid stock dividends, which ranged from 7%
      to
      10% and the Corporation has had eight stock splits since the Bank opened in
      1978. In 1999, the Board of Directors declared the first annual cash dividend
      of
      $.25 per share on post two-for-one split shares. On January 19, 2000, the Board
      declared the first quarterly cash dividend. Please see the table below for
      the
      detail of the year 2006 dividends declared.





Dividend
                Payable
            
            Record
                Date
            
            Payable
                Date$.113
            
            January
                9, 2006
            
            January
                24, 2006$.117
            
            April
                11, 2006
            
            April
                24, 2006$.12
            
            July
                10, 2006
            
            July
                24, 2006$.15
            
            October
                10, 2006
            
            October
                24, 2006





The
      Board
      will continue to review the dividend policy on a quarterly
      basis.


-
          43
          -




**STOCK
      REPURCHASE PROGRAM**




There
      was
      no stock repurchase activity in 2006. On August 16, 2006, the Corporation
      authorized a new plan to repurchase 5% of its outstanding stock. There are
      currently 2,263,323 authorized under this plan. Subsequent to year-end, the
      Corporation repurchased 218,940 shares at an average cost per share of $26.85
      through February 21, 2007.




**LOAN
      PORTFOLIO**





The
      Bank
      classifies its lending activities in the following principal areas: installment,
      commercial and agriculture, real estate commercial, real estate construction
      and
      land development, and residential. As of December 31, 2006, these categories
      accounted for approximately 2.2%, 13.4%, 32.9%, 43.2% and 8.3% respectively
      of
      the Bank’s loan portfolio.





The
      chart
      below summarizes the composition of the loan portfolio for the past three years
      by average balance:




In
                Thousands
            
            2006
            
            2005
            
            2004Amount
            
            Percentage
            
            Amount
            
            Percentage
            
            Amount
            
            PercentageInstallment
            
            $
            60,871
            
            
            2.2
            %
            $
            47,930
            
            
            2.2
            %
            $
            44,111
            
            
            2.3
            %Commercial
                and agriculture
            
            
            366,601
            
            
            13.4
            %
            
            320,923
            
            
            14.6
            %
            
            287,180
            
            
            15.2
            %Real
                estate commercial
            
            
            897,258
            
            
            32.9
            %
            
            866,647
            
            
            39.4
            %
            
            831,823
            
            
            44.1
            %Real
                estate construction and land development
            
            
            1,180,486
            
            
            43.2
            %
            
            779,364
            
            
            35.4
            %
            
            564,726
            
            
            29.9
            %Real
                estate residential
            
            
            226,041
            
            
            8.3
            %
            
            185,480
            
            
            8.4
            %
            
            159,688
            
            
            8.5
            %Total
            
            $
            2,731,257
            
            
            100.0
            %
            $
            2,200,344
            
            
            100.0
            %
            $
            1,887,528
            
            
            100.0
            %





Total
      average loan balances increased $530.9 million, or 24.1% over the average
      balance for 2005. Loan balances in 2005 increased $312.8 million, or 16.6%
      over
      2004. 2004 average loans increased $196.5 million, or 11.6% over 2003. These
      increases were mostly driven by the increases in real estate commercial and
      real
      estate construction and land development loans that, combined, have historically
      comprised the largest portion of the Corporation’s loan portfolio and
      represented 76% of the loan portfolio in 2006.





The
      average balances of real estate construction and land development loans, which
      represented 43.2% of the Corporation’s loan mix in 2006, increased by $401.1
      million, or 51%, as continued demand for housing and favorable interest rates
      continue to fuel this growth. Real estate construction loans are generally
      composed of commitments to customers within our market area for construction
      purposes. Loans within this category are used for construction projects that
      range from residential and commercial land development to residential and
      commercial building projects. They are generally secured by first trust deeds
      with well-defined repayment sources following project completion. Maturities
      are
      set to match the time required for project completion, which typically run
      from
      12 to 18 months depending on complexity.





Our
      commercial real estate portfolio consists of a wide cross-section of retail,
      small office, warehouse, and industrial type properties. These loans are secured
      by first trust deeds with maturities from three to ten years and original
      loan-to-value ratios generally from 65% to 75%. Ten-year maturities generally
      reprice every five years. A substantial number of these properties are
      owner-occupied. While the Corporation has significant balances within this
      lending category, management believes that its lending policies and underwriting
      standards are sufficient to minimize risk even during uncertain economic times.
      Management closely monitors the effects of current and expected market
      conditions and other factors that may influence the repayment of these
      loans.





Average
      commercial and agriculture loans balances increased $45.7 million, or 14.2%
      in
      2006. Expanding our branch network and the recruitment of seasoned local lenders
      provided strong support for favorable growth in commercial loan totals.


-
          44
          -


At
      2.2%
      of total average loans, our installment lending continues to be the smallest
      portion of our overall loan portfolio, while these loans increased 27% in 2006,
      the percentage of these loans remained relatively unchanged for the year. This
      area of consumer lending continues a shift toward credit card, factory-lending
      programs for automobiles and home equity lines of credit. While the Corporation
      does offer credit cards and home equity lines, emphasis has not been placed
      on
      these product offerings.





Real
      estate residential loans averaged $226.0 million in 2006. Loans within this
      category are used to finance individual owner and nonowner occupied residences.
      These loans will generally be repaid at maturity as they move into lower
      interest rate term mortgage loans available through secondary market programs.





The
      yield
      on the loan portfolio average balance increased to 8.98% in 2006 from 7.92%
      in
      2005 and 7.08% in 2004. There were four rate increases in 2006 and eight rate
      increases in 2005. Although FRB increased rates five times in the second half
      of
      2004, many variable rate loans in our portfolio had floors, which slowed down
      the increase in interest income.





For
      2006,
      the tax equivalent interest and fees totaled $245.3 million, increasing $70.9
      million or 40.7% from the prior year-end. In 2005 we saw an increase in tax
      equivalent loan interest and fees, which totaled $174.3 million and increased
      $40.6 million, or 30.4% from 2004. Tax equivalent interest and fee income from
      loans increased $6.8 million in 2004, or 5.3%. The increase of $530.9 million
      in
      the average balances of loans in 2006 increased interest income $46.5 million
      and the increase in rates increased interest income by $24.4 million, for a
      total increase of $70.9 million. The increase of $312.8 million in the average
      balance of loans in 2005 increased interest income $23.1 million and the
      increase in rates increased interest income by $17.5 million, for a net increase
      of $40.6 million. The increase of $196.5 million in the average balance of
      loans
      in 2004 increased interest income by $15.0 million and the decline in rates
      reduced interest income by $8.2 million, for a net increase of $6.8 million.





**CRITICAL
      ACCOUNTING POLICIES AND ESTIMATES**





The
      preparation of the consolidated financial statements in conformity with
      accounting principles generally accepted in the United States requires
      management to make estimates and assumptions that affect amounts reported in
      the
      consolidated financial statements and the accompanying notes. Changes in these
      estimates and assumptions are considered reasonably possible and may have a
      material impact on the consolidated financial statements and thus actual results
      could differ from the amounts reported and disclosed herein. The Company
      considers the allowance for loan loss a critical accounting policy subject
      to
      estimate.





For
      additional information regarding the allowance for loan losses, see “Analysis of
      the Allowance for Loan Losses” in this Management’s Discussion and Analysis and
“Allowance for Loan Losses” in Note 1 in Notes to the Consolidated Financial
      Statements.




The
      Company’s financial statements are based on the selection and application of
      significant accounting policies which require management to make significant
      estimates and assumptions (see Note 1 to the consolidated financial statements).
      The Company believes that the allowance for loan losses is one of the more
      critical judgment areas in the application of its accounting policies that
      affect financial condition and results of operations. This is more fully
      described in the Liquidity section.





Material
      estimates that are particularly susceptible to significant change, relate to
      the
      determination of the allowance for loan losses, deferred income taxes, and
      the
      valuation of stock options, and valuation of real estate acquired in connection
      with foreclosures or in satisfaction of loans. In connection with the
      determination of the allowance for loan losses and the valuation of foreclosed
      assets held for sale, management obtains independent appraisals for significant
      properties.


-
          45
          -


**FORWARD
      LOOKING STATEMENTS**





Except
      for historical financial information contained herein, the matter discussed
      in
      this annual report of the Corporation may be considered “forward-looking
      statements” within the meaning of Section 27A of the Securities Act of 1993, as
      amended, and Section 21E of the Securities Exchange Act of 1934, as amended
      and
      subject to the safe harbor created by the Private Securities Litigation Reform
      Act of 1995. Forward-looking statements are subject to risks and uncertainties
      that may cause actual future results to differ materially. Sentences containing
      words such as “may”, “will”, “expect”, “anticipate”, “believe”, “estimate”,
“should”, “projected” or similar words may constitute forward-looking statement.
      The Corporation may have used the statements to describe expectations and
      estimates in various areas, including, but not limited to: changes in the
      economy of the markets in which it operates: interest rate movements; future
      acquisitions and growth strategies; system conversions and integration
      activities; the impact of competitive products, services and pricing; and
      legislative, regulatory and accounting changes affecting the banking and
      financial service industry. Actual results could vary materially from the future
      results covered in forward-looking statements. Factors such as interest rate
      trends and loan delinquency rates, as well as the general state of the economy
      in Washington state and the United States as a whole, could also cause actual
      results to vary materially from the future results anticipated in such
      forward-looking statements. These factors should be considered in evaluating
      the
      forward-looking statements and undue reliance should not be placed on such
      statements.


-
          46
          -





***AVERAGE
      BALANCES AND TAX-EQUIVALENT NET INTEREST MARGIN - Table
      1***





Year
                Ended December 31,2006
            
            2005
            
            2004In
                Thousands
            
            Average
              Balance
            
            Interest
              Income/
              Expense
            
            Average
                Rates Earned/
              Paid
            
            Average
              Balance
            
            Interest
              Income/
              Expense
            
            Average
                Rates
              Earned/
              Paid
            
            Average
              Balance
            
            Interest
              Income/
              Expense
            
            Average
              Rates
                Earned/
              Paid**Interest
                Earning Assets**Taxable
                investments
            
            $
            102,488
            
            $
            4,097
            
            
            4.00
            %
            $
            117,268
            
            $
            4,586
            
            
            3.91
            %
            $
            154,381
            
            $
            6,411
            
            
            4.15
            %Nontaxable
                investments (1)
            
            
            4,872
            
            
            306
            
            
            6.28
            %
            
            5,810
            
            
            423
            
            
            7.28
            %
            
            9,438
            
            
            731
            
            
            7.75
            %Total
            
            
            107,360
            
            
            4,403
            
            
            4.10
            %
            
            123,078
            
            
            5,009
            
            
            4.07
            %
            
            163,819
            
            
            7,142
            
            
            4.36
            %Federal
                funds sold
            
            
            28,534
            
            
            1,448
            
            
            5.07
            %
            
            11,445
            
            
            361
            
            
            3.15
            %
            
            13,779
            
            
            170
            
            
            1.23
            %Loans
                (1) (2)Installment
            
            
            60,871
            
            
            5,764
            
            
            9.47
            %
            
            47,930
            
            
            4,244
            
            
            8.85
            %
            
            44,111
            
            
            3,626
            
            
            8.22
            %Commercial(1)
            
            
            366,601
            
            
            31,013
            
            
            8.46
            %
            
            320,923
            
            
            23,364
            
            
            7.28
            %
            
            287,180
            
            
            18,383
            
            
            6.40
            %Real
                estateCommercial
                (1)
            
            
            897,258
            
            
            68,350
            
            
            7.62
            %
            
            866,647
            
            
            60,468
            
            
            6.98
            %
            
            831,823
            
            
            56,868
            
            
            6.84
            %Construction
            
            
            1,180,486
            
            
            121,319
            
            
            10.28
            %
            
            779,364
            
            
            71,155
            
            
            9.13
            %
            
            564,726
            
            
            43,110
            
            
            7.63
            %Residential
            
            
            226,041
            
            
            18,826
            
            
            8.33
            %
            
            185,480
            
            
            15,111
            
            
            8.15
            %
            
            159,688
            
            
            11,718
            
            
            7.34
            %Total
            
            
            2,731,257
            
            
            245,272
            
            
            8.98
            %
            
            2,200,344
            
            
            174,342
            
            
            7.92
            %
            
            1,887,528
            
            
            133,705
            
            
            7.08
            %Total
                earning assets/total interest income
            
            
            2,867,151
            
            
            251,123
            
            
            8.76
            %
            
            2,334,867
            
            
            179,712
            
            
            7.70
            %
            
            2,065,126
            
            
            141,017
            
            
            6.83
            %Reserve
                for loan losses
            
            
            (38,766
            )
            
            
            
            
            
            
            
            (32,031
            )
            
            
            
            
            
            
            
            (28,908
            )Cash
                and due from banks
            
            
            83,351
            
            
            
            
            
            
            
            
            80,644
            
            
            
            
            
            
            
            
            75,768Other
                assets
            
            
            129,836
            
            
            
            
            
            
            
            
            85,205
            
            
            
            
            
            
            
            
            69,260TOTAL
                ASSETS
            
            $
            3,041,572
            
            
            
            
            
            
            
            $
            2,468,685
            
            
            
            
            
            
            
            $
            2,181,246**Interest
                Bearing Liabilities**Money
                Market, Sweep & NOW accounts
            
            $
            542,335
            
            
            17,123
            
            
            3.16
            %
            $
            302,497
            
            
            4,195
            
            
            1.39
            %
            $
            249,789
            
            
            1,707
            
            
            0.68
            %Savings
                accounts
            
            
            374,167
            
            
            8,718
            
            
            2.33
            %
            
            575,164
            
            
            11,539
            
            
            2.01
            %
            
            649,678
            
            
            9,246
            
            
            1.42
            %Other
                time deposits
            
            
            1,063,229
            
            
            47,685
            
            
            4.48
            %
            
            708,201
            
            
            24,980
            
            
            3.53
            %
            
            539,784
            
            
            15,465
            
            
            2.87
            %Total
                interest bearing deposits
            
            
            1,979,731
            
            
            73,526
            
            
            3.71
            %
            
            1,585,862
            
            
            40,714
            
            
            2.57
            %
            
            1,439,251
            
            
            26,418
            
            
            1.84
            %Short-term
                borrowings
            
            
            20,089
            
            
            910
            
            
            4.53
            %
            
            21,614
            
            
            588
            
            
            2.72
            %
            
            15,400
            
            
            156
            
            
            1.01
            %FHLB
                borrowings
            
            
            258,991
            
            
            12,195
            
            
            4.71
            %
            
            221,392
            
            
            10,434
            
            
            4.71
            %
            
            180,860
            
            
            8,365
            
            
            4.63
            %Subordinated
                debt
            
            
            4,726
            
            
            311
            
            
            6.58
            %
            
            -
            
            
            -
            
            
            
            
            
            -
            
            
            -Total
                interest bearingliabilities/totalinterest
                expense
            
            
            2,263,537
            
            
            86,942
            
            
            3.84
            %
            
            1,828,868
            
            
            51,736
            
            
            2.83
            %
            
            1,635,511
            
            
            34,939
            
            
            2.14
            %Noninterest
                bearing deposits
            
            
            389,945
            
            
            
            
            
            
            
            
            348,737
            
            
            
            
            
            
            
            
            298,711Other
                liabilities
            
            
            23,722
            
            
            
            
            
            
            
            
            15,979
            
            
            
            
            
            
            
            
            12,481Shareowners'
                equity
            
            
            364,368
            
            
            
            
            
            
            
            
            275,101
            
            
            
            
            
            
            
            
            234,543TOTAL
                LIABILITIES AND CAPITAL
            
            $
            3,041,572
            
            
            
            
            
            
            
            $
            2,468,685
            
            
            
            
            
            
            
            $
            2,181,246NET
                INTEREST INCOME
            
            
            
            
            $
            164,181
            
            
            
            
            
            
            
            $
            127,976
            
            
            
            
            
            
            
            $
            106,078NET
                YIELD ON INTEREST EARNING ASSETS
            
            
            
            
            
            
            
            
            5.73
            %
            
            
            
            
            
            
            
            5.48
            %
            
            
            
            
            
            
            
            5.14
            %





(1)
      Includes amounts to convert nontaxable amounts to a fully taxable equivalent
      basis at a 35% tax rate.


(2)
      Includes nonaccruing loans.


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          47
          -




***RATE/VOLUME
      ANALYSIS OF CHANGES IN NET INTEREST INCOME - Table 2***





Year
                ended December 31,2006
                versus 2005
            
            2005
                versus 2004
            
            2004
                versus 2003In
                Thousands
            
            Increase
                (Decrease) Due
              to
                Change in
            
            Increase
                (Decrease) Due
              to
                Change in
            
            Increase
                (Decrease) Due
              to
                Change inAverage
              Volume
            
            Average
              Rate
            
            Total
              Increase
              (Decrease)
            
            Average
              Volume
            
            Average
              Rate
            
            Total
              Increase
              (Decrease)
            
            Average
              Volume
            
            Average
              Rate
            
            Total
              Increase
              ](Decrease)INTEREST
                INCOMETaxable
                investments
            
            
            ($578
            )
            $
            89
            
            
            ($489
            )
            
            ($1,541
            )
            
            ($284
            )
            
            ($1,825
            )
            $
            659
            
            
            ($1,293
            )
            
            ($634
            )Nontaxable
                investments
            
            
            (68
            )
            
            (49
            )
            
            (117
            )
            
            (281
            )
            
            (27
            )
            
            (308
            )
            
            (837
            )
            
            (36
            )
            
            (873
            )Total
            
            
            (646
            )
            
            40
            
            
            (606
            )
            
            (1,822
            )
            
            (311
            )
            
            (2,133
            )
            
            (178
            )
            
            (1,329
            )
            
            (1,507
            )Federal
                funds sold
            
            
            539
            
            
            548
            
            
            1,087
            
            
            (29
            )
            
            220
            
            
            191
            
            
            (412
            )
            
            24
            
            
            (388
            )LoansInstallment
            
            
            1,146
            
            
            374
            
            
            1,520
            
            
            314
            
            
            304
            
            
            618
            
            
            119
            
            
            (225
            )
            
            (106
            )Commercial
            
            
            3,325
            
            
            4,324
            
            
            7,649
            
            
            2,160
            
            
            2,821
            
            
            4,981
            
            
            796
            
            
            (1,318
            )
            
            (522
            )Real
                estateCommercial
            
            
            2,136
            
            
            5,746
            
            
            7,882
            
            
            2,381
            
            
            1,219
            
            
            3,600
            
            
            5,155
            
            
            (4,437
            )
            
            718Construction
            
            
            36,622
            
            
            13,542
            
            
            50,164
            
            
            16,385
            
            
            11,660
            
            
            28,045
            
            
            7,198
            
            
            (1,390
            )
            
            5,808Residential
            
            
            3,304
            
            
            411
            
            
            3,715
            
            
            1,893
            
            
            1,500
            
            
            3,393
            
            
            1,760
            
            
            (897
            )
            
            863Total
            
            
            46,533
            
            
            24,397
            
            
            70,930
            
            
            23,133
            
            
            17,504
            
            
            40,637
            
            
            15,028
            
            
            (8,267
            )
            
            6,761TOTAL
                INTERESTINCOME
            
            
            46,426
            
            
            24,985
            
            
            71,411
            
            
            21,282
            
            
            17,413
            
            
            38,695
            
            
            14,438
            
            
            (9,572
            )
            
            4,866INTEREST
                EXPENSEMoney
                Market, Sweep &NOW
                accounts
            
            
            3,326
            
            
            9,602
            
            
            12,928
            
            
            360
            
            
            2,128
            
            
            2,488
            
            
            (188
            )
            
            (716
            )
            
            (904
            )Savings
                accounts
            
            
            (4,032
            )
            
            1,211
            
            
            (2,821
            )
            
            (1,060
            )
            
            3,353
            
            
            2,293
            
            
            1,299
            
            
            (2,643
            )
            
            (1,344
            )Other
                time deposits
            
            
            12,523
            
            
            10,182
            
            
            22,705
            
            
            4,825
            
            
            4,690
            
            
            9,515
            
            
            621
            
            
            (1,862
            )
            
            (1,241
            )Total
                interest bearing deposits
            
            
            11,817
            
            
            20,995
            
            
            32,812
            
            
            4,125
            
            
            10,171
            
            
            14,296
            
            
            1,732
            
            
            (5,221
            )
            
            (3,489
            )Short-term
                borrowings
            
            
            (41
            )
            
            363
            
            
            322
            
            
            63
            
            
            369
            
            
            432
            
            
            (22
            )
            
            19
            
            
            (3
            )FHLB
                borrowing
            
            
            1,772
            
            
            (11
            )
            
            1,761
            
            
            1,875
            
            
            194
            
            
            2,069
            
            
            1,208
            
            
            (606
            )
            
            602Subordinated
                debt
            
            
            -
            
            
            311
            
            
            311
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -TOTAL
                INTERESTEXPENSE
            
            
            13,548
            
            
            21,658
            
            
            35,206
            
            
            6,063
            
            
            10,734
            
            
            16,797
            
            
            2,918
            
            
            (5,808
            )
            
            (2,890
            )CHANGE
                IN NETINTEREST
                INCOME
            
            $
            32,878
            
            $
            3,327
            
            $
            36,205
            
            $
            15,219
            
            $
            6,679
            
            $
            21,898
            
            $
            11,520
            
            
            ($3,764
            )
            $
            7,756




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